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401k Basics

the concepts that shape 401k plans


401k Plans

401k Plans Are Defined Contribution Plans

The Plan Sponsor

The Plan Sponsor

The Plan Vendor

The Plan Vendor

Third-party Administrators

Third-party Administrators

Auto Enrollment

Auto Enrollment

Employee Contributions

Employee Contributions

Employer Contributions

Employer Contributions

Employer Contributions

401k Contribution Guidelines and Limitations.

401k Investments

401k Investments

401k Investing

401k Investing and Tax-deferred Saving

Withdrawals and 401k Loans)

Withdrawals and 401k Loans

ERISA Participant Rights Protections)

ERISA Participant Rights Protections

IRS Compliance Testing)

IRS Compliance Testing

Safe Harbor 401k Plan Administration)

Safe Harbor 401k Plan Administration

Economic Growth and Tax Reconciliation)

Economic Growth and Tax Reconciliation Act of 2001 (EGTRA)

401k-Type Plans)

401k-Type Plans for One-Person Businesses

[topic 1]

401k Plans Are Defined Contribution Plans

A 401k plan is what's called a defined contribution retirement savings plan. In defined contribution plans...

-- The amount contributed to each participant's account is set ("defined") -- either by the plan participant or by the employer, and as either a flat rate or a percentage of pay.


-- The amount each participant will receive upon retirement is left up to the effect of investment performance on the contributions.

Other defined contribution retirement savings plans include SEPs, Simple IRAs, Profit Sharing Plans, and Money Purchase Plans. The 401k is by far the most popular.

Defined contribution plans differ from traditional pension plans, called defined benefit plans, which specify specific amounts of money (the "benefit") employees will receive when they retire rather than the periodic contribution amounts that will be put into the plan to ensure that final benefit amount.

In 401k plans...

-- Each participating employee decides the amount to be withheld each month from his or her pay as a 401k contribution.

-- The employer withholds these amounts BEFORE calculating income taxes on the employee's pay.

-- The employer forwards the money to a third party administrator, who invests the employees' contributions per specific instructions provided by the employees.

-- Some employers choose to add to participants' 401k contributions through employer matching contributions.

[topic 2]

The Plan Sponsor

401k plans must be "sponsored" by an employer. Their very IRS-mandated operation -- i.e., that contributions are pulled from employees' pay BEFORE are taxes -- is predicated upon the plans being run through the employer.

401k plan sponsorship does not, however, mean the employer must contribute financially to its 401k plan. Please see "Employer Contributions" below for information on contribution options -- including the option not to contribute -- open to plan sponsors.

The Internal Revenue Code allows for retirement savings plans that DO NOT require employer sponsorship; these include annuities and Individual Retirement Accounts (IRAs), but the 401k plan is by far the most popular:

-- 401k plans are extremely convenient for plan participants. Participants simply establish the contribution level they want, then the employer has the amount pulled from the participant's pre-tax pay each period and forwarded to the 401k investments the participant has selected. Participants save money they might spend if it was ever issued to them and left up to them to deposit in their retirement account.

-- 401k plans allow for significantly higher annual contribution levels than IRAs or annuities.

-- Higher contribution levels mean a greater impact on lowering participants' current income taxes.

-- Higher contribution levels mean more money being set aside -- and allowed to compound -- for retirement.

-- 401k plans can include loan features that allow participants to borrow from their retirement savings; IRAs and most annuities do not offer the  possibility of loans.

Plan sponsorship generally entails the employer appointing an in-house person to act as liaison between the plan's vendors and the company's employees. This person is the plan administrator (not to be confused with the outside vendor, if any, providing the overall plan administration; in the case of run-it-yourself 401k plans such as 401(k) Easy, there is no such outside vendor).

[topic 3]

The Plan Vendor

401k plans are supplied by a vendor, who typically supplies the 401k plan itself and all its related documentation. The vendor deals with the IRS and related governing agencies in making sure the startup plan is consistent with current regulations.

Often the vendor supplies 401k administration services, too. Sometimes the vendor even supplies its own lineup of 401k plan investments.

-- Administration for a 401k plan can be legally supplied almost any party -- the plan vendor, the plan sponsor, or any third party -- so long as the plan is run in accordance with current regulations.

-- Investments for a 401k plan can be supplied by the plan vendor or by another party, the investment custodian.

[topic 4]

Third-party Administrators (TPAs)

Administration for a 401k plan can be legally supplied almost any party -- the plan vendor, the plan sponsor, or a third party -- so long as the plan is run in accordance with current regulations, among them IRS compliance testing stipulations.

-- Third-party administrators (TPAs) are often contracted by 401k vendors or by the 401k plan sponsors themselves to handle a 401k plan's month to month administration.

-- Plan sponsors (i.e., the employers) supply the third-party administrators with payroll and related 401k participation data (such as loan and distribution requests) each month. The TPA processes the data and instructs the plan sponsor regarding forwarding 401k monies to the appropriate investment custodian(s).

-- 401(k) Easy is like a plan sponsor's personal third-party administrator residing within the employer's desktop PC. The software handles all plan administration off the payroll and related data the plan sponsor feeds it and supplies the plan sponsor with instructions regarding forwarding monies to the appropriate investment parties.

-- Go to Key Reasons to Choose 401(k) Easy for a brief comparison of 401k plan administration via traditional third-party administrators and via 401(k) Easy.

[topic 5]

Auto Enrollment

The 401k "auto enrollment" procedure allows employers to AUTOMATICALLY enroll employees in the 401k plan as soon as the employee meets the plan's eligibility requirements. Employees can elect to decline enrollment at any time.

-- The employer must set the auto enrollment contribution level in advance; 3% to 5% of compensation is the typical auto enrollment contribution level chosen.

-- The employer must set an auto enrollment investment selection ahead of time; a money market fund is the most typical auto enrollment investment.

-- Employers must, at least annually, notify all employees that the company 401k uses the auto enrollment feature and how an employee can cease participation in the plan or put a block on being enrolled automatically in it.

-- Employers must immediately notify auto-enrolled employees of their new 401k participation status.

-- Any employer contributions being made to traditionally-enrolled participants' accounts must also be made to auto-enrolled participants' accounts.

-- Auto-enrolled plan participants must have the opportunity to change their default investment selection and/or contribution rate.

-- If an automatically-enrolled employee soon after cancels his or her participation in the plan, any money put into the plan on the person's behalf must stay in the plan until the person's employment is terminated, or the employee reaches age 65.  At that point, the employee has the same withdrawal choices (IRA rollover, rollover into another employer's qualified retirement plan, or distribution) as any 401k participant of the same age and employment status.

Automatic enrollment is also called passive enrollment and negative enrollment; the default contribution and investment designations are called the plan's negative elections.

The IRS has only recently approved negative elections and certain legalities outside of the scope of the IRS remain unclear. It is prudent to consult a legal advisor before adopting automatic enrollment for your 401k plan.

[topic 6]

Employee Contributions

Contributions to a 401k account can come from employees and/or their employers. Employee contributions are withheld from the participant's pay BEFORE income tax withholding is calculated. Thus, 401k contributions are pre-tax contributions.

-- Employees can also transfer their money into their current 401k from their previous employer's 401k in the form of a rollover. Consolidating accounts can simplify oversight and management of a comprehensive investment strategy under the direction and control of the plan participant.

-- Participating in a 401k plan can reduce a person's lifetime income tax burden, because income taxes aren't assessed on 401k contributions until the money is withdrawn from the plan, usually years down the road, during retirement, when the participant is likely in a lower income tax bracket.

Employees cannot contribute more than 15% of their annual earnings to their 401k account. Additionally, they cannot contribute more than $11,000 (for year 2002) of their annual earnings to their 401k account, a limit adjusted each year by lawmakers.

-- These limits apply to employee contributions only.

-- Employer contributions to an employee's account can take the total annual contribution amount much higher.

-- Returns earned on 401k investments are never included in these annual contribution limits and can be a substantial source of growth for a 401k account.

[topic 7]

Employer Contributions

Contributions to a 401k account can come from employees and/or their employers. Employers choose whether or not to contribute to their employees 401k accounts. If they choose to contribute, they can do so in any of three ways:

-- In a flat fixed-dollar amount to each participant's account (e.g., $500 to each participant's account each year)

-- At a fixed rate of each participant's pay (e.g., each participant gets an amount equal to 3% of his or her salary).  This is called a profit sharing contribution or a discretionary employer contribution.

-- At a rate that depends on how much the employee contributes to the 401k plan, This is called a matching contribution. Because matching contributions depend on the employee's level of participation (25¢ for every dollar the employee contributes, for example), they encourage employees to join the 401k, contribute as much money as they can, and stay with the company over the years.

-- Employers are NOT required to contribute to their employees' 401k accounts in any way. Employer contributions are completely voluntary on the part of the employer (unless being used to satisfy a plan imbalance, in which case qualified nonelective contributions might be made to, say, all nonhighly compensated employees' accounts).

Any employer qualified nonelective contributions are 100% vested to employees when made. Employer matching and profit sharing contributions, on the other hand, do not have to immediately become the property of the employees. Instead, employers can impose a vesting schedule by which the 401k participants gain full ownership of employer contributions incrementally, over time. For example...

-- An employer chooses to make matching contributions of 25¢ to each dollar plan participants contribute. This is called the matching formula.

-- The employer stipulates that people who have participated in the plan two years or less only get 25% ownership of these employer-provided matching contributions. People who have participated in the plan three years get 50% ownership of the matching contributions. People who have participated in the plan four years get 75% ownership of the matching contributions, and people who have participated in the plan five years or more get 100% ownership of matching contributions. This schedule of ownership is an example of a vesting formula. It is relevant if a participant leaves the plan before reaching fully vested status. Any non-vested employer contributions revert back to the plan and can be used to pay matching contributions owed to other participants.

-- The  Internal Revenue Code places dollar amount ceilings and other restrictions on matching and vesting formulas.


[topic 8]

401k Contribution Guidelines and Limitations.

There are federally mandated limitations as to how much an employee can contribute to his or her 401(k) plan annually, and how much the employer can likewise contribute to the company's plan. The following information and examples are provided by the IRS:

• The limit is $15,500 for 2008 and $16,500 for 2009. 
• The limit is subject to cost-of-living increases after 2009.

Generally, all elective deferrals that you make to all plans in which you participate must be considered to determine if the dollar limits are exceeded.

Limits on the amount of elective deferrals that you can contribute to a SIMPLE 401(k) plan are different from those in a traditional or safe harbor 401(k).

• The limit is $10,500 for 2008 and $11,500 for 2009. 
• The limit is subject to cost-of-living increases after 2009.

Although, general rules for 401(k) plans provide for the dollar limit described above, that does not mean that you are entitled to defer that amount. Other limitations may come into play that would limit your elective deferrals to a lesser amount. For example, your plan document may provide a lower limit or the plan may need to further limit your elective deferrals in order to meet nondiscrimination requirements.

Catch-up contributions. For tax years beginning after 2001, a plan may permit participants who are age 50 or over at the end of the calendar year to make additional elective deferral contributions. These additional contributions (commonly referred to as catch-up contributions) are not subject to the general limits that apply to 401(k) plans. An employer is not required to provide for catch-up contributions in any of its plans. However, if your plan does allow catch-up contributions, it must allow all eligible participants to make the same election with respect to catch-up contributions.

If you participate in a traditional or safe harbor 401(k) plan and you are age 50 or older:

• The elective deferral limit increases by $5,000 for 2008 and $5,500 for 2009.
• The limit is subject to cost-of-living increases after 2009.

If you participate in a SIMPLE 401(k) plan and you are age 50 or older:

• The elective deferral limit increases by $2,500 for 2008 and 2009.
• The limit is subject to cost-of-living increases after 2009.

The catch-up contribution you can make for a year cannot exceed the lesser of the following amounts:

• The catch-up contribution limit, above, or
• The excess of your compensation over the elective deferrals that are not catch-up contributions.

 Participation in plans of unrelated employers. If you participate in plans of different employers, you can treat amounts as catch-up contributions regardless of whether the individual plans permit those contributions. In this case, it is up to you to monitor your deferrals to make sure that they do not exceed the applicable limits.

Example: If Joe Saver, who’s over 50, has only one employer and participates in that employer’s 401(k) plan, the plan would have to permit catch-up contributions before he could defer the maximum of $20,500 for 2008 (the $15,500 regular limit for 2008 plus the $5,000 catch-up limit for 2008). If the plan didn’t permit catch-up contributions, the most Joe could defer would be $15,500. However, if Joe participates in two 401(k) plans, each maintained by an unrelated employer, he can defer a total of $20,500 even if neither plan has catch-up provisions. Of course, Joe couldn’t defer more than $15,500 under either plan and he would be responsible for monitoring his own contributions. 

The rules relating to catch-up contributions are complex and your limits may differ according to provisions in your specific plan. You should contact your plan administrator to find out whether your plan allows catch-up contributions and how the catch-up rules apply to you.

Treatment of excess deferrals. If the total of your elective deferrals is more than the limit, you can have the difference (called an excess deferral) returned to you from any of the plans that permit these distributions. You must notify the plan by April 15 of the following year of the amount to be paid from the plan. The plan must then pay you that amount plus allocable earnings by April 15 of the year following the year in which the excess occurred. 

Excess withdrawn by April 15. If you withdraw the excess deferral for 2007 by April 15, 2008, it is includable in your gross income for 2007, but not for 2008. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10% tax on early distributions.

Excess not withdrawn by April 15. If you do not take out the excess deferral by April 15, 2008, the excess, though taxable in 2007, is not included in your cost basis in figuring the taxable amount of any eventual distributions from the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan. 

Reporting corrective distributions on Form 1099-R. Corrective distributions of excess deferrals (including any earnings) are reported to you by the plan on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. 

Additional limits. There are other limits that restrict contributions made on your behalf. In addition to the limit on elective deferrals, annual contributions to all of your accounts - this includes elective deferrals, employee contributions, employer matching and discretionary contributions and allocations of forfeitures to your accounts - may not exceed the lesser of 100% of your compensation or $46,000 (for 2008, $49,000 for 2009). In addition, the amount of your compensation that can be taken into account when determining employer and employee contributions is limited. In 2008, the compensation limitation is $230,000; for 2009, the limit is $245,000.

[topic 9]

401k Investments

Certain types of investments are "qualified" under the Internal Revenue Code to receive 401k contributions. These include:

-- Mutual fund investments (stocks, bonds and money market funds). Mutual fund investments are by far the most popular 401k investments.

-- Publicly traded stocks and bonds (excepting municipal or tax free bonds)

-- Bank collective funds

-- Insurance company investments

Every 401k plan must offer a minimum spectrum of investments, as defined in the Internal Revenue Code.

-- Most plans offer between five and 15 investment choices.

-- Returns earned on 401k investments are automatically reinvested in the participants' accounts, increasing the account value over time.

-- Removing investment returns from a 401k, just like removing any other money from a 401k account, constitutes a withdrawal and is subject to the penalties and withholdings of such.

[topic 10]

401k Investing and Tax-deferred Saving

All 401k contributions -- employee, employer and even returns earned on 401k investments -- are exempt from income taxation (in most cases state, in all cases federal) so long as the money remains in the plan. Delaying income taxation can have a dramatic positive effect on the compounding growth of an account:

-- An investor can amass nearly THREE TIMES as much money in a 401k tax-deferred investment over a 30 year period as in a  taxable savings plan or investments earning the same rate of return but whose returns are reduced each year by income taxation.

-- When money is taken out of a 401k plan -- for ANY reason except a 401k loan or rollover into an IRA or new employer's 401k plan -- it is considered income and taxed as such.

[topic 11]

Withdrawals and 401k Loans

Although 401k plans are meant to be long term savings vehicles, participants cannot leave money in a 401k account indefinitely:

-- Plan participants generally MUST begin taking withdrawals from their 401k accounts when they reach age 70 1/2.

-- Plan participants CAN begin taking withdrawals from their 401k accounts as soon as they reach age 59 1/2.

-- Earlier withdrawals can be made without penalty if the participant dies or incurs a qualifying permanent disability.

-- At any time, a plan participant leaving the company can remove his or her 401k money without subjecting it to early withdrawal penalties by rolling the money over into a Rollover IRA or new employer's qualified retirement savings plan (401k or other).

Outside of these instances, there are only two ways for participants to withdrawal money from a 401k account while employed: hardship withdrawal and 401k loan.




401k LOAN

Does NOT have to be paid back

Must be paid back within the agreed-upon time (within six months if the participant leaves the company)

No interest

Bears interest (market rate, or thereabouts)

Substantial federal early withdrawal penalties

No federal early withdrawal penalties, unless the loan goes into default

Six month suspension of 401k participation upon taking out of a hardship withdrawal

No participation suspension

Substantial long-term negative effect on the compounding growth of the 401k account

Less substantial long-term effect on the compounding growth of the 401k account -- but still a significant negative effect

Sometimes asset liquidation fees

Sometimes assets liquidation fees

Plan participant generally ends up with about 1/2 of the amount withdrawn (the reminder goes to taxes and federal early withdrawal penalties)

Plan participant generally ends up with most of the amount withdrawn

Withdrawn money taxed as income for the year

No tax consequences (unless participant defaults on loan)

Must be included in all 401k plans

Does NOT have to be included in 401k plans

Generally involve nominal administrative processing costs

Generally involve nominal administrative processing costs

All other resources must have been exhausted for person to qualify

Qualifications less stringent

Hardship withdrawals and 401k loans can increase a plan's popularity even if participants never take advantage of the features, because employees don't feel participation means sending their money into some seemingly never-to-be-seen-again abyss. Retirement, after all, may be decades away.

[topic 12]

ERISA Participant Rights Protections

Two bodies of legal work comprise the framework for 401k plans: the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA).

ERISA sets standards for, among other things...

-- Participant eligibility

-- Investment choice

-- Plan funding/bonding

-- Vesting of employer contributions

-- Disclosure of plan and investment and investing-related information to current and prospective plan participants and their beneficiaries

ERISA aims to ensure that retirement monies actually exist at employees' retirements by preventing fund mismanagement by administrators, trustees and others. An employer interested in purchasing an ERISA bond for the company's 401k typically buys a bond that covers 10% of the plan's total assets. ERISA bonds are very economical and easy to buy --- most insurance agents offer these bond's to small companies at very low annual rates.

Fiduciary Liability Insurance
Fiduciary liability insurance is different than an ERISA bond. Fiduciary liability insurance is a completely discretionary purchase on the part of the employer; it provides broad coverage for all persons who are de facto "fiduciaries" of the company's plan. A fiduciary is someone who provides investment advice to the plan for a fee, and/or has discretionary control or authority over the administration of the plan, and/or who has authority or control over plan assets. (note: NASD Registered Representatives are not considered fiduciaries; they earn commissions on plan assets and typically do not charge fees for investment advice.)

Fiduciary liability insurance is very inexpensive; the cost is approximately five 5 percent of the coverage limits purchased, unless the company offers its own stock as an investment option, which increases the premium. Coverage is broad, and the only exclusions are for deceptive practices and fraud, which is covered by the ERISA bond. Providers of fiduciary liability insurance coverage include American International Group (AIG); Chubb Executive Risk; Lloyd's of London; Reliance Insurance; and Travelers Property Casualty.

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[topic 13]

IRS Compliance Testing

To prevent employers from designing 401k plans that economically benefit only highly-paid personnel, lawmakers wrote compliance test mandates into the rules governing 401k plans.

-- In general, no plan can be set up in a way that discriminates "as to the availability of rights, benefits and features" available to different employees under the plan.


-- Every 401k must pass mandated compliance testing every year. The tests compare the participation rates of different classes of employees (see below).

-- Beginning in 1999, employers can choose to skip the tests and instead make a requisite contribution to their so-called non-highly-compensated employees' 401k accounts. This is called the safe harbor method of plan administration.

-- Employers can decide as late as 30 days before the end of each plan year whether or not to take the safe harbor route. However, if, as its safe harbor contribution, the employer wants to make matching contributions rather than the flat 3% of compensation contribution (explain), the employer must define the matching formula well ahead of those 30 days; in fact, any safe harbor matching contribution must be defined and communicated to employees no later than 30 days before the START of the applicable plan year so employees have plenty of time to adjust their contribution rates accordingly.

Not correcting a failed year-end compliance test can mean substantial penalties and possibly even disqualification of the plan's tax-exempt status. Test failures can be VERY expensive in terms of IRS penalty fees, man-hours spent trying to correct the problems and lost rapport with your employees, who may have to amend and refile their income tax forms -- and often pay additional income taxes, too.

The most common compliance tests are the ADP test, ACP test, and top-heavy test.

-- The ADP test (Actual Deferral Percentage test) compares the percentage of salaries that different classifications of employees are diverting into the 401k plan.

-- The ACP test (Actual Contribution Percentage test) compares the percentage of employer contributions being diverted into the 401k accounts of different classifications of employees.

-- The top-heavy test looks at the degree to which higher-paid employees' money dominates the 401k plan.

back to page topics

[topic 14]

Safe Harbor 401k Plan Administration

401k compliance tests are designed to ensure 401k plans have a threshold balance, at minimum, of participation of rank-and-file employees in relation to highly-paid employees.

The IRS offers an alternative means of achieving 401k plan balance: The safe harbor method of plan operation lets 401k plans skip their annual 401k discrimination testing so long as the sponsoring employer meets certain employer 401k contribution requirements designed to ensure broad participation in the company plan and provides 100% immediate vesting of the contributions.

-- To qualify a 401k plan as a safe harbor plan, an employer must make matching contributions that fulfill the below requirements or make nonelective contributions equal to 3% of each eligible employee's compensation.

-- Nonelective contributions are made to all eligible employees, regardless of if the employees participate in the company 401k plan. Matching contributions, on the other hand, being based upon salary deferral amounts, are made only to active 401k participants' accounts.

-- If the employer chooses to make safe harbor matching contributions, those contributions must meet two requirements: First, each non-highly-compensated employee must receive a dollar-for-dollar match on salary deferrals up to 3% of compensation and a 50¢ to the dollar match on salary deferrals from 3% to 5% of compensation. Second, the rate of any matching contributions being made to highly compensated employees cannot exceed that being made to non-highly compensated employees.

The employer must provide annual information to employees explaining the 401k plan's safe harbor provisions and benefits, including that safe harbor contributions can not be distributed before termination of employment and that they are not eligible for financial hardship withdrawal.

Employers can decide as late as 30 days before the end of each plan year whether or not to take the safe harbor route. However, if, as its safe harbor contribution, the employer wants to make matching contributions rather than the flat 3% of compensation contribution, the employer must define the matching formula well ahead of those 30 days; in fact, any safe harbor matching contribution must be defined and communicated to employees no later than 30 days before the START of the applicable plan year so employees have plenty of time to adjust their contribution rates accordingly.

Your 401(k) Easy system includes such notification within your customized 401k plan's Summary Plan Description, a document that's updated at least annually for all eligible employees.

-- If you don't choose the safe harbor method of 401k plan administration, we encourage you to use your customized 401k plan administration software's point-and-click compliance testing every month to keep well apprised of your plan's health.

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[topic 15]

Economic Growth and Tax Reconciliation Act of 2001 (EGTRA)

The Economic Growth and Tax Reconciliation Act of 2001 made the following changes to federal 401k regulations. Unless otherwise noted, the EGTRA amendments took effect January 1, 2002.


Previous Law

EGTRA Amendment

Tax Credits for New Small Employer Plans

An employer's costs related to the establishment and maintenance of a retirement plan were basically deductible as business expenses, but there was no tax credit for such expenses.

For the first three years of sponsoring a 401k plan, an employer can now take a tax credit of up to 50% of the first $1,000 spent on retirement education and administration. The employer's 401k MUST have at least one non-highly compensated employee, and the company cannot have more than 100 employees who received $5,000 or more of compensation in the preceding year.

Participant Loans for Small Business Owners

Generally, plans can make loans to participants, but sole proprietors, partners and subchapter S corporation shareholders were prohibited from taking out 401k loans.

Sole proprietors, partners, and subchapter S corporation shareholders can now take out 401k loans; the provision also applies prospectively to pre-existing loans.

Repeal of Multiple Use Test

In addition to satisfying the ADP and ACP nondiscrimination tests, some 401k plans also needed to satisfy the Multiple Use Test, which compared the two.

The Multiple Use Test is repealed as of 2002.

Tax Credits for Lower Income Savers

There were no tax credits for low and/or moderate income savers.

Eligible persons will receive a nonrefundable tax credit of up to 50% on up to $2000 in contributions to an IRA, 401k, 403b, SIMPLE, SEP, or 457 plan. Credit is in addition to the tax deduction already associates with contributions to such plans.

Individuals whose adjustable gross income is less than $30,000 are eligible for a 50% credit; joint filers with adjusted gross income between $30,000 and $32,500 are eligible for a 20% credit; joint filers with income between $32,00 and $50,000 are eligible for a 10% credit. The threshold for single filers is one-half the threshold for joint filers.

Catch-up Contributions for Older Workers

Was limited to the amount that can be contributed to a defined contribution plan on behalf of an employee for any year. In the case of elective deferrals, the limit was $10,500 per year, with no separate limits for older workers.

Persons age 50 or older can make an additional contribution to a 401k, 403b, or 457 plan of $1,000 in 2002, then increased by $1,000 each year until $5,000 in 2006, and then indexed in $500 increments. The catch9-up amount for SIMPLE plans is half the above.

The amount of the catch-up contribution will not be subject to nondiscrimination testing provided all participating employees over age 50 are eligible to make a catch-up contribution. The catch-up contribution will not count against the employer's deduction limit under section 404 or against the individual's overall 415c dollar limit.

Modification of Top Heavy Rules

A plan is generally considered top heavy if more than 60 percent of plan asset are held on behalf of "key employees." Due to the design of this test, top heavy rules essentially affect only small businesses. Key employees generally include officers earning more than half the Section 415 defined benefit plan dollar limit ($70,000 in 2001), 5 percent owners, 1 percent owners earning over $150,000, and the 10 employees with the largest ownership interest in the business (as long as they earn more than $30,000 a year). Also, family members of 5 percent owners are deemed to be key employees under family attribution rules.

Top heavy plans must meet a special vesting schedule and make minimum contributions to all non-key employees to the extent that contributions are made on behalf of key employees.

1. The definition of "key employee" is modified to delete "the top 10 employees with the largest ownership interest in the business," provided he/she will not be a key employee based on his/her officer status unless the employee earns more than $130,000 a year; also the four year look-back rule for identifying key employees was eliminated.

2. Matching contributions now count toward satisfying top heavy minimums.

3. Matching contributions made as 401k plan safe harbor contributions now satisfy the top heavy rules. Any accompanying profit sharing contributions do NOT automatically satisfy top heavy rules, however.

4. The five-year look-back rule applicable to distributions is shortened to one year. However, the five-year look-back rule continues for in-service distributions.

5. A frozen top heavy defined benefit plan no longer is required to make minimum accruals on behalf of non-key employees.

Modifications of Safe Harbor Relief for 401k Plan Hardship Withdrawals

401k plans had to restrict distributions of amount attributable to elective contributions. An exception applied in the case of certain hardship distributions: Treasury regulations provided a safe harbor for determining whether a distribution qualified as a hardship distribution and mandated that participants receiving a hardship distribution be prohibited from making elective contributions to the plan for 12 months following the date of the distribution.

The 12 month participation exclusion is reduced to 6 months.

Also, hardship withdrawals under the terms of the 401k plan are no longer treated as eligible rollover distributions.

Modifications to Limits on Retirement Plan Contributions and Benefits

Limits were...

1. Annual compensation taken into account was limited to $170,000

2. Elective deferrals were limited to $10,500

3. 415b maximum annual benefits were the lesser of 100 percent of three-year high salary or $140,000 (or less for pre-65 retirees)

4. Maximum defined contribution plan contribution was the lesser of $35,000 or 25 percent of compensation

5. Elective deferral contribution limit was generally $8,500 a year

6. The maximum elective deferral in SIMPLE plans was $6,500 a year.

Limits were raised in 2002 to...

1. Annual compensation taken into account raised to $200,000 and then indexed in $5,000 increments.

2. Elective deferrals maximum raised to $11,000

3. 415b annual benefit limit raised to $160,000 and then indexed in $5,000 increments (for years ending after 12/31/01)

3a. 415b annual benefit limit no longer need be reduced for retirements ages 62 thru 65 (for years ending after 12/31/01)

4. Maximum defined contribution plan contribution raised to $40,000, then indexed in $1,000 increments

5. Elective deferral contribution limit raised to $11,000 in 2000, then increased $1,000 a year until $15,000 in 2006, then indexed in $500 increments

6. The maximum elective deferral in SIMPLE plans increased to $7,000 in 2002, then increased $1,000 a year until $10,000 in 2005, then indexed in $500 increments/p>

Deduction Limits

A sponsor of a profit sharing plan could not deduct contributions to the plan in excess of 15% of aggregate employees' compensation. In stand-alone money purchase plans, the deduction limit was the minimum funding requirement for the plan.

The deduction limit for profit sharing plans increased to 25% of aggregate employees' compensation. Money purchase plans are now treated as profit sharing plans in this instance and thus also now have the 25% limit.

Increase in 25% of Compensation Limitation

Under section 415c, the total annual contributions to a defined contribution plan could not exceed the lesser of 25% of compensation or $35,000.

The 25% of compensation limitation increased to 100% of compensation, with the same $35,000 dollar limit stilly applying. The maximum exclusion allowance for 403b plans was repealed.

Repeal of "Same Desk Rule"

A distribution to a terminated employees was not allowed if the employee continued performing the same functions for a successor employer (applied to 401k, 403b and 457 plans)./p>

The rule was eliminated by replacing "separation from service" with "severance from employment" in the IRC language. The changes apply to distributions made after 12/31/01, regardless of when the severance from employment occurred.

Employers Can Disregard Rollovers for Purposes of Cash-out Amounts

Terminated participants' benefits could be cashed out if the non-forfeitable present value of such benefits did not exceed $5,000.

A plan can now ignore amounts attributed to rollover contributions when determining the cash-out amount.

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[topic 16]

401k-Type Plans for One-Person Businesses: Introducing 401(k) Easy-For-One for only $495 per year- plus a one-time only set-up charge of $495-complete!

I. Overview

401(k) Easy-For-One is an affordable and complete retirement plan that allows sole owners of one-person companies and one-person corporations to shelter a significant portion of their income -- in some cases, more than twice as much -- than they can shelter with other qualified retirement plans, such as money purchase pension plans, simplified employee pension (SEP) plans and savings incentive match plans for employees (SIMPLEs). It is estimated that nearly 18 million one-person business owners are eligible to participate in one-person 401(k) plans; Eligible businesses include corporations, sole proprietorships, and non-profits. Participants include accountants, lawyers, consultants, doctors, software programmers, etc.

401(k) Easy-For-One is made to fit owner-only businesses (including spouse) and businesses with employees that can be excluded under federal laws governing plan coverage requirements.

II. One-Person 401(k)s and Their Advantages Over SEP IRAs and SIMPLE IRAs.

One-Person 401(k) plans can be used for incorporated and unincorporated businesses, including C corporations, S Corporations, single member LLCs, partnerships and sole proprietorships. Real estate brokers, consultants, attorneys, manufacturers representatives, interior designers, retirees starting a new business and other professionals who work by themselves are prime candidates.

Under rules created by changes in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that became effective in January 2002, a business consisting of only an owner, or an owner and his or her spouse, can make greater tax-deductible contributions in a One-Person 401(k) than under a SEP-IRA or SIMPLE IRA. Contributions are discretionary, so owners can vary them from year to year or skip them altogether. 

Total tax-deferred contributions in a One-Person 401(k) cannot exceed 100% of pay, up to a maximum of $41,000 for those under age 50. This amount includes salary deferrals of up to $13,000 ($16,000 if age 50 or older), plus an employer contribution of up to 25% of pay (20% for self-employed). While SEP-IRA contributions also max out at $41,000, they are limited to 25% of pay (20% for self-employed). And, SEP-IRAs do not provide for additional catch-up contributions. With a SIMPLE IRA, employees under age 50 can defer up to $9,000 this year, while those age 50 or older can contribute up to $10,500. The employer can make additional required contributions. 

Under these guidelines, a business owner under age 50 with earned income of $100,000 who is the sole employee of his business could contribute a maximum of $25,000 to a SEP-IRA, $12,000 to a SIMPLE IRA, and $38,000 to a One-Person 401(k) (consisting of a $13,000 salary deferral plus an employer contribution of $25,000). Someone with $150,000 in W-2 income could contribute as much as $37,500 to the SEP-IRA, $13,500 to the SIMPLE IRA, and $41,000 to the One-Person 401(k). 

The ability to make generous contributions at lower income levels means that business owners who want to catch-up on retirement contributions can do so more quickly than they could with a SEP-IRA or a SIMPLE IRA. Someone in his fifties with $100,000 in income could put away $41,000 for retirement this year with a One-Person 401(k); that amount of tax-deferral is not possible with a SEP or SIMPLE IRAs.

Retirement plan experts say that investment flexibility, and possible increased protection of personal assets from litigation, in addition to higher contribution levels, are additional the major draws of One-Person 401(k) plans. The plans can accept rollovers from virtually any type of retirement plan, including a corporate 401(k) or an IRA. Business owners can also borrow the lesser of 50% of the plan balance, or $50,000. Loans are not allowed from SEP and SIMPLE IRAs, or IRA Rollovers.

The One-Person 401(k) loan feature is a powerful advantage for business owners who may need quick, short-term access to their money without incurring the taxes and penalties associated with taking an early distribution from a rollover IRA. A lot of people are using a One-Person 401(k) to consolidate existing retirement accounts, and then borrow against the plan.

For someone under age 59 ½ who has left a job and is strapped for cash, the loan feature can be a way to get money out of a 401(k) without facing the penalties and taxes associated with a premature retirement plan distribution. The only requirement to establish an ad count is that you have self-employment income, so someone who is between jobs and doing consulting work would qualify. Loans must be repaid according to IRS guidelines as they would with a corporate 401(k), or become subject to taxes and penalties.

III. If you are considering a One-Person 401(k) be sure it includes the following 3 features, which are not typically available in plans provided by insurance companies and mutual fund companies, or plans priced less than $300 annually.

-- Broad spectrum of no-load investment options, and the option to use a self-directed discount brokerage account.

--A loan feature---it may come in handy in a family emergency.

--The ability to easily and affordably convert to a standard 401(k), should the business grow to include more employees.


Benefits of 401(k) Easy-For-One

* Affordable and complete, at only $495 per year.

* Employer/owners may contribute up to $41,000 per year, depending on their income.

* 401(k) Easy-For-One contributions are made with "pre-tax" dollars, and earnings grow tax-deferred until withdrawn

*Employer/owners can make salary deferrals equal to 100% of compensation, up to a maximum of $12,000 for 2003. This maximum will increase by $1,000 per year until 2006, when it reaches $15,000.

* Employer/owners may also make company profit-sharing contributions up to 25% of salary.

* Employer/owners who are age 50 and above may contribute an additional "catch-up" contribution of $1,000 annually, in addition to the $40,000 maximum. This catch-up contribution maximum will increase by $1,000 per year until 2006, when it reached $5,000.

*If new employees are hired the 401(k) Easy system will immediately accommodate them---additional set-up and annual maintenance fees will apply.

*Rollovers into the 401(k) Easy-For-One are permitted from SEP, SARSEP, SIMPLE IRA, traditional IRA, rollover IRA, Keogh, 401(k), 403(b) and 457 plans.

*Loans are available to the employer/business owner via the 401(k) Easy-For-One.

*Employer/owners have complete control over their 401(k) Easy-For-One investments, as do all 401(k) Easy Online users.

* 401(k) Retirement Plans are Excluded from the Bankruptcy Estate 

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 excludes from the bankruptcy estate retirement funds that are exempt from taxation under the Internal Revenue Code (the "Code")--such as one-person 401(k) plans, profit sharing plans, traditional 401(k) plans, defined benefit plans and IRAs. In addition, the Act protects tax-exempt retirement funds that are transferred to another tax-exempt retirement fund (i.e. a rollover to an IRA).

The Act provides a limited exemption of $1,000,000 to traditional and Roth IRAs. The debtor may petition the bankruptcy court for protection beyond that limit, and the court may grant the relief "if the interest of justice so requires." The benefits in IRA-based retirement plans, such as simplified employee pension plans (SEPs) or simple retirement accounts (SIMPLEs), are fully protected (the dollar limit does not apply to those plans). 

As a practical matter, IRA holders often commingle rollover and traditional contributions in a single IRA. Under the Act, rollover contributions have unlimited protection, if they came from tax-exempt funds. For this reason, IRA holders should account separately for those funds. The most prudent approach may be to put them in a separate IRA. 

Finally, it should be noted that the Act clarifies that participant loans are not discharged in bankruptcy if they are owed to a pension, profit-sharing, stock bonus or other tax-exempt deferred compensation arrangement. And, it is permissible to ensure repayment of such loans through payroll withholding. 

The Act is significant because it excludes from the bankruptcy estate a much broader range of tax-exempt retirement arrangements than prior law. And, the Act provides specific federal authority for exempting IRAs from bankruptcy estates. Historically, IRAs were thought to be subject to the claims of bankruptcy creditors--at least under federal law. (Note that many states gave full or partial protection to IRAs.) More recently, the U.S. Supreme Court held that there was limited protection for IRA benefits. 

Overall, the new law affords greater asset protection, which should be particularly beneficial to corporate officers, directors and other higher-compensated individuals. The Act becomes effective October 17, 2005. The Act will not apply to any bankruptcy cases filed prior to its effective date. And, it is important to note that its protections apply only if a participant has filed for bankruptcy.



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