Know your 401(k) plan contribution types
Posted on Wednesday, January 17, 2007
Abstract: Over the past 15 to 20 years, 401(k) plans have become an extremely popular retirement plan design. They allow various contribution types, giving employers flexibility in providing retirement plan benefits. This article discusses the different types of contributions allowed, including elective deferrals, catch-up contributions, matching contributions and more.
Over the past 15 to 20 years, 401(k) plans have become an extremely popular retirement plan design. They allow various contribution types, giving employers flexibility in providing retirement plan benefits. To maximize these benefits, you must understand the different types of contributions allowed.
Elective deferrals
The most basic 401(k) contribution type is the "elective deferral." These are contributions made from the employee's salary to his or her account and are excludible from the employee's gross income. They are pretax contributions and aren't treated as basis for tax purposes. Employee elective deferrals are known as cash or deferred arrangements.
Before employees can make elective deferrals, they must meet the plan's eligibility requirements. Once the terms are met, the employee is considered eligible even if he or she chooses not to make deferrals.
Catch-up contributions
A catch-up contribution is a type of elective deferral with special requirements. Eligible employees are those who are 50 or older or turn 50 during the calendar plan year.
Basically, an elective deferral isn't a catch-up contribution unless it exceeds a limit set by the plan, the Internal Revenue Code (IRC) Section 402(g) dollar limit (governing the maximum amount contributable pretax), or the IRC Sec. 415 limit (governing the maximum amount contributable by both the employer and employee both pre- and posttax). If contributions exceed one of these limits, and the participant is eligible to make catch-up contributions, the exceeded amount is considered a catch-up contribution.
Matching contributions
A matching contribution is an employer contribution made in conjunction with elective deferrals or after-tax employee contributions. You can design your plan to include matching for catch-up contributions, too. They may also include forfeitures (unvested forfeited employer matching contributions from terminated employees).
A 401(k) plan may make matching contributions available based on a portion or all of an employee's elective deferrals or after-tax employee contributions. In your plan document you can write the matching formula as discretionary and determine it each plan year. If your plan includes a matching formula, it must also include the formula by which the matching contributions are allocated.
Why are matching contributions important? They are incentives for employees to make elective deferrals to your plan.
Nonelective contributions
Nonelective contributions are employer contributions to a qualified plan that aren't elective deferrals or matching contributions. This term is normally used in the context of 401(k) plans to distinguish employer profit-sharing contributions from those that the employer makes according to the employees' salary reduction agreements (elective deferrals) and from matching contributions made on those elective deferrals. But the expression could be used to refer to any employer contributions (other than matching contributions) to any type of plan.
Initially, you must designate your 401(k) plan as either a profit-sharing plan or a stock bonus plan. If you choose a profit-sharing plan, you may design the plan to include an employer contribution formula establishing how the profit-sharing contributions will be allocated. The plan may be designed to include an employer contribution formula other than the matching formula. This formula is called a nonelective contribution or profit-sharing contribution.
Roth contributions
Beginning Jan. 1, 2006, a plan may allow employees to designate all or part of their elective deferrals as Roth contributions. You'll need to amend existing plans to allow for such contributions. Plans must maintain Roth contributions separately from others.
The plan treats Roth contributions in the same manner as other elective deferrals. The difference between regular elective deferrals and Roth elective deferrals is that Roth contributions are includible in the employee's gross income and subject to special tax rules. Roth contributions matched by the employer are on the same basis as the pretax deferrals.
After-tax employee contributions
Qualified plans may still permit participants to elect to make after-tax contributions. These contributions are subject to the limitation under IRC Sec. 415(c) - the lesser of 100% of compensation or $44,000 for 2006. The Sec. 415 limitation is inclusive of all contributions except catch-up contributions. Because these contributions are made with after-tax dollars, the participant doesn't pay tax when removing the money from the plan. But any earnings to those contributions are taxed when removed from the plan.
Both stock bonus plans and profit-sharing plans can include after-tax employee contribution provisions in their plan documents. The plan can make the contributions voluntary or mandatory.
Your plan could also allow matching for after-tax employee contributions. If your plan permits after-tax contributions and also has an elective deferral provision, the matching contribution formula could apply to both elective deferrals and after-tax contributions, or to just one or the other.
Defined contribution plans commonly keep these types of contributions separate (along with the earnings) from other plan contributions, whether they are made voluntarily or are mandatory. Your plan administrator must track after-tax contributions separately from other contributions so that they are properly reported for tax purposes.
Options abound
401(k) plans provide a number of contribution options. Knowing the rules of each contribution type can help you provide a better benefit plan to your employees.
Sidebar: QNECs and QMACs
Plans may not discriminate between employees. If a plan fails nondiscrimination testing, you can correct the failure by contributing to a qualified nonelective contribution (QNEC). This type of employer contribution is made under the same limitations as elective deferrals that are 100% vested.
Your plan document may limit the way you can allocate the QNEC. If it's allocated to only nonhighly compensated employees, you have a great deal of flexibility as to how to make the contributions. But if you use the QNEC and make allocations in proportion to elective deferrals, it constitutes a matching contribution. Then the QNEC is called a qualified matching contribution or QMAC. The difference between QNECs and QMACs is the manner in which they are allocated.
