Frequently asked questions
about 401(k)
ERISA (Employee Retirement Income Security Act of 1974) sets minimum standards for most voluntarily established retirement and health plans in private industry. It ensures fiduciary responsibilities, mandatory information disclosure, grievance and appeals processes, and the right to sue for benefits and breaches of fiduciary duty.
The IRC includes sections like 401(k), 403(b), and 457, which govern different types of retirement plans, including their tax treatment, contribution limits, and distribution rules. It also outlines the rules for Roth vs. Traditional accounts.
The SEC regulates firms under the Investment Advisers Act of 1940, which requires registration and adherence to fiduciary responsibilities. The Securities Act of 1933 and the Securities Exchange Act of 1934 govern the issuance of securities and the operation of securities markets.
RMD is the minimum amount that must be withdrawn annually from retirement accounts (except Roth IRAs) starting at age 73. Failing to take the RMD can result in significant tax penalties.
A 401(k) is an employer-sponsored retirement plan with higher contribution limits and typically pre-tax contributions. An IRA (Individual Retirement Account) is a retirement savings account that individuals can open independently, with lower contribution limits and options for both Traditional (pre-tax) and Roth (after-tax) contributions.
Payment Questions
A Safe Harbor 401(k) plan is a specific type of 401(k) that includes mandatory employer contributions, which can be either matching or non-elective. These contributions are designed to automatically satisfy specific IRS non-discrimination requirements, thus exempting the plan from annual non-discrimination testing.
Safe Harbor 401(k) plans meet the ADP and ACP nondiscrimination tests without the need for annual testing. This helps highly compensated employees (HCEs) be eligible to contribute the maximum allowable amounts without the risk of plan failure due to discrimination issues.
Additionally, employer contributions are immediately vested, meaning employees have full ownership of these contributions as soon as they are made. This benefits employees who may leave the company before traditional vesting schedules are completed.
Another benefit Safe Harbor plans have is they encourage higher participation rates among all employees due to the guaranteed employer contributions, making the plan more attractive.
A Roth 401(k) is an employer-sponsored retirement savings plan that combines features of a traditional 401(k) and a Roth IRA. Contributions to a Roth 401(k) are made with after-tax dollars, meaning you pay taxes on the money before it goes into the account. However, qualified distributions from a Roth 401(k) are tax-free, provided the account has been held for at least five years and the account holder is at least 59½ years old. This can provide significant tax savings during retirement.
Contributions are made with after-tax dollars, but employer matches are made with pre-tax dollars and are held in a traditional 401(k) account. These employer contributions are taxed upon withdrawal.
Employees may be given the option to contribute to a traditional 401(k), a Roth 401(k), or both, depending on what the plan sponsor chooses to include in the plan.
Yes, self-employed individuals can contribute to a Solo 401(k), also known as an Individual 401(k). This type of plan is designed for business owners with no employees except possibly a spouse.
Contribution Limits:
Employee Contribution: As an employee, you can contribute up to $23,000 for 2024, with an additional catch-up contribution of $7,500 if you are aged 50 or older.
Employer Contribution: As the employer, you can contribute up to 25% of your compensation. The total combined contributions (employee and employer) cannot exceed $69,000 for 2024 or $76,500 including catch-up contributions.
Contributions to a Solo 401(k) are tax-deductible, and the earnings grow tax-deferred until withdrawal, providing significant tax advantages. Additionally, Solo 401(k) plans often offer many investment options, allowing for greater control over retirement savings.
Employer contributions to a 401(k) plan can come in several forms:
Matching Contributions: The employer matches a portion of the employee's contributions, typically up to a certain percentage of the employee’s salary. For example, an employer might match 50% of contributions up to 6% of the employee’s salary.
Non-Elective Contributions: The employer contributes a fixed percentage of an employee’s salary to the 401(k) plan, regardless of whether the employee makes any contributions. This type of contribution is common in Safe Harbor 401(k) plans. For example an employer may give each employee a non elective contribution of 3% of their salary.
Profit-Sharing Contributions: The employer makes discretionary contributions to the 401(k) plan based on company profits. These contributions are usually a percentage of the employee’s salary and can vary from year to year.
Safe Harbor Contributions: As part of a Safe Harbor plan, employers must make either matching or non-elective contributions immediately vested. This ensures the plan meets IRS non- discrimination requirements without annual testing. Benefits of Employer Contributions:
A combo plan combines a 401(k) plan with another type of retirement plan, which in most cases is a cash balance plan.
A combo plan allows for higher overall contributions and potential tax savings, as the combined plan can maximize the retirement savings potential for business owners and key employees. It also combines the growth potential of a 401(k) with the guaranteed benefits of a defined benefit plan, providing a more stable and predictable retirement income.
Some things to consider are that combo plans are more complex to administer and may involve higher costs due to the need for additional actuarial and compliance services and are best suited for business owners with stable profits that have fewer and younger employees and want to maximize their retirement savings.
Form 5500 is an annual report that must be filed with the Department of Labor (DOL), Internal Revenue Service (IRS). It provides detailed information about the plan’s financial condition, investments, and operations. It also ensures the plan complies with federal laws and regulations, including ERISA (Employee Retirement Income Security Act). The purpose of this form is to allow the government to monitor the plan's financial condition and ensure that participants’ benefits are protected.
Form 5500 includes details on plan assets, liabilities, income, and expenses and provides information on the number of participants and their status (active, retired, etc.).
Form 1099-R reports distributions from qualified retirement plans like 401(k)s. It provides information on the distribution amount, any federal income tax withheld, and the type of distribution. The plan administrator issues form 1099-R to report distributions to the IRS and the recipient. It shows the taxable amount of the distribution and any federal income tax withheld on their tax returns. This includes information on the type of distribution, such as normal distributions, early distributions, rollovers, and disability payments. Recipients must use the information on Form 1099 R to report income on their federal and state tax returns accurately.
Distributions from a 401(k) plan can generally be taken under the following circumstances:
Retirement: Usually at age 59½ or older, allowing penalty-free withdrawals. Separation from Service: Leaving the employer, though early distributions before age 59½ may incur a 10% early withdrawal penalty and income taxes. Hardship Withdrawals: For immediate and heavy financial needs, such as medical expenses, purchase of a primary residence, or tuition fees. These withdrawals are subject to plan rules and may incur penalties and taxes. Required Minimum Distributions (RMDs): Must begin by April 1 of the year following the year you turn 73. Failure to take RMDs can result in significant tax penalties.
Special Considerations:
In-Service Withdrawals: Some plans allow in service withdrawals, which are distributions taken while still employed. These are usually limited to specific situations, such as reaching a certain age or financial hardship.
Loans: Many 401(k) plans offer loan provisions that allow participants to borrow against their account balance. Loans must be repaid with interest, and failure to repay can result in the loan being treated as a taxable distribution.
For 2024, the maximum contribution limits for a 401(k) are as follows:
Employee Contributions: You can contribute up to $23,000.
Catch-Up Contributions: If you are 50 or older, you can make an additional catch up contribution of $7,500, bringing the total to $30,500. Employer Contributions: Employers can contribute up to 25% of the employee’s compensation.
Total Contributions: Employee and employer contributions cannot exceed $69,000 or $76,500 if you are eligible for catch up contributions. These limits are subject to annual adjustments for inflation.
Non-Discrimination Testing (NDT) ensures that 401(k) plans do not disproportionately favor highly compensated employees (HCEs) over non highly compensated employees (NHCEs).
Some of these tests include:
Actual Deferral Percentage (ADP) Test: Ensures that the average deferral rates of HCEs do not significantly exceed those of NHCEs. Actual Contribution Percentage (ACP) Test: This test is similar to the ADP test but tests employer contributions to HCEs and NCHEs.
Top-Heavy Test: Ensures that the plan’s benefits do not favor key employees excessively.
Ensuring compliance:
Safe Harbor Plan: Implementing a Safe Harbor 401(k) plan automatically satisfies ADP and ACP requirements by providing required employer contributions and immediate vesting.
Automatic Enrollment: Encourages higher participation rates among NHCEs, improving the likelihood of passing the tests.
Plan Design: Carefully design the plan to balance contributions and benefits between HCEs and NHCEs. Failure to pass non discrimination testing can result in corrective actions, such as returning excess contributions to HCEs or making additional contributions to NHCEs, which can be administratively burdensome and potentially reduce employee satisfaction.
When you change jobs, you have several options for your401(k):
If the plan allows, you can keep your 401(k) with your previous employer. This option may be convenient, but you must manage multiple accounts if you change jobs again. If your new employer offers a 401(k) plan and allows rollovers, you can transfer your balance to the new plan. This keeps your retirement savings consolidated and easier to manage. You can also roll your 401(k) into an Individual Retirement Account (IRA). This option provides more investment choices and flexibility but may involve more management responsibilities. Lastly, you can take a lump-sum distribution, but this is generally not recommended due to significant tax implications and potential early withdrawal penalties if you are under 59½.
Rolling over your 401(k) account to another retirement account avoids immediate taxes and penalties and can make managing it easier. Compare the fees and investment options of your old and new 401(k) plans and IRAs to make an informed decision.
The taxation of 401(k) withdrawals depends on the type of 401(k) plan and the timing of the withdrawals:
Traditional 401(k):
Withdrawals are taxed as ordinary income in the year they are taken. Withdrawals made before age 59½ may incur a 10% early withdrawal penalty in addition to regular income tax unless an exception applies (e.g., hardship, disability, or substantially equal periodic payments).
Required Minimum Distributions (RMDs) must begin by April 1 of the year following the year you turn 72. RMDs are also taxed as ordinary income.
Roth 401(k):
Qualified Withdrawals are tax-free if the account has been held for at least five years and the account holder is at least 59½ years old. Contributions can be withdrawn tax-free at any time, but earnings may be subject to taxes and penalties if withdrawn before meeting the qualified withdrawal criteria. Roth 401(k)s are subject to RMDs, but you can roll over your Roth 401(k) into a Roth IRA, which does not have RMDs.
In addition to federal taxes, you may owe state taxes on your withdrawals, depending on your state’s tax laws.
Highly compensated employees (HCEs) are subject to additional scrutiny under IRS rules to ensure that 401(k) plans do not disproportionately favor them over non-highly compensated employees (NHCEs). Contribution limits and non-discrimination testing are designed to prevent such favoritism.
HCEs can contribute up to the annual contribution limits, but the amount they can defer may be restricted if the plan fails non-discrimination testing. Non-Discrimination Testing (NDT) ensures that HCEs do not contribute significantly more than NHCEs. If a plan fails NDT, corrective measures may include refunding excess contributions to HCEs or making additional contributions to NHCEs. Safe Harbor 401(k) plans automatically meet specific nondiscrimination requirements, allowing HCEs to contribute more with less risk of corrective actions.