A 401(k) is a retirement plan that is sponsored by an employer that allows employees to save pre-tax or after-tax contributions for their retirement. 401k plans have become tremendously popular and plan providers have improved dramatically over the last few years and now offer many more services such as increased investment selection, reduced administrative costs and efficient administration.
If a small business owner has W-2 employees (other than the business owner or their spouse) who work more than 1,000 hours per year then they do not qualify for an Individual 401k and must establish a traditional 401k plan for their small business. 401k plans can have custom features and BCM helps small businesses with their 401k plan design to maximize the benefits to our small business clients while maintaining compliance with the IRS rules. Below are a couple of examples.
A Safe Harbor 401k can be beneficial for small business owners who would like to contribute the salary deferral limit ($18,000 or $24,000 if age 50+), but anticipate they will fail the non-discrimination tests in a 401(k) plan. The Safe Harbor 401k plan allows owners and highly compensated employees to make the maximum salary deferral contributions to a 401k even if the other employees want to make limited or no contributions to the 401k. With a Safe Harbor 401k, the employer must make contributions to eligible employees according to one of two formulas. An employer is required to match employee contributions (100% of the participants first 3% of salary and 50% of the next 2% of salary) or make a non-elective contribution (make a contribution of 3% of salary for all eligible employees whether they contribute to the 401k or not). Each year the employer must make either the matching contributions or the non-elective contributions. The plan document will specify which contributions will be made and this information must be provided to employees before the beginning of each year.
A small business may want to add a profit sharing plan to their 401k. One type of profit sharing plan is a New Comparability Plan. If a small business owner would like to maximize the profit sharing contribution to the business owners or key employees while minimizing the contributions into the other employees they may be interested in establishing a New Comparability Plan. A New Comparability Plan is a profit sharing plan in which employees are divided into groups with each group receiving an employer contribution that is a different percentage of compensation. A small business can set up a New Comparability Plan to maximize contributions to the business owner and to benefit key employees while still satisfying IRS rules for a 401k profit sharing plan.
In 2015 a 401k participant can elect to defer up to 100% of their W-2 compensation up to a maximum of $18,000. 401k participants that will become age 50 or older during the calendar year January 1-December 31 are permitted to make an additional "catch-up" contribution of $6,000. The 2015 401k contribution limit is $24,000 for those age 50 or older. Employee contributions are 100% tax deductible and dividends and investment earnings grow tax-deferred until they are withdrawn.
In general, withdrawals from a 401k before age 59 ½ incur a 10% IRS penalty and are taxed as income. After age 59 ½ an employee can withdraw the money without penalty, but will pay income taxes. This is advantageous for many investors because they are able to make a contribution to their retirement plan and receive a tax deduction during their working years while in a higher tax bracket, get many years of growth in dividends and investment earnings without being taxed, and when retired and typically in a lower tax bracket, they withdraw the money as needed.
Some 401k plans have a loan provision which allows employees to take a loan. Tax free loans (up to 50% of the total 401k value with a $50,000 maximum) are permitted. Loans must be repaid according to the terms of the loan amortization schedule which is provided when a loan is initiated. Failure to repay the loan according to these terms may result in a loan default causing income taxes as well as IRS penalties.
Generally the total loan balance is due within a short time period (60 or 90 days) upon voluntary or involuntary termination of service with an employer. If the full remaining balance of the loan can't be repaid at that time, then the loan is considered defaulted which may cause taxes and IRS penalties.
Employers are not required to make contributions on behalf of employees in a 401k plan. Although not required, many employers do make contributions called a "company match." A common employer match is a 1 for 2 match up to a maximum of 3%. For example, if an employee contributed 6% of their salary an employer would contribute 3% for the employee.
Frequently, there would be a vesting schedule on the company match. When there is a vesting schedule an employee would need to work for an employer for a specified time period or else they may receive none or only a fraction of the company match. Of course, employee contributions do not have a vesting schedule and are immediately 100% vested. A company match can reward loyal employees and frequently improves employee retention and helps to attract new employees.