Traditional 401(k) Plan Contribution Rules
401(k) Plan contribution rules are easier to understand than some may think. Traditional 401(k) Plans give eligible employees (employees who can participate in the plan) the option to make pre-tax elective deferrals through Payroll deductions or Roth. This is only if the plan documents permit it. Furthermore, with a traditional 401(k), employers can make contributions on behalf of all participants. They can also match contributions based on employees’ elective deferrals, or do both. These employee contributions can be subject to a vesting schedule. This means that an employee’s right to employer contributions become nonforfeitable, or in other words, fine/penalty-free after a period of time. Otherwise, the contributions will be immediately vested, and the employee will own a percentage of his/her account after the stipulated requirements.
401(k) Plan contribution rules must meet nondiscrimination requirements. To ensure that these requirements are met, the employer must perform annual tests. These tests are ‘Actual Deferral Percentage’ (ADP) and ‘Actual Contribution Percentage’ (ACP). Both tests verify that deferred wages and employer matching contributions don’t discriminate in favor of employees who receive a higher compensation. For example, in certain cases, plans favor employees in more valuable positions, and in some respects, neglect employees who receive a lower wage with a lower standing.
Safe Harbor 401(k) Plan
A Safe Harbor 401(k) Plan is similar to a traditional 401(k) plan. One primary difference is that with this plan, employers provide contributions that are fully vested when made. In other words, the employee owns 100% of the account balance after three years of service. These can be employer matching contributions (only for employees who defer). Also, employees can make employer contributions on behalf of all eligible employees (they don’t have to make elective deferrals). Another important difference is that the Safe Harbor 401(k) Plan is not subject to nondiscrimination requirements, such as the ADP and ACP, as is the case with the traditional 401(k).
The Safe Harbor 401(k) Plan is good for small businesses. Additionally, it helps employees avoid the strenuous ADP and ACP tests, which they can potentially fail. The Safe Harbor 401(k), established in 1999, is a much simpler plan to administer in contrast to the traditional 401(k). If employers adopt this type of 401(k) plan, in certain cases, there’s no need to make Top Heavy Contributions. Such contributions mainly favor partners, sole proprietors and other valuable employees. Employees who receive a lower pay also receive minimum benefits in plans where highly compensated employees are the owners. The Safe Harbor 401(k) Plan benefits are in exchange for a commitment to make a minimum level of contributions that most sponsors make regardless. This contribution is typically 3% of the employee’s salary.
ROBS and the 401(k) Plan Contribution Rules
If you or another disqualified person is looking to use your retirement funds to invest in a business you will benefit from personally, there is only one way to do this. This is the Rollover Business Start-up Solutions, or ROBS solution. You may know this plan as the Business Acquisition Solution (BACSS) at IRA Financial. As you may already know, the ROBS takes advantage of an exception in the tax code under IRC Section 4975 (d) (13). This exception is ‘qualifying employer securities’, which allows you to use your 401(k) plan funds to buy stock in a C corporation. So, let’s clarify: to use your retirement funds, as a disqualified person, and invest in a business that personally benefits you, you need two primary requirements to avoid triggering the prohibited transaction rules:
- You must establish your business as a C corporation
- That C corporation must adopt a 401(k) plan
What is a 401(k) Plan?
This retirement account is an employer-sponsored employee benefit arrangement. It provides retirement income for eligible employees. 401(k) participants can choose to contribute a portion of their salary into their retirement account. A 401(k) plan is also a profit sharing plan where employees may be permitted to defer a portion of their compensation of their plan on a pre-tax basis. Also, a 401(k) Plan allows employees to receive taxable compensation in the current year, or defer taxation and have the employer contribute compensation into a retirement plan. If the plan allows, participants can make Roth (after-tax) contributions up to the deferral limits. Along with the employee deferrals, which are $19,000 (under 50) or $25,000 (over 50), the 401(k) allows:
- Employer matching contributions
- Employee after-tax contributions
- Employer profit sharing contributions
The employer contributions are tax-deferred.
Similar to other profit-sharing plans, the 401(k) contribution limits are 25% for a multi-member/corporation’s profit during the employer’s tax year. For a single member LLC for a sole proprietorship, it’s 20%. For 2019, the maximum amount an individual can contribute to a 401(k) plan is $56,000 (under 50) or $62,000 (over 50).
At IRA Financial Group, our 401(k) Plan administration experts can help you navigate the complex IRS and ERISA plan rules. You can adopt the most beneficial plan for you and your employees. Contact us today.