What is a 401(k) Plan?
A 401(k) is known as an employer-sponsored employee benefit arrangement that is established for the purpose of providing retirement income for those that are eligible. But how does one contribute towards an account established on the participants’ behalf within a qualified retirement plan? The 401(k) participants have the option to elect to have a portion of their salary paid as a contribution towards the retirement account. Also, the amount deferred is NOT taxed until distributed to the employee at a later time.
What does the term “Qualified Plan” mean?
The term “qualified plan” generally means that the written arrangement and the operation of the plan meet specific qualification requirements, outlined in Internal Revenue Code Sec. 401(a).
What are some of the benefits as an Employer?
Some of the key benefits as an employer include lower cost and tax savings, employee appreciation, and employee attraction and retention. Also, there are Tax and non-tax benefits. As part of Tax benefits, 401(k) plans can be less costly to fund compared to other retirement plans. As part of non-tax benefits, employees view an employer-sponsored retirement plan as part of an overall benefits package, thus attracting high quality employees.
What are some of the benefits for the Employees?
As with Employer benefits, employees receive tax and non-tax benefits. For Employee tax benefits, contributions and earnings are generally tax-deferred until distributed from the plan. Employee elective deferrals may be made on a pretax basis. In simpler terms, this gives an immediate tax savings to participants. Also, if the employer offers a qualified Roth contribution, employees who make designated Roth contributions may be eligible to distribute those assets tax-free and penalty-free. Some of the non-tax benefits for employees include the opportunity to participate in a 401(k) plan which will help the employees prepare for financial security in retirement.
What is a common example of a plan qualified under IRC Sec. 401(a)?
A profit sharing plan is a common example of a plan qualified under IRC Sec. 401(a). When a plan meets these requirements, the business establishing the plan and the employee benefiting from the plan are entitled to special tax considerations.
What are some of the benefits associated with QRPs?
- Generally, employer QRP contributions are tax-deductible.
- Employer contributions made to a plan on behalf of plan participants are not included in the taxable income of participants for the contribution year. Rather, participants generally are taxed on employer contributions when they receive a distribution from the plan.
- QRP assets accumulate earnings on a tax-deferred basis. As with the plan contributions, earnings on contributions are not taxed until a distribution from the plan actually occurs.
- QRP distributions at retirement may be eligible for favorable tax treatment.
- A smaller employer that establishes a new QRP may receive a tax credit of up to 50 percent of the QRP start-up costs for a period of up to three years.
What are Non-tax Benefits associated with QRPs?
- Many employers offer a QRP as an employee benefit to attract quality employees.
- Many employers also find that by offering a QRP for the benefit of employees, they can enhance employee security and morale.
- Also, a QRP tends to increase employee incentive and productivity, which, in turn, increases company profitability.
What type of Employers are Eligible to Establish a QRP?
- Sole Proprietor: an individual is considered a sole proprietor if he/she has earned income from personal services rendered and reports the income to the IRS on schedule C.
- Partnerships: the plan must be established by the partnership as a business entity, not by each partner individually. Partnerships wishing to adopt a QRP must consult either the partnership agreement or, in the absence of as partnership agreement, state law to determine the identity of the person(s) with authority to adopt the plan on behalf of the partnership. In addition, a preliminary inquiry regarding the ownership interest of any partners in other business entities must be made.
- Corporations: typically, a corporation must adopt a resolution to authorize the adoption of a QRP. The corporation also must appoint persons or entities to oversee administrative and fiduciary responsibilities with respect to the plan. Special rules come into play if the corporation is a member of a controlled group or an affiliated service group.
- Limited Liability Companies: LLCs combine the benefits of partnerships and corporations to create a separate business type. Because LLC members generally can choose to be treated as as a partnership or a corporation for tax purposes, LLCs must presumably follow the respective entity’s tax rules when adopting a QRP.
Types of QRP Contributions:
Employer Contribution Types:
- Profit Sharing Contributions: typically are discretionary and may range from 0 – 25 percent of the aggregate covered compensation earned by eligible plan participants during the employer’s tax year.
- Matching Contributions: an employer may make matching contributions to a 401(k) for those employees making elective deferrals. For example, the plan can allow an employer to match an employee’s deferrals in the amount equal to 50 percent of each dollar deferred into the plan
- Qualified Nonelective and Qualified Matching Contributions: employers may make qualified nonelective contributions and qualified matching contributions to non-highly compensated employees to correct non-discrimination testing problems.
- Forfeitures: these are typically created when participants who are not fully vested separate from service and take distributions of their vested balances. The unvested portions of their accounts are given up.
Employee Contribution Types:
- Pretax Deferrals: an employee that is eligible to participate in a 401(k) plan may choose to defer a percentage or dollar amount of his wages into the plan each pay period. The employees may also receive the option to receive bonuses in cash or defer all or a portion towards the 401(k) plan.
- Designated Roth Contributions: As of January 1, 2006 employers may allow participants to make Roth (after-tax) elective deferrals to the plan. These after-tax Roth contributions are still treated as elective deferrals for most purposes.
- Catch-up Deferrals: participants who become 50 years of age or older during the year, may make catch-up deferral contributions.
- Nondeductible Employee Contributions: some 401(k) plans allow employees to make contributions to the plan on an after-tax basis. These contributions also are subject to non-discrimination testing.
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