401k FAQ

How does a 401(k) plan work?

How do 401(k) loans work?

What is a rollover?

My employer said I can’t withdraw my money while I’m employed, why?

How does a company match work?

What is company profit-sharing contribution?

What is a “true up”?

What is vesting?

What is a Hardship Distribution?

Why do 401(k) plans undergo annual discrimination tests?

What is the definition of a Highly Compensated Employee (HCE)?

What is a Key Employee?

What is the Average Deferral Percent (ADP) Test?

What is the Top-Heavy Test?

What is a Safe Harbor 401(k) Plan?

Why do I get a refund check every year from my 401(k)?

What are catch-up contributions?

Why can’t I invest in stocks in my 401(k)?

How does a 401(k) plan work?

How 401(k) Plan Works for Employers

• Gives incentives to attract talented employees – As workforce competition get fiercer every year, employers need to give benefits such as 401(k) plans in order to reduce employees turnover ratios, as well as to hire new, skilled employees.

• Reduces income taxes through tax-deductible company contributions – Employers who will provide match or profit-sharing to their employees will see the benefits of tax deductions because the amount they give out to their employees will be deducted from their income, reducing net income, therefore employers will pay less income taxes.

• Remove burdens of providing future benefits for retired employees – 401(k) plans work differently than traditional defined benefit plans. Generally, under traditional defined benefit plans, employers are responsible for meeting certain future benefits for employees at the time of their retirement. This makes the company solely responsible for providing the ‘defined benefit’ to that employee. However, under a 401(k) plan, employees are deciding how much they defer from their paycheck, making employees responsible their own retirement.

• Flexibility in plan design – Generally, 401(k) plan may be set up differently based on employers’ financial situations as well as their needs and wants.
How a 401(k) Plan Works for Employees

• Employees elect a fixed-dollar amount or percentage of salary to defer into a 401(k) account – Once this amount has been determined, the employee does not have to worry about contributing to a savings account every paycheck because it is automatically deducted. And while an employee can change their deferral amount, it is more common for them to adjust their lifestyle to their “new income.”

• Reduces income taxes by pre-tax deferrals – Employees may enjoy paying fewer taxes on their income because their net income will be deducted by the amount they defer to their 401(k) plan. For example, if John makes $30,000 per year and defer $3,000 to his 401(k) plan per year, he will pay his income tax based on $27,000, not $30,000.

• Employers may contribute 401(k) match or profit sharing to their employees – Employees may receive 401(k) match or profit sharing from their employers. The amounts of these contributions are solely determined by employers.

• Tax-deferred investing – On top of pre-tax deferrals, employees are not paying taxes on gains from their retirement plans until they actually withdraw from their 401(k) plan.

How do 401(k) loans work?

First, find out if your plan allows for loans; not all retirement plans allow participants to take a loan for many reasons including cost, additional administrative expense, or the plan administrator simply does not want to allow for loans.

There are a few things to know before taking a loan:

You may take a loan for up to 50% of your vested account balance, up to a maximum loan amount of $50,000 and a minimum loan amount of $1,000. So, you must have at least a $2,000 vested balance in order to take a loan.

Just like a car loan or a mortgage, you will have to pay interest on the loan. The good thing is that you are paying the interest back to yourself. This helps your account keep pace with inflation while the funds are not in your account being invested. Interests rates vary by plan, so check with your administrator to find out the current interest rate for a plan loan.

Loan repayments come directly out of your paycheck, after taxes are taken out. This makes it easy because you don’t have to write a check every month to pay back your loan. The “catch” here is that the loan interest will be double-taxed because you are paying it back with after-tax money, and when you withdraw your 401(k) at retirement you are taxed on any amounts you withdraw.

Repayment periods can be from 1 – 5 years for a general purpose loan, and up to 15 years for a residential loan (a loan used to make a down payment on a principal residence, not an investment property).

If your employment ends while you have an outstanding loan any remaining balance may be defaulted. Any amount that is defaulted will become taxable income to you for that year, and if you’re under 59 1/2 then you may be subject to the 10% early withdrawal penalty. Most providers will let you payback anywhere from 1% – 100% of the remaining balance after your employment has ended, but there are deadlines so find out before it’s too late!

What is a rollover?

When you move funds from one tax-qualified retirement account (e.g. 401k, IRA, etc) to another tax-qualified account, it is called a “rollover.” Rollovers prevent the money from being taxable income. You can rollover an old 401k account into a new 401k account, rollover a 401k to an IRA, or rollover an IRA to a 401k.

My employer said I can’t withdraw my money while I’m employed, why?

There are two main reasons why you cannot withdraw your funds while you’re employed: 1) The IRS doesn’t allow individuals who are under 59 1/2 to access salary deferrals from a company-sponsored 401(k) plan, as long as you are still employed with that company. 2) If you’re over 59 1/2 and you cannot access your funds it is because your plan does not allow for “in-service distributions.”

How does a company match work?

If your company offers a 401(k) match, take advantage of it! With a match, you have to defer your salary in order to receive the company contribution. Because matching formulas vary greatly from company to company, check with your plan administrator to find out their matching formula. If you’re not taking full advantage of your company’s match, you’re selling yourself short.

For example: Your company matches 50% of the first 8% of salary you defer. This means that your company will contribute $0.50 for every $1.00 you contribute, up to the first 8% of your salary saved. So if you make $1,000 per paycheck, you should save at least $80 to get a free $40 match.

What is company profit-sharing contribution?

If your company makes profit-sharing contributions to your 401(k) account, take a second to thank them! Profit-sharing contributions are generally discretionary deposits made to your account without you having to contribute (unlike a company match where you must defer salary to receive the company contribution). Profit-sharing contributions are usually expressed in terms of a percentage of your salary. So, a 3% profit-sharing contribution would be equal to 3% of your salary for a given year.

What is a “true up”?

If your company has a matching formula then you may receive a true up contribution — an additional deposit into your account which makes it so that you have received the full, or true, match that you deserved for a given year.

Example: You earn $52,000 per year; you are paid every two weeks and your paychecks are $2,000 gross. Your company matches 100% up to the first 5% of salary deferred. You begin your contributions half-way through the year. You contribute 15% of your salary for the remainder of the year, or $7,800 in salary deferrals. Because the match is usually calculated each paycheck, you only received $100 per paycheck as a match (5% of $2,000). So, at the end of the year you have received a match of $1,300, but you contributed over 5% of your salary so you should receive the full match, right? If your plan does a true-up, then you’ll see an extra $1,300 deposit into your account, bringing your total match to $2,600, or 5% of your income (to coincide with the match formula).

What is vesting?

Also referred to as a company’s “golden handcuffs,” vesting is a term used to express the amount of company contributions made to your account of which you are entitled to. You will need to contact your plan administrator to find out your plan’s vesting schedule, and how many hours are required to be credited for a year of vesting (maximum is 1,000 hours). Vesting schedules are put in place to save employers from making contributions to an employee who only works at a company for a short time, or part-time. If your employment with the 401(k) plan sponsor ends, and you are not fully vested, any unvested portion of your account gets credited back to the plan; these unvested portions are called “forfeitures.” Companies may use forfeitures to offset other costs relating to the plan, such as future employer contributions, or administrative costs of maintaining the plan.

What is a Hardship Distribution?

A hardship distribution is one of the few ways to withdraw money from your 401(k) account while you are employed. The IRS definition of a financial hardship is an immediate and heavy financial need, and all other resources have been utilized leaving only the 401(k) account as a means to satisfy the financial need. Further, the IRS has listed the following expenses as approved financial hardships:

(1) certain medical expenses;

(2) costs relating to the purchase of a principal residence;

(3) tuition and related educational fees and expenses;

(4) payments necessary to prevent eviction from, or foreclosure on, a principal residence;

(5) burial or funeral expenses; and,

(6) certain expenses for the repair of damage to the employee’s principal residence.

Unlike a 401(k) loan, hardships are not repaid to the account. Any amount taken as a hardship distribution will be considered taxable income for the year in which the withdrawal was made, and if you are under 59 1/2 you may be subject to the 10% early withdrawal penalty.

Why do 401(k) plans undergo annual discrimination tests?

There are many reasons why discrimination tests are in place, and while we can’t cover all of them (or rationalize some of the tests), but we can give you a general idea of why every 401(k) plan in America undergoes the same tests.

The idea of a 401(k) is to provide a benefit to employees, while at the same time benefiting owners and officers of a company. Discrimination tests see that the owners/officers of companies are not the only ones benefiting from a plan being in place. Here’s a simple example: A company with one owner and one employee establishes a 401(k) plan. The owner is the only one contributing to the plan; well, this plan will fail most discrimination tests because the IRS cannot insure that the employee(s) are aware of the benefits of the plan, or that there is a plan even in place. See, when 401(k)’s were new, owners of companies would establish them, reap all of the benefits and never even tell the employees that a plan is in place (one reason why you have to inform employees if they are eligible to participate in a plan). Another reason is simply to prevent tax “loopholes.” An owner with one employee could hire their son, daughter, wife (or husband), mother, father…well, you get the point. All of those relatives could just defer 100% of their income (up to the limits), and not pay any income taxes. If you think the IRS is going to let this slide, think again.

The flip-side of this is when an owner with 10 employees establishes a plan, but no one participates. This limits the owner from benefiting from the plan, and may prevent him from benefiting at all. Luckily the IRS did setup a type of 401(k) plan to help owners in these situations (see: Safe Harbor 401(k) Plan)

There are many, many other reasons for annual discrimination testing, but in short, the tests are in place to insure that owners and employees benefit alike.

What is the definition of a Highly Compensated Employee (HCE)?

An HCE is any employee who made over a specific dollar amount (for 2010 that amount is $110,000) in the prior plan year. Additionally, all key employees are also considered HCE for discrimination testing purposes.

What is a Key Employee?

A key employee is any employee who owns over 5% of the company; an employee who owns more-than-1% owner in a year who makes over a certain dollar amount (that amount for 2010 is $150,000); an officer of the company who makes over a certain dollar amount (that amount for 2010 is $130,000). These dollar amounts are indexed for inflation. Additionally, attribution rules will apply to certain relatives of key employees — for example, the spouse, children, grandchildren, and parents of a key employee will also be considered key employees for testing purposes.

What is the Average Deferral Percent (ADP) Test?

One of the more limiting discrimination tests in a 401(k) plan is the ADP test. This test breaks a company into two groups: Highly-Compensated Employees (HCE), and Non-Highly Compensated Employees (NHCE). Then, each employee’s deferral rate is calculated by dividing the total deferrals for the plan year by their annual compensation, creating their deferral percentage. The deferral percentages for each of the groups is added, and divided by the number of people in the respective group.

Example: A company has 10 employees, all whom are eligible participants for that company’s 401(k) plan. There is one “greater than 5%” owner (HCE 1), and one employee who made over $110,000 in the prior year (HCE 2). The eight remaining employees are all NHCEs for testing purposes.

· HCE Group · NHCE Group
HCE 1 – Deferred $15,000; earned $100,000 in salary;· Deferral Percent – 15% NHCE 1 – Deferred $2,000; earned $50,000 in salary;· Deferral Percent – 4%
HCE 2 – Deferred $10,000; earned $200,000 in salary;· Deferral Percent – 5% NHCE 2 – Deferred $5,000; earned $30,000 in salary;· Deferral Percent – 17%
· NHCE 3 – Deferred $500; earned $50,000 in salary;· Deferral Percent – 1%
· NHCE 4 – Deferred $2,000; earned $90,000 in salary;· Deferral Percent – 2%
· NHCE 5 – Deferred $10,000; earned $100,000 in salary;· Deferral Percent – 10%
· NHCE 6 – Deferred $15,000; earned $75,000 in salary;· Deferral Percent – 20%
· NHCE 7 – Deferred $16,500; earned $105,000 in salary;· Deferral Percent – 16%
· NHCE 8 – Deferred $0.00; earned $100,000 in salary;· Deferral Percent – 0%
· HCE Average Deferral Percent (ADP): 10% ([15% + 5%]/2) · NHCE Average Deferral Percent (ADP): 8.75%

The example above (a common scenario for small businesses) would lead to a plan failing the ADP test. Why? Because HCEs are limited to what they can defer based on how much the NHCEs defer.

So, what are the limits? The lesser of

NHCE deferral rate times 1.25, or;

The greater of:

NHCE plus 2.00%, or;

NHCE times 2%

Pretty simple, right? All sarcasm aside, most plans end up using the NHCE plus 2.00% rule. Most small business fail the ADP test because they don’t receive enough participant from the NHCEs in the company. The result is that the HCEs end up receiving returns of their contributions, or the company can make a contribution to the NHCEs to bring them the plan to a level that would pass the ADP test.

What is the Top-Heavy Test?

The top-heavy test, like the ADP test, breaks the employees into two groups, but this time they are broken into Key employees and Non-Key employees and tests the account balances (based on the prior year-end account balance). The prior year-end’s account balance of the Key employees cannot be greater than 60% of the total plan assets.

Example: In a 2-person plan there is one key employee and one non-key employee. The key employee has an account balance of $61,000 at the end of the previous plan year, and the non-key employee has a balance of $29,000 at the end of the previous plan year. The total plan assets are $100,000. The key employee controls 61% of the plan assets (the limit is 60%). Note: Rollovers into the plan from unrelated employers are not taken into account for the top-heavy account balance.

Effect of a plan being top-heavy: A top-heavy plan requires a contribution to the non-key employees equal to the highest contribution rate of a key employee, with a maximum of 3% of salary.

So, in the example above, if the key employee contributed 2% of his salary during a top-heavy year, the company would be required to make a 2%-of-salary contribution to the non-key employee. If the key employee deferred 10%, they would make a 3% contribution to the non-key (because it is capped at 3%). The way around making this company contribution is to have the key employee cease contributions during any plan years in which the plan is top-heavy, thus making the key employee’s contribution 0% which means that the company does not have to make a contribution to the non-key employee’s account.

What is a Safe Harbor 401(k) Plan?

A Safe Harbor 401(k) Plan is a type of retirement plan which receives a ‘free pass’ on most 401(k) discrimination tests, such as the aforementioned ADP and Top-Heavy tests. The “catch” is that the company is required to offer a fully-vested matching contribution to all eligible participants (minimum formula of 100% match on the first 3% of salary deferred, and 50% on the next 2% of salary deferred), or a profit-sharing contribution to all eligible participants (minimum of 3% of compensation).

Safe Harbor plans have provided relief to employers who want to maintain their own benefits from the plan (not being limited because of failing the ADP test, being limited by the Top-Heavy test).

Why do I get a refund check every year from my 401(k)?

This is most likely because you are an HCE in your company and your company’s 401(k) plan has failed the ADP test. A method of resolution to the ADP test is for HCEs to take refunds of their contributions.

What are catch-up contributions?

A catch-up contribution allows for participants who turn age 50 or older during a plan year to make an additional contribution to a 401(k) plan. For 2010, the deferral limit for individuals under 50 years old is $16,500; if you turn 50 or older during the year, you can make an additional catch-up contribution of $5,500 bringing the max deferral limit for those age 50 or older to $22,000.

Why can’t I invest in stocks in my 401(k)?

401(k) plans are generally placed in a trust account, with the owner(s) of your company being the trustee(s) on the plan. In an effort to reduce their fiduciary liability, they may have restricted the plan to a list of set mutual funds, and not allowed for stocks due to their inherently more volatile nature. Note: Some 401(k) plans do allow for investment into stocks, bonds, CDs and ETFs (example: www.lowcost401k.com).