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What is 401 (K) - Every thing you need to know


What is a 401 K and How does it work??

401(k) is a retirement plan for employees working in the private sector and is offered in the USA by many employers. In this arrangement, there lies a feature for employees to elect to have the employer’s contribution portion of the employee salary/wage into an individual account under this plan. In this plan, income is not taxable in income tax returns.

In the United States, the US Congress started retirement plans for Americans to save for the retirement age. 401(k) is an employer-sponsored retirement plan for employees having tax benefits to the saver. It is named after the section of the US IRC – Internal Revenue Code.

Usually, within mutual funds options in such a plan, the employees have options to choose from. And, the employer may invest a matching portion into that too.

What is meant by the Legal Status of a 401(k) Plan?

United States Law Internal Revenue Code sub-Section 401(k), a plan offered to employees working in private companies namely 401(k) is for the employees of and/or under the United States, US agency, or its instrumentality, established by the employer.

What is the Employee Perspective in a 401(k)?

Arrangements under the 401(k) are to be made in a nondiscriminatory way. The proficiency of deferring income taxes to a time when an individual’s tax rate may be lower is a vital benefit of this plan. It would have been of no worth if at the time of retirement the tax rates were levied, and not the time of participation portion of the income, into the plan. Moreover, the capital gains earned in 401(k) are not referred to as capital gains taxes.

As per Section 404 of IRC - Internal revenue Code – Publication referred to as: read Publication 560, Retirement Plans for Small Business {SEP Simple and Qualified Plans}, the employer’s contributions to 401(k) are deducted against Federal Income Tax Return subject to the conditional limit prescribed therein 404 – IRC, reference made at aforementioned publication document.

What is the Employer’s perspective regarding a 401(k) retirement plan?

In a 401k plan, the employer’s portion contribution is deductible for the employer’s federal income tax returns, subject to the limit as prescribed in section 404 of the Internal Revenue Code (IRC). Employers have the choice to aid on behalf of employees on a matching contribution basis, employees’ elective deferrals, or both. In practice, the employees are not allowed to withdraw funds from 401(k) plan arrangements up to 59.5 years of employee age.

How are contributions made in 401k plans?

Contributions are made in 401(k) plans as per predefined limits of a certain amount of currency (USD) by the IRS – Internal revenue Service. There are employee contributions as well as employer contributions. For both, the limits of such contributions may be checked with the concerned U.S. government official website, for the tax year of the plans.

While a defined IRS lingo is a plan - though the alternative to a traditional pension – and is also known as a defined benefit plan. As per pension, the employer pays a defined amount to employees for life during retirement.

In the recent past, the practices of pension are diminishing whereas retirement plans are in vogue to shift the risk as well as the responsibility of saving for retirement, from the employer to the employee.

Nowadays, employees are at their own choice to choose from several options of savings for old age as per their fit alternative. Employers often offer their shares and stocks in the company; or mutual funds investment opportunities lie in the market; GICs – Guaranteed Investment Contracts – and an assortment of stocks availability; target dated funds; etc. having lesser inclination towards risk factors of losses, thereupon the practice of pension is replacing the working environments around the globe.

What Internal Revenue Service (US - IRS) says about 401(k)?

As per the author’s inference: the US (IRS) Internal revenue Service an official website of the United States Government 401(k) is a feature of a qualified profit share plan which permits the workers to contribute a certain amount portion of the salary into an individual account.

What is more, the elected salary deferments are in exclusion of taxable income of a worker, save Roth designated deferment.

Employers can contribute to the workers’ accounts. Except for the Roth-qualified distribution, another distribution is taxable at the retiring time including earnings. Until distributed, the contributions to the 401(k) are not taxable.

Along with 401k, an employee may have other retirement plans as well. 401(k) is having flexible contributions. Workers may contribute more under 401(k) in contrast to an IRA plan. It solves your cash flow issues. Loan flexibility and additional withdrawal options make it easy for the workers and a burden for the employers.

Participant loans are permitted under such an arrangement but withdrawing funds before the age of 59.5 are subject to a possible 10% additional pay tax.

401(k) permits workers to elect some or all their elective deferrals as Roth Elective Deferrals subject to general IRA Roth rules. Though, Roth deferrals are under the inclusion of the worker’s taxable income in the deferral year.

What are the different types of 401 K?

Several types of 401k available to employers are

Traditional 401(k)

Safe harbor 401(k)

and SIMPLE 401(k) plans

Every 401 K plan must be executed as per its applicable rules and regulations as per the language meeting certain eligibility requirements (qualification) as well as provisions of the plan itself, mentioned as per law, therein. Not all-inclusive, but below mentioned are a few qualifications of plans.

What is a Traditional 401k?

Traditional 401(k) permits eligible employees (that is employees who are eligible to participate in the 401k plans) for making pre-tax elective deferrals via payroll deductions. Employers in such a plan may make either matching contributions based on elective deferrals selected by the employee or contribute on behalf of all participants, or both.     

To further simplify, in traditional 401k the taxable income is reduced, that is the transactions of withdrawal are taxed but contributions are pre-tax meaning that reduces taxable income. The contribution amount is made from the payroll gross salary of the employee before income tax is deducted. Hence the taxable income is reduced in the traditional 401k accounts plan.  

As per rules, a traditional 401(k) plan must meet nondiscrimination requirements. What is more, either immediately or after a certain period, the vesting of non-forfeitable contributions by the employer in favor of the employee takes place.

As per IRS, the employers must conduct certain tests annually to satisfy the operations of the plans as per rules provision applicability of the legal bodies. Such tests are two:

  1. Actual Deferral Percentage (ADP)
  2. Actual Contributions Percentage (ACP)

Both these tests are for verification that the deferred wages and employer matching contributions limit are not discriminating in favor of the employees who are drawing the high compensations.

What are Safe Harbor 401(k) plans?

The safe harbor 401(k) plans are identical to the traditional 401(k) plans save one thing that is as soon as the employer contributions are made it is to be fully vested. The contributions by the employers may be by the matching concept (match contributions) as per employee deferred wages or on behalf of all employees regardless of whether elective deferrals are made.

What is more, the safe harbor 401(k) plans are not subject to the annual nondiscriminatory tests like traditional 401(k) plans do. In a year when safe harbor plans do not provide additional contributions are exempt from top-heavy rules of section 416 of the Internal Revenue Code.

Top-heavy rules of Section 416 of the Internal Revenue Code inference made is: these rules are made that a lower-paid employee receives at least a minimum benefit as most of the assets are owned by key employees. The key employees are the ones who are higher-paid employees.

key employee is an employee, who at any time during the plan year containing the determination date is:

  • Have employer ownership of more than 5% (as per family attribution rules application);
  • More than 1% owner of the employer along with annual compensation of more than $150,000 (as per family attribution rules application); or
  • Officer who earns an annual compensation of $200,000 these statistics are for the year 2022

Importantly, it is pertinent to know that the plans having fewer than 100 participants are most likely to be top-heavy, hence affected by top-heavy rules. Failing top-heavy rules compliance can cause a plan to lose its qualified status.

The employers who sponsor safe harbor 401(k) plans must follow notice eligibility requirements. The notice requirement is satisfied if the workers are given notice in writing about the employee’s rights and obligations as per the plan and if the notice complies with the timing as well as content requirements. The content requirements are, to be in line with the Income Tax Regulations section 1.401(k)-3(d)(2) (PDF), regarding using electronic media and referencing the plan – Summary Plan Description.

The timing requirement is to be satisfied by the employers that each year plan beginning notice be given 30 days and not more than 90 days before the start of each plan year. However, there are exceptions in terms of those employees who might become eligible after 90the days; then employers have to follow self-explanatory instructions as per Income Tax Regulations section 1.401(k)-3(d)(3) (PDF), mentioned therein, and referring to that is mandatorily better as that if it may, may not, change from time to time.

Both the traditional as well as the safe harbor 401(k) plans are for employers of any size and may be combined with other retirement plans.

What is SIMPLE 401(k)?

SIMPLE 401k plan is for small businesses so that they may offer effective and cost-efficient retirement plans to their employees. A SIMPLE 401(k) plan is not mandatory to conduct nondiscriminatory tests per year like a traditional 401(K) plan. And as with the safe harbor 401(K) plan, the employers have to satisfy the conditions of fully vested contributions. This SIMPLE 401(K) plan is for the employer to have 100 or fewer employees receiving at least an amount of $5,000 in a preceding calendar year. The workers who are eligible to participate in a SIMPLE 401(k) plan may not receive contributions or accruals on benefits as per any other plan of the employer.

What is Roth 401(k)?

In Roth 401k (Roth account) the contributions are made as after-tax income, which means withdrawals are tax-free and the tax is not deducted in the contribution year. It means the contributions are deducted from the income of the employee after the deduction of income tax.

2020 was the year when the COVID-19 pandemic-affected people were exempted from the tax bracket on withdrawals as well under CARES Act.

How to Develop a 401(k) Plan?

For developing a 401(k) plan, you must take the very first decision being the employer that whether you shall engage a bank, an insurance company, or financial consultant services hired or you will establish at own.

The next step for setting up a 401(k) plan is to:

Have a plan written document

Arrangement of trust for assets of the plan

Developing a record-keeping system

Provision of the information of the plan to the eligible employees

Have a plan written document

A plan is often started with a document in writing on your discussion table. If you have developed that document on your own then it is available to you otherwise if you have hired any services, like of financial institution or a retirement fund consultant agency, then the service provider would make it available for you on the table. In either case, you are bound to abide by the agenda mentioned therein in your planned document along with the required timelines, if you want to be successful in whatever you are planning.

Once, you are decided to go for offering a 401(k) plan for your employees, you are now required to decide which 401(k) plan you are opting from within 401(k) traditional, 401(k) safe harbor; and automatic 401(k) enrollment.                                 

Traditional 401(k) permits eligible employees (that is employees who are eligible to participate in the 401(k) for making pre-tax elective deferrals via payroll deductions. Employers in such a plan may make either matching contributions based on elective deferrals selected by the employee or contribute on behalf of all participants, or both.    

The safe harbor 401(k) plans are identical to the traditional 401(k) plans save one thing that is as soon as the employer contributions are made it is to be fully vested. The contributions by the employers may be by the matching concept as per employee deferred wages or on behalf of all employees regardless of whether elective deferrals are made.

Other plans, not unlike 401(k) traditional, do not require annual testing for contributions. Like in the safe harbor the contributions made on part of the employer should be fully vested. Automatic enrollment of the 401(k) plan automatically deducts the contributions of employees for the 401(k) plan until the elective contribution is made by employees. An automatic enrollment system for 401(k) plans is an effective way to enhance such retirement saving plans.

All three: traditional, safe harbor, and automatic 401(k) plans are for employers of any size.

Arrangement of trust for assets of the plan

Assets of the plan should be kept with trust to ensure that those are for benefit of the participants and their beneficiaries. The trust must have one trustee for the handling of contributions, investments in the plan, and distributions. As the selection of a trustee is sensitive in terms of financial integrity thereupon such selection should be made with utmost care. This will be your most important decision for the establishment of a 401(k) plan. If you plan to hire the services of an insurance company, in that case, contracts are not required to keep held in a trust.

Developing a record-keeping system

The development of a record-keeping system is always necessary for anything documentary you are doing in the office. Accuracy in record keeping will make it easy for you to trace cases, contracts, assets, benefits, losses, investments, distributions, and expenses administration. The records would be kept by the service provider if you have hired one for the establishment and management of a 401(k) plan. What is more, the record-keeping helps you with annual reporting in terms of benefits and losses which is to be furnished to the Federal Government on yearly basis as a requirement.

Provision of the information of the plan to the eligible employees

Information provision to the eligible employees for a 401(k) plan is necessary so that your employees know what benefits such a plan provides to them when they are at their retirement stage. You should give knowledge to your employees about the 401(k) plan, its features, rights, and benefits. An SPD – Summary Plan Description – should be provided to all the participants. The SPD is the first vehicle to inform the participants and their beneficiaries about such a plan and their rights, the features of the plan, and the benefits mentioned therein. Not only this, but the SPD also communicates about how a 401(k) plan operates. SPD is often translated as the Disclosing of plan information documents to Participants.

This information may contain, along with basic features, rights, and benefits, the tax advantages to employees such as pre-tax contributions in traditional 401(k) plan, tax-free distributions in Roth contributions, employer contributions (if chosen so), tax-deferred earning, these things help you for highlighting of the advantages for the implementation of 401(k) plan you are establishing for your employees.

How to Operate a 401(k) Plan?      

When you have established a 401(k) plan, now the question arises of how to operate it! But nothing to worry about, the HR experts at WebHR help you solve your operating problems.

First of all, if you had hired certain services of financial institutions, banks, or the insurance company of a retirement fund consultant agency for the establishment of a 401(k) plan, in that case, you may have the additional services of operating such a plan by the service provider.  

Or, if the service provider had established 401k only, and now you need an operating system to operate it, you may hire services of certain financial institutions, banks, or insurance companies of a retirement fund consultant agency.

Or, if you have established it on your own, or through the service provider of a certain bank, insurance company, financial institution, or a retirement fund management consultant, and you want to operate the 401(k) plan on your own.

In either case, you have to take care of the certain details of elements, which are vitally most important to look into and those are as appended below:

  • Participation
  • Contributions
  • Vesting
  • Nondiscrimination
  • Investing the contributions
  • Fiduciary responsibilities
  • Disclosing plan information to participants
  • Reporting to government agencies
  • Distributing plan benefits

What is meant by Participation in a 401(k)?

Participation means a mix of your employees that all participants that are employees as well as the managers and the owners, making a matrix of a mix of employees in 401(k) plan contributions except if an employee has not reached the age of 21 years, has less than a year’s job tenure till the establishment of 401(k), covered by a collective bargaining agreement if retirement benefits were subject of good faith bargaining, or employee is a certain nonresident alien.

What are the Contributions in 401(k)?

Contribution is defined as all the employees may contribute through their salary deductions in a 401(k) plan. You may decide your contributions to participants’ accounts in the plan.

How do you implement the Vesting in 401(k)?

Vesting refers to workers’ salary deferrals that are immediately vested as 100 percent. It means the amount which employees have contributed cannot be forfeited. Upon the leave of an employee, the leaving employee is entitled to deferrals in addition to the investment gains (and even losses minus) upon their deferrals made amid their tenure with the organization. Like in a safe harbor plan, 100 of the contributions are to be vested - as per law – whereas in a traditional 401(k) plan the employer may vest as per vesting scheduling overtime.

How to achieve Nondiscrimination in 401(k)?

Nondiscrimination refers to preserving the tax benefits of a 401(k) plan. The plan should give the functional benefits of such a plan to its rank-and-file employees all employees and not only the managers and the owners. This is called nondiscrimination because the participation, as well as contributions, are compared of the rank and file employees to the owners and the managers.  

Traditional 401(k) plans are subject to annual testing that the contributions made against rank-and-file employees are proportional to the contributions made by the owners and the managers. While in most cases, safe harbor plans are not subject to such annual testing.

How to invest the contributions in 401(k)?

When it is decided by you to establish a 401(k) plan, and your employees have decided to contribute to a 401(k) too, it is time for you to decide on its investment, out of options. In the planning phase, you had to decide that either permit employees to direct the investments of their accounts (investment advice) or you will manage that on their behalf. If you manage for them, you will have to do it in the very interest of the employees to invest in the safe domain or hire the services of consultants for such a task. And if the option is for employees to direct themselves, then you make available your employees the investment options mandatorily.

What are the Fiduciary responsibilities in 401(k)?

Among other actions, fiduciary responsibility is important. This is based on the functions of the plans and not the named fiduciary. Hiring a fiduciary is itself a fiduciary action. Provision of investment advice is also making someone a fiduciary. Now, it depends upon you that all the functions of the plan, or some of those, you hire services of or you do it on your own.

When you run a business, you decide to offer a 401(k) plan or otherwise, this is not a fiduciary action, rather it is business-related, hence business action. Therefore, what should be in a plan, how to manage it, amend it, and administer it are all business decisions. But when you make regulations and give directions, whosoever acts on behalf of the plan, like a hired server, etc. may be a fiduciary action doer – hence may be a fiduciary.

Fiduciary acts as a trust for participants and beneficiaries and its responsibilities are as appended below:

  • Act for the sole benefit of the participants and beneficiaries
  • Act for the exclusive purpose of provision of benefit to participants and beneficiaries by defraying reasonable plan expenses    
  • Carry on the duty with prudence, care, and diligence under the supervision of an experienced person familiar with such matters
  • Plan documentation following
  • Act for the Plan investment diversification

If you being an employer do not have the expertise of such plans management before, it is advised to hire consultant services having such wide experiential brackets in life so that the plan actions become beneficial for you and your employees. That consultant may be from accounting, finance, or investment fields, as deemed appropriate.

There are certain things to be taken care of reasonably like the one is payday. The deductions of such plans should be made no later than the 15th day of the payday from the paychecks of your employees, or even before that if you can make reasonably the deposits contributions to the plan.

Like, For employers having less than 100 participants in the plan, salary deductions may be deposited in the plan before the 7th day after the withholding of such reductions by the employer, it is considered compliance as per law.

For plans, all contributions, employees, and the employer (if so), the plan must designate a fiduciary - typically the trustee – for making sure that the contributions are transmitted. Even if the plan is ambiguous or silent in terms of this action, it is the responsibility of the fiduciary to do so. Nevertheless, you – if operating on your own, or the consultants or the hired services – must update the documents in the plan as per the law if changing from time to time.

How to limit your liability in 401(k)?

Limiting your liability is your responsibility of you.  Which is the potential responsibility for such a plan. You may carry out such actions to demonstrate your responsibilities in handling administration and limiting liabilities management.  

Fiduciary responsibility is to carry out the plan functions, not only the results. For example, if anyone takes a decision, you or the services of the hiring representative, for certain prudent investments options but it did not result in a winner, the responsibility of the fiduciary is to carry out this responsibility in a prudent manner and you should document the process of such decision making and the rationale behind taking a such decision at the time it was taken.

There remains another way to limit the liabilities that are to give considerable decision-making reins into the hands of the plan participants. This control in the hands of the plan participants may result in more specific information dug into by the participants about the investment opportunities. This limits the liability of the employer and a decision control shift takes place in favor of the plan participants. Consultants or other service providers can be hired for working as fiduciaries so that the consultants or the persons hired then assume liability.

Who to hire as a consultant in 401(k)?

When you need to hire some consultant services for your 401(k) plan, you should select from within a financial institution, an insurance agent, a retirement fund management agency, or a consultant. Any of those may be selected as your consultant but should have experience in the field of such or similar retirement plans so that the specialized functions may take place for the total good of employees as well as you - the employer.      

When you select a consultant, you retain some fiduciary responsibility for decision-making for selecting as well as retaining the persons hired. Therefore, you should document your selection process, and look for the change as and when required. This change can be in your selecting of the next hiring consultant and discontinuing the current, one or some changes to your selection procedure itself.

For the best service you can get, you must make a list of the actions and functions your service provider would be offering and carrying on. Not only this but also the schedule of charges should be mentioned by the service provider so that you may cross-compare the rates of similar-level consultants if any. This information would assist you in understanding the portfolio management of the service providers amongst the best available in the market, and to the comprehension of the service provider, you may offer a better cost versus benefit analysis of the service hiring for the plan. This also determines a conflict of interest between you and your service provider. And this way you will be better able to monitor the performance of your service providers in terms of the expertise they claimed to have had been rendered accordingly or otherwise.

What are some important features to look into when hiring a service provider for a 401(k) retirement plan?

Below mentioned are some important features that you must take into your consideration when hiring a service provider for your 401(k) retirement plan:

The firm’s information about the consultant

The firm’s information on the consultant includes any affiliations, financial conditions of the firm, the experience of the 401(k) plans, and the assets under the control of the firm

Descriptive of the Consultant practices

Descriptive consultant practices encompass the way the consultant would work on the plan investments and how the participants’ investments would be directed and handled

Information regarding the quality of the prospective provider

This part includes any identity, experience, or qualification having professionals as part of the firm which is your service provider who would be the key handlers of your plan.

This also includes any litigation or charges that recently taken place against the firm, if so should be well known to you while selecting a firm as your 401(k) plan consultant.

The firm’s experience and record of performance also come under this domain. Also, the firm’s fiduciary information is important for you to know its status and reputation in the market.

How can you monitor the service providers’ functions in 401(k)?

Once you had hired the service providers for your 401(k) plan establishment, administration, or its management - or all three functions – now you should do as appended below to monitor the firm’s or the consultants or the service providers’ functions:

Obtain and see if any notices the service provider issues regarding any changes to the possible compensation or any other information when it is hired or when it is being renewed the contract of the services within you and your service providers.

Review the performance of your service provider periodically. And, read carefully the reports – if any – the service providers issue to you, your participants, or your company as a whole.

Check for the actual fees the consultant service providers are charging. Keep an open eye on the trading, investments, turnover into the investments, or proxy voting, if any, done by the service providers. And importantly, do follow up with the complaints, if any, of the plan participants.   

How you can provide information on Participant-directed plans in 401(k)?

The information can be provided in participant-directed plans so that if the participant directs the investments, the fiduciary responsibility is to create awareness in the participants about their rights and responsibilities for directing the investments. This awareness comprises of provision of information in terms of plan facts, information regarding investment, and the fees and expenses relating to participants’ need for making informed decisions for managing their accounts. You, or those you have hired, are obligatory for the provision of such data to participants for first-time investment directed by the participants and then annually as well. These figures for info about investment options should be presented to participants in the form of a format like a chart flow etc. for allowing participants to compare the options and choose from available better ones. At the same time, if you provide such information to the plan participants which your service provider has submitted to you who is trustworthy and in good faith with you, in this case, you will be in protection from liability in terms of the completeness as well as the accuracy of such information.

What transactions are prohibited to do in a 401(k) plan?

The transactions such as with certain parties or having connections with the plan or self-dealing, which point a figure toward the conflict of interest and could harm the plan, are prohibited. Nonetheless, there are a few exceptions that the United States government has provided, and additional exemptions may be acquired from the Department of Labor the US Government in case the plan protections are in place while conducting transactions.  

These exemptions are, for example, the ones like fiduciary advice for holding, investing, and directing the participants for their investments in accounts. This applies to buying, selling, or holding an investment relevant to the advice and to receiving certain fees and compensation from a fiduciary adviser.

Another exemption is the loan provision, provided that the plan protection of all the participants is intended.

Is this necessary to have a fidelity bond received from the plan handlers in 401(k)?  

Yes, it is necessary to have a fidelity bond to get received by you from the persons who are handling your 401(k) plan for you and your employees. This is for the reason to keep the plan, its participants, and you from any loss which might become a consequence of any fraudulent practice or dishonesty on part of the plan handlers, covered by the fidelity bond.

How do Disclose plan information to participants in 401(k)?

Plan disclosure documentation keeps your participants aware of the plan operations, and it provides an alert to the participants about the alterations in the plan or its operations if any. Not only this, but this information provision alert to the participants also gives them the right to decide upon whatever terms of any changes they want to make timely, and this happens because of the operative alterations made within their accounts in the plan, by any means.

What is Summary Plan Document (SPD) in a 401(k) plan?

There is a document named Summary Plan Document (SPD) which is an easy language document provided to the plan participants having plan features, participants’ rights and responsibilities, and the expectations of the plan. The SPD is the basic descriptive document of the 401(k) retirement plan.

What should be the key features of the SPD document in 401(k)?

The key features encompassing  an SPD document should be as mentioned below:

  • The eligibility criteria of the participants to participate in the 401(k) plan
  • Contribution criteria to the plan
  • How long it will take for vesting
  • When the employees’ eligibility reaches for receiving their benefits
  • How to file a claim for the benefits
  • Participants’ basic rights as well as responsibilities as per ERISA - Employee Retirement Income Security Act