401(k) Plan Description

A 401(k) plan is a type of profit-sharing or stock bonus plan to which employees can elect to have their employers make pretax contributions (e.g., salary deferrals) on the employees' behalf in lieu of paying an equivalent amount in currently taxable cash wages. These plans are sometimes called "cash or deferred arrangements" (CODAS).

Generally, 401(k) plans are the only qualified retirement plans that offer employees a way to defer taxation on amounts the employees contribute on a pretax basis to the plan. These amounts accumulate in the plan, along with investment gains or losses, and are taxed when distributed from the plan. The investment gains or losses also are not subject to current taxation. Presumably, if distributions begin at retirement age, the participant will be in a lower tax bracket.

Because the 401(k) plan is part of a profit-sharing plan, employers still have the advantage of flexibility in making discretionary contributions. Employers that cannot afford to make any discretionary contributions will still find a 401(k) plan an attractive option to offer employees that wish to contribute on their own. However, these contributions must meet certain nondiscrimination tests to ensure they are not discriminatory with respect to nonhighly compensated employees. However, the lower paid employees often will elect to receive cash in lieu of deferring salary. To encourage their participation, employers can offer to "match" salary deferrals under a formula stated in the plan. For example, an employer may match 50 cents of each dollar deferred by employees. The employer can also set a cap on the maximum amount they will match. For example, the employer may match 50 cents of each dollar, up to a maximum of 6% of compensation (resulting in a maximum match amount of 3% of compensation). However, matching contributions are not discretionary. They must be made according to the terms of the plan document.

Employees may elect to defer only future compensation [IRC Sec. 401(k)(2)(A)]. In other words, only compensation that has not yet been received or that the employees does not have the right to receive is eligible for salary deferrals.

For the purposes of 401(k) plans, self-employed individuals and partners are considered "employees." As such, these individuals are eligible to participate in the 401(k) plan. However, partners are not eligible to receive matching contributions [Reg. 1.401(k)-1(a)(6)(i)].

Special rules that apply to partnerships are found in Reg.1.401(k)-1(a)(6).

In order to qualify as a 401(k) plan, the plan must satisfy all the requirements of IRC Sec. 401(k). These include the following:

In addition, salary deferral contributions must satisfy one of two nondiscrimination tests that apply only to 401(k) plans [IRC Sec. 401(k)(3)(A)(ii)]. Each of these test relates the average rate of salary deferrals made by highly compensated employees to the comparable average rate for nonhighly compensated employees. The salary deferral rate is the ratio of the salary deferral contributed by the employee to the employee's compensation. This ratio is known as the "actual deferral percentage" (ADP).