401(k) and Other salary Savings Plans

Chapter 23

I. Introduction

• In general, a salary savings plan is a plan that gives the employees the choice whether to receive a part of their compensation in cash or to contribute it to a qualified plan

• Popularity can be explained:– No funding commitment by the employer– Cost to the employer is min– No long-term liability for employer– High portability – amount of savings is discretionary– could be simple to administer

II. 401(k) Plans (CODA)

• Employees agree to a salary reduction that is contributed to a qualified plan.

• It could be an independent plan or included with regular profit-sharing, savings or stock bonus plan.

• Section 401(k) plans can be adopted only by private employers and tax-exempt organizations.

• Advantages and Disadvantages:– Tax-deferred savings meduim– Employee can choose the amount of

contribution– Similar to IRAs easy to understand– attractive for employers– Design of the plan may save the employer

money

• $14,000 limit contribution is small compared to other plans

• Qualified plan is more complicated than individual savings vehicle

• Employer’s deduction is limited to 25% of covered payroll

• Deferral amounts must be 100% vested

• Features of 401(k) plans:

• salary reduction must be made before the beginning of the year

• Employer makes a matching contribution to the plan

• Employer participation is not a requirement for 401(k) plan.

• Plan may permit employees to make additional after-tax contributions.

• 401(k) plan must meet all the eligibility and coverage requirements for qualified plan

• Vesting: nontaxable employee salary reductions must be immediately 100% vested– employer contributions must meet the usual

vesting rules

• limit $14,000 contribution is imposed on all 401(k) plans, 403(b) and SIMPLEs

• ADP tests must be met: failure will cause the plan to disqualify

• Distributions: not before age 59 1/2 except upon death, disability, separation from separation.– 10% early withdrawal penalty

• FICA and FUTA are withheld

III. SIMPLEs

• Definition:Non-qualified salary savings plan where contributions are made to the participating employee’s IRA

• Employee’s contribution cannot exceed $10,000 /year

• Eligible employers:– 100 or fewer employees– employer does not maintain a qualified plan

• Advantages: – can be established by filling an IRS form– benefits are portable 100% vested– Accounts are owned by employees– Employees benefit from good investment

• Disadvantages:– SIMPLEs cannot be the only source of

retirement income

• Benefits are not adequate if employee does not make significant contributions

• Contribution limit = $10,000 / year• Employer is required to make contribution

equal to either– (a) a $-to-$ matching contribution up to 3% – (b) 2% of compensation for all eligible

employees

• Each employee must maintain an IRA

• Both salary reduction and employer contribution are not included in the employee’s taxable income.

• Employee contributions are subject to FICA and FUTA

• Distributions are subject to the same restrictions as IRA

IV. 403(b) Tax-Deferred Annuity Plans

• Designed for tax-exempt organizations as a supplement to qualified plan.

• Eligible employees as defined in Section 501©(3)

• Part-time or full time employee.

• Distributions from 403(b) plans are subject to the same rules as 401(k)

• Withdrawals are not permitted before age 591/2

• 403(b) plans have loan provisions• Taxation: same tax advantages as qualified

plan• Upon distribution the full amount is taxable

either during employment or at termination of service.

• Contribution limits: Max = lesser of two amounts: (1) the exclusion allowance for a given year and (2) $40,000-or-100-percent-of-income defined contribution limit.

• $14,000 limit applies to the salary reduction

V. Section 457 Plans

• Designed as a salary savings arrangement for governmental employers

• Limit = $9,000 /year or 1/3 of the employee taxable compensation.