module 4 fundamentals of 401(k) plans

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Module 4Fundamentals of 401(k) Plans

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits

Learning Objectives

4–1 Describe the basic characteristics of a 401(k) plan.

4–2 Identify the minimum coverage rules for 401(k) plans, including the ADP and ACP tests.

4–3 Describe the basic characteristics of the safe harbor 401(k) plan and the qualified automatic contribution arrangements (QACAs).

4–4 Describe the basic characteristics of profit sharing 401(k) plans, 401(k) stock ownership plans (KSOPs), solo 401(k)s, and Roth 401(k) plans.

4–5 Describe the basic characteristics of the SIMPLE 401(k) plan and how it compares to the regular profit sharing 401(k) plan.

4–6 Identify the rules dealing with investments offered in a 401(k) plan, and describe how qualified default investment alternatives need to be structured.

4–7 Describe the basic types of distributions available from a 401(k) plan.

4–8 Determine the factors that employers should consider when evaluating if a 401(k) plan would be appropriate.

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Questions to Get Us Warmed Up

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Learning Objectives









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401(k) Provision

• Allows pretax employee deferrals• Must be offered as part of either a profit

sharing plan (including stock bonus plans)

or a SIMPLE plan• SARSEPs may offer 401(k) provisions,

however new SARSEPs cannot be established (since 1997)

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Profit Sharing 401(k) Contribution Sources

• Employee discretionary deferral of up to $17,500 or 100% of compensation ($5,500 age 50 catch-up)

• Employer discretionary contributions• Employer matching or nonelective

contributions

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Eligible Entities

• Sole proprietors• Partnerships• Corporations (C & S)• Tax-exempt organizations• Indian tribal governmentsNote: State and local governments can no longer establish

new 401(k)plans, but plan established under prior law can continue.

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401(k)

Participant

Employer

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Nondiscrimination – Coverage & Discrimination Testing

Coverage tests•Ratio percentage •Average benefits

Discrimination testing•ADP•ACP

All four of these tests use highly compensated employees

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Highly Compensated Employee• Was a “5% owner”

(ownership of >5%) in the determination year or in the preceding plan year, or

• A person whose compensation was in excess of $115,000 in 2012 (lookback year for 2013)o Employer has the option

to limit highly compensated to the top-paid 20% employees.

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ADP & ACP Tests

• ADP (actual deferral percentage) – employee deferrals (does not include age 50 catch-up contributions)

• ACP (actual contribution percentage) – employer contributions and employee after-tax contributions must pass both tests, unless plan is a safe harbor plan

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Summary of ADP & ACP Tests

If the actual deferral percentage for the Non-highly compensated employees (NHCE) is:

Then the maximum actual deferral percentage for the highly compensated employees (HCE) is:

Between 0% and 2%2 times the actual deferral percentage for NHCE

Between 2% and 8%2 plus the actual deferral percentage for the NCHE

Greater than 8%1.25 times the actual deferral percentage for the NCHE

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Compliance Options if Plan Fails Either Test

• Corrective distribution• Recharacterization• Qualified Matching Contributions (QMACs)• Qualified Nonelective Contributions

(QNECs)

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Qualified Plan Vesting Schedules

Completed Service Years

Cliff Vesting% Vested

Graded Vesting% Vested

Defined benefit plans (non-top heavy)

5-Year Cliff 3-to-7-Year Graded

1-234567

0%0%0%

100%100%100%

0%20%40%60%80%100%

Defined contribution plans, and all top-heavy plans

3-Year Cliff 2-to-6-Year Graded

123456

0%0%

100%100%100%100%

0%20%40%60%80%100%

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Key Employee – Top Heavy Testing

A “key employee” is an employee who, at any time

during the plan year containing the determination date for the plan year to be tested, met either of the following criteria:• was a “5% owner” (ownership of >5%), or• owned >1% of the company and

received compensation >$150,000, or

• was an officer of the company and received compensation >$165,000 (2013)

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Testing – HCE & Key Employees

Test HCE Key Employee

50/40 (DB plans only)

All ERISA eligible

employees

All ERISA eligible

employees

Ratio % (DB & DC plans) Average benefits (DB & DC plans) ADP (401(k) plans) ACP (401(k) plans) Top heavy (DB & DC plans)

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Learning Objectives









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401(k) Safe Harbor Provisions

A plan may be a safe harbor plan if:•Notice is given, and •the employer makes a contribution:

o Deferrals are matched as follows:• 100% match on the first 3% of compensation and• 50% match on between 3% and 5% of

compensation• (or 100% match on the first 4% of compensation)

o or a non-elective contribution of 3% is made for all non-highly compensated employees

•and all employer contributions are 100% immediately vested.

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Automatic Deferral Arrangements

Created under the PPA of 2006•Participants must make a negative election to “opt out” – meant to encourage participation•ACA – Automatic Contribution Arrangement•EACA – Eligible Automatic Contribution Arrangement•QACA – Qualified Automatic Contribution Arrangement•QACA is a safe harbor plan •maximum vesting schedule is two-year cliff

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Learning Objectives









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401(k) Plan Types

• profit sharing plans• solo 401(k)• KSOPs• Roth 401(k)• SIMPLE 401(k)• SARSEPs

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Profit Sharing 401(k)

• Employee deferrals ($17,500/$5,500)• Employer contribution maximum is 25%

of covered payroll (employee deferrals do not count against the 25%)

• Employer contributions may be discretionary, matching, or nonelective

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The Solo 401(k) Plan for Sole Employee Companies

Appropriate candidatesAny business that employs only owners spouses and partners

Set-up deadline Business tax year-end

Elective employee deferral contributions (subject to FICA tax)

Up to $17,500 (2013)

Employee catch-up contributions

$5,500 (2013)

Employer contributions Up to 25% of compensation (20% for self-employed), maximum including employee deferral is $51,000 (2013)

Rollovers and transfers

Allowed from most programs

Loans Available to all participants, including sole proprietorships

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401(k) Stock Ownership Plans (KSOPs)

• Stock bonus plan with 401(k) provisions

• Must be a corporation since stock involved

• Employee deferrals and employer contributions, including matching contributions, are invested in employer stock

• Since company stock – eligible for NUA treatment

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Roth 401(k)

• Same employee deferral limits as profit sharing 401(k)

• No income phaseouts as with Roth IRAs• Roth 401(k):

o has its own five-year “clock”o has required minimum distributions

(RMDs) starting at age 70½o if rolled into a Roth IRA then the Roth

IRA clock applies, and there are no RMDs

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SIMPLE 401(k)

• 100 or fewer employees paid at least $5,000 in the preceding year

• Must be only plan offered by the employer• Employees with less than 1,000 hours of

service in the past year can be left out of the plan

• Permits employee elective deferrals ($12,000/$2,500)

• 100% immediate vesting• No discrimination testing• Mandatory employer

contribution4-26

SIMPLE Plan Employer Contributions

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SARSEP

• SEP with employee deferrals through 401(k) provisions

• May not be established after 12/31/96

• May have up to 25 employees, 50% of whom must participate

• No matching contributions allowed

• Contribution limit, lesser of 25% of compensation or $17,500 ($5,500 catch-up)

• Special ADP testo HC ADP less than 125% of NHC, oro ADP for each HC not greater than double

the NHC ADP and the difference is less than 2%

• IRA rules generally apply to distributions

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Investments in 401(k) Accounts• Must offer a broad range of investment

alternatives – defined as at least three alternatives, each of which is diversified with materially different risk and return characteristics

• Plan fiduciary responsibilities

• Qualified default investment alternatives (QDIAs):o life-cycle or target retirement fundso balanced fundso professionally managed fundo variable annuity that offers

any of the aboveo capital preservation product

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Distributions from 401(k) Plans• In-service (after 2 years)• Loans (allowed but not required) –

maximum is 50% or $50,000, whichever is less

• Hardship withdrawals (allowed but not required) – can only withdraw deferral amounts, generally subject to 10% early withdrawal penalty tax

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Multiple Choice Question 1

“Annual additions” consist of which of the following in a defined contribution plan account?I. employer contributionsII. employee contributionsIII. investment earningsIV. forfeiture reallocations

a. I onlyb. I and II onlyc. I, II, and III onlyd. I, II, and IV only

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Which of the following types of retirement plans are currently permitted to offer 401(k) provisions?I. money purchase plansII. SEPsIII. profit sharing plansIV. stock bonus plans

a. I and II onlyb. I and IV onlyc. II and III onlyd. III and IV onlye. I, II, III, and IV

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If the nonhighly compensated employees’ average deferral percentage (ADP) is 4%, what is the maximum allowable ADP for highly compensated participants?a. 4%b. 5% (4% × 125%)c. 6% (4% + 2%)d. 7% (4% + (75% × 4%))e. 8% (4% × 2)

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Which of the following accurately describe provisions under the hardship withdrawals from a profit sharing 401(k) plan?I. A withdrawal may be made from employee

elective deferrals and associated earnings.II. A participant must establish an “immediate and

heavy financial need.”III. A withdrawal is exempt from the 10% early

withdrawal penalty. IV. A participant must exhaust other available

resources.a. I and II onlyb. II and III onlyc. II and IV onlyd. I, III, and IV onlye. II, III, and IV only

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LMN Corporation provides a profit sharing 401(k) plan that covers 10 participants. The participants’ total compensation is $300,000, and their elective deferrals for the year total $20,000. What is the maximum additional amount the employer can contribute and deduct as a plan contribution for the year?a. $50,000 (25% of $280,000, minus $20,000 of

elective deferrals)b. $55,000 (25% of $300,000, minus $20,000 of

elective deferrals)c. $70,000 (25% of $280,000)d. $75,000 (25% of $300,000)

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Which one of the following is a characteristic of a SARSEP?a. Employees who are age 21 with one

year of service must be allowed to participate in the plan.

b. Only employers with up to 25 eligible employees may offer the plan if established prior to 1997.

c. Participants are 100% vested and may withdraw account balances without penalty.

d. No discrimination tests are required.4-36


Which of the following are correct statements regarding requirements an employer must satisfy in order to offer a SIMPLE plan?I. The employer cannot have more than 25

employees who earn $300 (indexed) or more.II. The employer cannot have more than 100

employees who earn $5,000 or more.III. An employer can combine a SIMPLE plan with

either a profit sharing plan or an ESOP.IV. To offer a SIMPLE plan, the employer cannot

sponsor another qualified plan, a 403(b) plan, or a SEP. a. I only b. II and IV only c. III and IV only d. I, III, and IV only

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Employee elective deferrals cannot exceed which one of the following under a SIMPLE plan in 2013?a. 25% of compensationb. $5,500 c. $11,000d. $12,000 e. $17,500

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Joan Smith works for XYZ Corp. and earns $268,000. XYZ Corp. provides a matching contribution under a SIMPLE 401(k) plan.What would be the maximum amount that could go into Joan’s account? (The Section 401(a)(17) limit on includible compensation is $255,000 in 2013.)a. $8,040b. $12,000c. $14,300d. $19,650e. $19,800

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LMN Corp. made the 3% matching contribution under its SIMPLE 401(k) plan in the prior three years. Due to extensive capital expenses anticipated for this year, the company is considering options on cutting back other expenses. Last year, the 3% matching contribution was actually 2.7% of the total aggregate salary. The company wants you to discuss its options for this year regarding the SIMPLE plan. Which one of the following would you recommend?a. Since the company has satisfied the 3% matching

contribution for three years, it could reduce the contribution to 1%.

b. By providing adequate notice, the company could move to the 2% nonelective contribution for this year.

c. Employer contributions under a SIMPLE plan are “discretionary,” and the company could provide notice that it will not provide any contributions for this year.

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module 4 fundamentals of 401(k) plans

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