7.17 Tax Benefits of 401(k) Plans

If your company has a profit-sharing or stock bonus plan, it has the opportunity of giving you additional tax-sheltered pay. The tax law allows the company to add a cash or deferred pay plan, called a 401(k) plan.

Your company may offer to contribute to a 401(k) plan trust account on your behalf if you forego a salary increase, but in most plans, contributions take the form of salary-reduction deferrals. Under a salary-reduction agreement, you elect to contribute a specified percentage of your wages to the 401(k) plan instead of receiving it as regular salary. In addition, your company may match a portion of your contribution. A salary-reduction deferral is treated as a contribution by your employer that is not taxable to you if the annual contribution limits are not exceeded.

Employers have the option of amending their 401(k) plans to allow employees to designate part or all of their elective contributions as Roth contributions (7.20).

Law Alert

Automatic 401(k) Plan Coverage

Employers are encouraged to automatically enroll employees in a 401(k) plan. Unless employees affirmatively opt out, a specified percentage of their pay is contributed to the plan. Even though the employees do not make affirmative elections to contribute, such plans are qualified provided that the employees are given advance notice of their right either to receive cash or have the designated amount contributed by the employer to the plan.

Employers are granted protection from nondiscrimination restrictions if they have automatic enrollment plans that include mandatory matching or non-elective employer contributions.

- - - - - - - - - -

Salary-reduction deferrals.

Making elective salary deferrals allows you to defer tax on salary and get a tax-free buildup of earnings within your 401(k) plan account until withdrawals are made.

The tax law sets a maximum annual limit on salary deferrals to a 401(k) plan, and the same limit applies to 403(b) annuities (7.21), 457 plans (7.22) and salary-reduction SEPs (8.16). However, the terms of your employer’s plan may limit your maximum deferral to a percentage of your compensation, so you may be unable to defer the maximum allowed by the law.

For 2012, the maximum deferral was $17,000 (up from $16,500 for 2009-2011), plus an additional $5,500 for plan participants age 50 or older if the plan permitted the extra “catch-up” contribution. If these limits are increased for 2013, the adjusted amounts will be reported in the e-Supplement at jklasser.com . The maximum deferral is lower for employees of “small” employers who adopt a SIMPLE 401(k); see below.

Elective deferrals within the annual limit are pre-tax contributions, so they are not subject to income tax withholding. However, the contributions are subject to Social Security and Medicare withholdings.

Your employer may not require you to make elective deferrals in order to obtain any other benefits, apart from matching contributions. For example, benefits provided under health plans or other compensation plans may not be conditioned on your making salary deferrals to a 401(k) plan.

Distributions.

Withdrawals from a 401(k) plan before age 59½ are restricted (7.19). Mandatory 20% withholding applies to a lump sum as well as other distributions that are eligible for rollover if the distribution is paid to you and not directly rolled over to another plan (7.8). For those born before January 2, 1936, a lump-sum distribution may be eligible for averaging (7.4).

Nondiscrimination rules.

The law imposes strict contribution percentage tests to prevent discrimination in favor of employees who are highly compensated. If these tests are violated, the employer is subject to penalties and the plan could be disqualified unless the excess contributions (plus allocable income) are distributed back to the highly compensated employees within specified time limits.

SIMPLE 401(k).

Nondiscrimination tests are eased for employers who adopt a 401(k) plan with SIMPLE contribution provisions. A SIMPLE 401(k) may be set up only by employers who in the preceding year had no more than 100 employees with compensation of at least $5,000. An employer who contributes to a SIMPLE 401(k) must report on a calendar-year basis and may not maintain another qualified plan for employees eligible to participate in the SIMPLE plan.

Caution

Reduced Deferral Limit for Highly Compensated Employees

To avoid discrimination problems an employer may set a lower limit for elective salary deferrals by highly compensated employees than the generally applicable ceiling.

If, after contributions are made, the plan fails to meet the nondiscrimination tests, the excess contributions will either be returned to the highly compensated employees or kept in the plan but recharacterized as after-tax contributions. In either case, the excess contribution is taxable. Form 1099-R will indicate the excess contribution.

- - - - - - - - - -

If the SIMPLE contribution requirements are met, the plan is considered to meet 401(k) nondiscrimination requirements. Employee elective deferrals may not exceed an annual limitation, which was $11,500 for 2012. The plan may also allow additional contributions by participants who are age 50 or older by the end of the year. The limit on the additional contribution was $2,500 for 2012. Any increase to the $11,500 and $2,500 limits for 2013 will be reported in the e-Supplement at jklasser.com .

The employer must either match the employee deferral, up to 3% of compensation, or contribute 2% of compensation for all eligible employees, whether or not they make elective deferrals. All contributions are nonforfeitable. No other type of contribution is allowed. In figuring the 3% or 2% employer contribution, compensation is subject to an annual compensation ceiling; for 2012, the compensation limit was $250,000.

Partnership plans.

Partnership plans that allow partners to vary annual contributions are treated as 401(k) plans by the IRS. Thus, elective deferrals are subject to the annual limit (7.18) and the special 401(k) plan nondiscrimination rules apply.