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).
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.
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).
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.
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.
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 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.
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