Retirement Plan Types
More and more employees view 401(k) plans as a valuable benefit, which has made them the most popular type of retirement plan today. Employees can benefit from a 401(k) plan, even if the employer makes no contribution. Employees can voluntarily elect to make pre-tax contributions through payroll deductions up to an annual maximum limit. The plan may also permit employees age 50 and older to make additional “catch-up” contributions, up to an annual maximum limit. Employee contributions are 100% vested at all times.
The plan may also permit employees to make after-tax Roth contributions through payroll deductions instead of pre-tax contributions. Roth contributions allow an employee to receive a tax-free distribution of the contributions and the earnings on the employee’s Roth contributions if the distribution meets specific requirements.
The employer will often match some portion of the amount deferred by the employee in order to encourage greater employee participation (e.g., 25% match on the first 4% deferred by the employee). Since a 401(k) plan is a type of profit-sharing plan, profit sharing contributions may be made in addition to, or instead of, matching contributions. Many employers offer employees the opportunity to take hardship withdrawals or to borrow from the plan.
Employee and employer matching contributions are subject to special nondiscrimination tests, which limit how much the group of employees referred to as “highly compensated employees” can defer based on the amounts deferred by the “non-highly compensated employees.” In general, employees who fall into the following two categories are considered to be highly compensated employees:
- An employee who owns more than 5% of the business at any time during the current plan year or immediately preceding plan year (ownership attribution rules apply which treat an individual as owning stock owned by his or her spouse, children, grandchildren or parents); or
- An employee who received compensation in excess of the indexed limit in the preceding plan year. The employer may elect that this group is limited to the top 20% of employees based on compensation.
For 403(b) plans, this is directly from the IRS:
A 403(b) plan (also called a tax-sheltered annuity or TSA plan) is a retirement plan offered by public schools and certain 501(c)(3) tax-exempt organizations. Employees save for retirement by contributing to individual accounts. Employers can also contribute to employees' accounts.
For Solo(k) plans, this is directly from the IRS:
A one-participant 401(k) plan is sometimes called a:
- Solo 401(k)
- One-participant k
The one-participant 401(k) plan isn't a new type of 401(k) plan. It's a traditional 401(k) plan covering a business owner with no employees, or that person and his or her spouse. These plans have the same rules and requirements as any other 401(k) plan.
401(k) Safe Harbor Plans
401(k) plans require special nondiscrimination testing (ADP & ACP) which limit the deferrals of highly compensated employees to the average deferrals of the non-highly compensated employees. Quite often the passing of these tests will limit the deferrals of highly compensated employees; or will require additional contributions from the employer. The employer must provide a safe harbor notice to all employees on a timely basis. The safe harbor may be changed from plan year to plan year with appropriate notice to employees.
A Cross-Tested plan is a type of 401(k) or Profit-Sharing plan where allocations are based on both age and compensation and allows for different allocation rates among different classes of employees (new comparability plan) or is allocated in a manner that solely considers age and compensation (age-weighted plan).
Retirement plans cannot discriminate against non-highly compensated employees; therefore, plans must prove nondiscrimination by testing benefits across the various groups. These groups are typically determined based on length of service, attaining certain organizational goals or by classifying each employee in their own group. This can sometimes allow the business owners (or favored employee groups) to receive larger employer contributions than the rest of the employees.
Age-Weighted Profit-Sharing Plans
Profit-sharing plans may also use an age-weighted allocation formula that takes into account each employee's age and compensation. This formula results in a significantly larger allocation of the contribution to eligible employees who are closer to retirement age. Age-weighted profit-sharing plans combine the flexibility of a profit-sharing plan with the ability of a pension plan to provide benefits in favor of older employees. The age-weighted plan allows the company to contribute up to 25% of eligible payroll each year. Unlike the typical profit-sharing plan, the total contribution to an age-weighted plan is allocated based on the employee's age. The older employees will receive a higher contribution than younger employees. This plan type is favorable when the employees targeted to receive larger allocations, are both older and more highly compensated than all other employees.