401k Plans, ADP Test, ACP Test

Text Box: A LESSON IN QUALIFIED RETIRMENT PLANS The information contained in these page focuses on pension benefit plans under the Employee Retirement Income Security Act of 1974 (ERISA), particularly those plans considered qualified for special tax considerations under the Internal Revenue Code. These plans are commonly referred to as “qualified plans.” 401(k) Plans Over the last decade, profit sharing plans that contain a 401(k) feature (sometimes called a qualified cash or deferred arrangement (CODA)) have become very popular. This feature permits an employee to elect to defer part of his or her compensation. The money is contributed to a 401(k) profit sharing plan instead of being paid as taxable compensation. These contributions are known as elective salary deferrals, or elective contributions, and reduce the current taxable income of the employee for federal income taxes purposes and, in most states, state income taxes. An elective contribution does not reduce compensation for Social Security taxes (FICA). Elective deferrals are considered employer contributions for all plan purposes. The rationale for this treatment is related to the manner in which the employer claims a deduction for these amounts on its tax return. Employee deferrals are deducted as retirement plan contributions rather than as compensation paid to employees. Each employee is limited in the amount he or she can contribute to all 401(k) plans in which he or she participates during a calendar year. The maximum amount an employee may defer each calendar year is adjusted annually for cost-of-living increases. This adjustment procedure is called indexing.

401(k) employee deferral limits since 1990 are listed at the right.

In many plans, the employer chooses to make employer contributions that match all or part of the employee elective salary deferrals. This encourages employees to participate. It also gives the employer the opportunity to manage its costs for the plan. For example, an employer may match 50 percent of the first 6 percent of pay the employee defers to the 401(k) plan. In this example, the employer knows its maximum cost for matching contributions to the 401(k) plan is 3 percent of the wages of eligible participants (50 percent of 6 percent of pay).

The employer may also elect to make a discretionary contribution under the profit sharing provisions of the plan. All employer contributions to 401(k) plans, other than elective salary deferrals, are known as non-elective contributions.