401(K) Plans

Passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) changed the taxation landscape in the Untied States. With respect to 401(k) plans, several changes were made. For the most part these changes helped to increase the amount that individuals and companies are able to contribute to 401(k) plans on a tax-deferred basis.

As of 2006, the amount an employee could defer annually under such programs was set at $15,000. In addition, the sum of employer and employee contributions to one individual's account was set at either 100 percent of annual compensation or $40,000, whichever was higher. The employer was further limited to an annual contribution of 15 percent of total payroll, including both employee deferrals and employer matching and profit-sharing contributions. Finally, the amount of compensation that could be considered in determining an employee's deferral was limited to $200,000 per year. The contribution limits and percentage rates used to calculate plan-wide limits change from year to year and make the administering of these plans a very complex task.

These limits tend to restrict senior executives and other highly paid employees more than the majority of employees. Mandatory "top heavy" tests prevent 401(k) programs from favoring highly compensated employees by restricting the amount that a company's top earners can contribute to 401(k) plans. Known as "nondiscrimi-nation tests" in the benefits industry, top heavy rules separate employers and employees into two groups: those who are highly compensated and all the rest. The amount that the highly paid employees may defer is based upon what the lower-paid employees deferred during the year. If the average lower-paid employee only contributed 2 percent of his or her compensation to the corporate 401(k), for example, highly paid employees may only divert 4 percent of their pay. Benefits and tax specialists have, of course, devised strategies to circumvent these restrictions, such as 401(k) wrap-arounds, "rabbi trust arrangements," and other "non-qualified" plans that consciously and legally operate outside the bounds of "qualified" 401(k)s. Such plans are costly to administer and run and are not often seen in small company settings.

ADVANTAGES AND DISADVANTAGES OF 401(K) PLANS

The shift from defined-benefit plans to defined-contribution plans such as 401(k)s has had both positive and negative ramifications. On the downside for employees is their need to shoulder more of the financial burden for their retirement. Compared to defined-benefit plans, defined-contribution plans are risky. Instead of a federally guaranteed pension pay-out upon retirement, 401(k) plan holders make their own investments which offer the hope of great gains but also contain the potential for great losses. The story of Enron and the stock market declines of the early 2000s both showed what could happen to investments in a 401(k) plan. Nonetheless, most observers have applauded the movement towards greater reliance on 401(k) plans. Employees have gained greater control over their retirement assets. The plans provide immediate tax advantages as the contributions are not subject to federal income taxes nor to most state and local taxes. They also provide long-term tax advantages, as earnings accumulate tax-free until withdrawal at retirement, when withdrawals can presumably receive favorable tax treatment. In addition, 401(k)s offer loan provisions that many other pension plans lack.

For employers, 401(k) plans offer many advantages. For example, employers have been able to share or entirely eliminate their pension contributions. And if employers do choose to contribute, the employer too gets a tax deduction. 401(k)s have evolved into a valuable perk to attract and retain qualified employees. Employers can even link contributions to a profit-sharing arrangement to increase employee incentive toward higher productivity and commitment to the company. By enabling employees to become active participants in saving and investing for their retirement, 401(k) plans can raise the level of perceived benefits provided by the employer.

Small business owners can set up a 401(k) plan by filling out the necessary forms at any financial institution (a bank, mutual fund, insurance company, brokerage firm, etc.). There are several types of 401(k) plans that may be used, one of which is the SIMPLE 401(k) plan. The IRS Web site explains that this sort of plan was especially created so that small businesses could have an effective cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to the traditional plans. The employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. In addition, employees that are covered by a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.

The fees involved in establishing and administering a 401(k) plan can be relatively high, since sponsors of this type of plan are required to file Form 5500 annually to disclose plan activities to the IRS. The preparation and filing of this complicated document can increase the administrative costs associated with a plan, as the business owner may require help from a tax advisor or plan administration professional. Fortunately, for companies with fewer than 100 employees, a SIMPLE 401(k) plan is an option and one that entails fewer fees and administrative costs.

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