Contibutions

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Four different types of contributions can be made to 401k plans -- each with its own vesting and distribution rules. Of the four types of possible 401k contributions only elective contributions are required in order to establish a 401k plan. The other options may be added to make the plans more attractive to employees and to increase the amounts that can be sheltered from current taxation -- but they are not required.

Elective contributions are the contributions that an employer makes to a plan based on its employees' elections, instead of paying the employee cash. Employees are not currently taxed on these amounts. Elective contributions and the income earned on these contributions must be fully vested at all times -- but are subject to restrictions on premature withdrawals.

Under some plans employees may make additional contributions -- a fixed percentage of salary -- through payroll deductions. These additional contributions are included in the employee's income, but the plan earnings attributable to them are not taxed until distribution. These contributions must be fully vested when made and may be withdrawn at any time without restriction.

Some employers agree to make additional contributions to their 401k plans for every dollar that employees elect to contribute. No particular matching formula is required as long as the formula does not result in discrimination or contributions in excess of statutory maximums. For example, some plans may offer a dollar-for-dollar match, other plans a 25 cents-on-the-dollar match.

Nonelective contributions are another type of contribution employers may make to their 401k plans. These contributions are made irrespective of any election or contributions by the employee. These contributions are generally computed on the basis of the employer's profits and are allocated to employees in proportion to their salaries. They are subject to restrictions on premature withdrawal and may be subject to deferred vesting as well.

Example: American Saddle Works, Inc., has had a profit-sharing plan for its employees since 1965. In 1980 it added a 401k feature to its plan that allowed employees to defer up to 6% of their salaries through payroll deductions. Employees may also contribute an additional 4'% of their salaries to the plan in after-tax dollars. American Saddle matches the first 6% of employee contributions on a dollar-for-dollar basis and matches the next 4%% on a 50-cents-on-the-dollar basis. In addition, the company makes a profit-sharing contribution on behalf of its employees in an amount that is annually determined on the basis of profits for the year. This contribution, once determined, is allocated in proportion to employees' salaries. Employees are not fully vested in matching contributions or profit-sharing contributions until they have been with the company for three years.

In 2006, Kyle Miller earned $32,000. He decided to contribute 9% of his salary to the plan. At the end of 2006, American Saddle made a profit-sharing contribution to its plan and Kyle's share of the contribution was $1,500. The total contributions made to Kyle's account in the plan for 2006 are:

Kyle began his employment with American Saddle in 2003 and enrolled in the plan at the beginning of the 2004 plan year. Of the 2006 contributions, $2,880 (his elective and voluntary contributions) are immediately vested with Kyle. The "employer contributions" of $3,940 (matching and non-elective) will fully vest in 2007 (three years after he was enrolled).

The tax code places three separate limits on the amounts that can be contributed to a 401k plan. The first limitation applies to the total amount of all contributions made into a 401k account during the year - regardless of the type of contribution. The second annual limitation applies to the total amount of elective contributions that an employee may make. Lastly, the tax code limits the amount of compensation that an employer may take into account when calculating matching and non-elective contributions. These are, of course, subject to any other limits placed on the plan by the employer.

Forfeitures occur when an employee terminates employment. Any unvested amounts in their plans must be retained by the plan - the law does not allow employers to simply reclaim the unvested share. In most defined contribution plans (including 401k plans), forfeitures are allocated among the remaining participants, based on their levels of compensation.

For purposes of this "100% / $40,000 rule", the tax code defines compensation as net of the employee's elective contribution (this is discussed in greater detail in Solo 401ks). The tax code also limits the amount of compensation that an employer may consider when calculating matching contributions .

The tax code limits the amount of compensation employers may take into consideration when determining contributions to qualified plans. Initially, this limit was set at $150,000 per employee (adjusted for inflation). For 2007, the adjusted compensation limit is $225,000. In effect, the employer may only take the first $225,000 of the employee's compensation when calculating matching or non-elective contributions.

Example: An employer matches contributions, dollar-for-dollar, of up to 5% of an employee's compensation. Employee A earns $300,000 in 2007 and makes elective contributions of 5% or $15,000. The employer may only contribute $11,250 (5% of $225,000) not the "full match" of $15,000. Employee B, earning $400,000 in 2007, may only defer $15,500 in elective contributions [the flat dollar limit discussed below] not the full 5% or $20,000. The employer may "match" this with $11,250 (5% of $225,000).

Employees may not contribute more than $7,000 (indexed for inflation) as elective contributions per year. The inflation-adjusted limit is $15,500 for 2007. This aggregate annual dollar limit applies not to a single 401k, but rather to all retirement accounts to which an employee may make elective contributions. Currently, employees may make elective contributions to 401k plans, tax sheltered annuities (403b plans) and SEP-IRAs. (A reduced limit applies to SIMPLE plans). This limit on elective deferrals applies to all such plans in which the employee participates, whether sponsored by the same employer or other employers. The total amount of elective contributions that an employee may make to all of these plans is subject to this annual limit.

If an employer maintains more than one such plan, the employer is responsible for enforcing this rule on total contributions. If the employer contributes more than the legal limit on behalf of an employee - the plans may lose their tax-advatanged status. If an employee contributes more than the legal limit to "unrelated" plans of different employers, the plans will not be disqualified - however, the individual will be subject to taxation on the excess contribution.

Example, An employee defers $7,500 to the 401k plan of Employer A and $9,000 to the SEP IRA plan of Employer B has an excess elective deferral of $1,00 in 2007. Unless withdrawn, this excess is included in the employee's taxable gross income for the year.

Employees aged 50 and older may contribute additional elective contributions as a "catch-up" provision. Presumably this is a way to make up for "missed" contributions as one approaches retirement age. In 2007, the catch-up provision for elective contributions is $5,000 -- and adjusted for inflation thereafter.

Catch-up provisions may be make into the account even if by doing so, the total contributions exceed the limits discussed above ),i.e., catch-up contributions are exempt from the other limitations. The catch-up provision, like the general limit on elective contributions, applies to the total amount that can be contributed by an employee each year to all eligible plans each year (that is, it applies "per employee", not "per plan").

Plan documents must specifically allow for catch-up provisions; the vast majority of them do. Employers may choose whether or not to make matching contributions for an older worker's "catch-up" elective deferrals. Employees should review their plan documents to see how their employer treats these contributions.

Example: Tatiana is a participant in Kwik Copier's 401k plan. Her salary for 2007 is $78,000. She has 5% of her salary deducted as her elective contribution to the plan. The plan provides a dollar-for-dollar match. Tatiana also defers 6% of her salary as a voluntary after-tax contribution. At the end of 2007, the board of directors of Kwik Copiers decided to make a non-elective profit-sharing contribution to the plan. Of this contribution, $5,400 is allocated to Tatiana's account. And, due to recent departures of a number of unvested employees, her account is allocated $1,000 of these employees' forfeitures.

Tatiana's elective contribution does not exceed the special limitation for elective contributions ($15,500 for 2007). Therefore, no part of that contribution is included in her gross income. If Tatiana was eligible to participate in other plans such as a SEP-IRA or 403(b) tax sheltered annuity, she could make additional elective contributions of up to $11,600 ($15,500 - $3,900) to those plans. Since the elective contribution is not included in her gross income, it is not treated as "compensation". When calculating the "100%/$40,000" limit, her net compensation is $74,100 ($78,000 less $3,900). The total "additions" of $18,880 to her account are less than her compensation and do not exceed $45,000 in 2007 - so these contributions are all permissible under the contribution limits.

Employers must deposit "employee" contributions (i.e., elective and voluntary contributions) into the plan as soon as these amounts can be reasonably segregated from the employer's general assets. The tax code requires that the deposit be made no later than the 15th business day of the month following the month in which contributions were withheld or received by the employer.

To be an acceptable "separate accounting," the plan must allocate gains, losses, withdrawals, and other credits or charges on a reasonable and consistent basis to the participant's account -- that is, not discriminate in favor of highly compensated employees. This rule applies to plans that impose a vesting requirement or restrictions on withdrawals of employer contributions. Employers who wish to simplify accounting by maintaining only one account for each employee must consider all contributions 100% vested.

Generally, employers and employees are not taxed on elective, matching, or non-elective contributions as long as these do not exceed the annual contribution limits or violate the non-discrimination rules (discussed later). In other words, they are not included in either the employee's or employer's taxable income. Naturally, an employee's voluntary, after-tax contributions come from amounts that have already been taxed. The employee may not deduct voluntary contributions from his or her taxable income.

Elective contributions are excluded from an employee's federal income tax (and withholding calculations), however, they are included in the Social Security and Unemployment Insurance wage base to calculate withholding and the employer's contribution to these taxes. Voluntary after-tax contributions come from compensation that has already been taxed.

If an employee is a participant in two or more 401k plans, it is the employee's responsibility to notify his or her employers how excess deferral is to be allocated among the plans - no later than March 1st of the year after the excess deferral occurred.

Example: Joseph Blough is an engineer for Futurtek Instruments and also teaches at Engineer Institute, a private college. Both companies maintain 401k plans and Joseph contributes to both. In 2007 he made elective contributions of $9,665 to the Futurtek's plan and $7,200 to the Institute's plan, for a total of $16,865. Joseph must include $1,365 (the excess over the $15,500 limit for 2007) in his taxable income for 2007. In February 2008, Joseph discovers the excess deferral while preparing his 2007 tax return and decides to withdraw the $1,365 to avoid being taxed on that amount twice. Joseph chooses from which account to make the withdrawal. He decides to withdraw the $1,365 from the Institute's plan because Futurteks' plan has had a better investment record. Joseph notifies the Institute of the excess deferral and his intention to withdraw it (plus allocable income) on February 15, 2008, and receives the funds on April 1, 2008. He includes $1,365 - the actual amount of the excess deferral - on his 2007 tax return. The income attributable to the excess deferral is included in his taxable income for 2008.

If an individual defers more than the maximum for a tax year of two or more unrelated-employers (as in the example above), neither of the plans is disqualified due to the excess - whether the excess is withdrawn or not. On the other hand, if an individual defers more than the maximum amount under a single plan or multiple plan of the same or related employers, the plan or plans will be disqualified - unless corrective action is taken.

Within limits, an employer is entitled to deduct elective, non-elective, and matching contributions to an employee's 401k account as employee compensation - so long as the total amount of compensation is "reasonable". Deductions are allowed for the plan year if monies are deposited into the plan no later than the employer's tax filing date (including extensions).

Deductions for elective and matching contributions for the plan year must relate to income earned by the employee during that tax year. For example, an employer maintains its 401k plan on a calendar year basis, but has a fiscal (or tax) year running from July 1, 2006 to June 30, 2007. When claiming a deduction for elective and matching contributions for tax year 2007, the employer may not claim contributions based on employee compensation earned after June 31, 2007. These will be deductible in tax year 2008.

To maintain their tax-qualified status, 401k plans must explicitly limit a participant's annual elective deferrals under the plan ($15,500 in 2007 plus $5,000 catch-up deferrals). If an individual defers more than the maximum amount under a single plan or multiple plan of the same or related employers, the plan or plans will be disqualified. To avoid disqualification, the plan may make corrective distributions [In some cases, these distributions may have an impact on the non-discrimination rules.]

While the tax code limits the amount that an employee may contribute to his or her 401k account, the tax code also limits the size of tax deduction that can be taken by employers on their tax return. Employers may deduct up to 25% of employee contributions as a business expense.

This 25% limitation applies to the employer's total "payroll" of all eligible employees, not the compensation of individual workers. Bear in mind that elective, matching and non-elective contributions, are treated as employer contributions for this purpose. Even though the contribution for each individual may be as high as 100% of the employee's compensation, the 25% deduction limitation almost always represents the practical limit on the amount of the employer's contributions. Theoretically, an employer could contribute more than 25% for some employees and less than 25% for others and still have an overall contribution not exceeding 25%. However, such a plan would be discriminatory unless a greater percentage of compensation is contributed on behalf of lower-paid workers rather than highly compensated employees - but that is an unlikely scenario for most employers.

Any contribution in excess of the 25% limit is made entirely out of after-tax profits of the employer - and the employer must pay a 10% excise tax on the excess. [Employers who contribute to both a defined benefit plan and a defined contribution arrangement (such as a 401k) may not deduct annual contributions in excess of 25% of the compensation paid to plan participants, or the amount of contributions made under the defined benefit plan necessary to satisfy the minimum funding standard.]

Many types of employee benefits are keyed to an employee's compensation. For example, benefits under a defined benefit pension plan may be based on a percentage of a participant's compensation. An employee who elects to defer a portion of compensation under a 401k plan may, therefore, be reducing entitlement to other benefits at the same time.

Example: Dwayne Schroeder is employed by E-Z Rental Co. at a salary of $40,000 per year. He elects to contribute 6% of this amount, or $2,400, to E-Z's 401k plan. E-Z Rental also maintains a pension plan that pays an annual pension equal to 80% of an employee's final compensation. The pension plan also defines compensation in such a way that Schroeder's salary is reduced by his elective contribution before application of the 80%. If this is Schroeder's last year before retirement, his elective contribution to the 401k plan of $2,400 would reduce his annual pension from the pension plan by $1,920 (80% of $40,000 versus 80% of $37,600)

The IRS has ruled that pension plans may (or may not) count elective contributions as part of compensation for the purpose of computation benefits. Plans that exclude elective contributions from "compensation" are not considered discriminatory for that reason. The employer who establishes such plans has the discretion in how it defines "compensation". Other such pay-related benefits may include group life insurance, medical benefits, and disability benefits.

Example: E-Z Rental also provides disability insurance coverage equal to 50% of its employees' annual compensation -- using the above example: Schroeder's 401k contribution would reduce his annual disability coverage from $20,000 (50% x $40,000) to $18,800 (50% x $37,600) -- or a reduction of $100 per month, if he were to become disabled.

Elective contributions to a 401k plan are excluded from the employee's income for federal income tax and income tax withholding purposes. However, elective contributions are included in the FICA (Social Security and Medicare) and FUTA (federal unemployment tax) wage bases, for both withholding purposes and to determine the employer's contribution to these taxes. Any voluntary contributions made by the employee are subject to FICA and FUTA taxes.

Matching contributions and nonelective contributions (i.e., amounts contributed to the plan by an employer which the employee could not have elected to receive in the form of cash or other taxable benefit) are not subject to FICA, FUTA or federal income taxes.