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401k Contributions Limits & Vesting

Q: Does an employer have to pay Social Security and unemployment taxes on elective deferrals made under a 401(k) plan?

A: Yes. Although federal income tax is deferred on 401(k) plan 'contributions, Social Security (FICA) taxes and federal unemployment (FUTA) taxes are not. An employer is liable for FICA and FUTA taxes on all wages, including elective deferrals under a 401(k) plan.

Q: What is the difference between a matching contribution and a qualified matching contribution (QMAC)? -TOP

A: A qualified matching contribution, or QMAC, is a matching contribution that an employer has elected to treat the same as an elective contribution - that  is, vesting it 100 percent as soon as it is made and restricting its distribution. Under certain circumstances, QMACs may be treated as elective contributions for purposes of the actual deferral percentage test because they may help the plan pass that test. 

401k Tip
Mutual fund 401(k) plans have been aggressively promoted to the small business communities both by no-load fund companies (e.g., Fidelity Funds, Vanguard Funds) and load fund companies (e.g., MFS, John Hancock, Putnam). recent new articles, however, have reported a trend among many of these plan vendors to abandon the very small plans because the costs of providing 401(k) services for such plans versus the revenue generated from them has proved to be a losing proposition. For economic reasons, the sales target for mutual fund bundled plans has been raised, and now companies with fewer than 100 employees are not being actively solicited by most of these vendors. One company that has enjoyed the benefits of a 401k using no-load mutual fund investments is Target Labs (www.targetlab.com) a small employer.

Q: Other than elective and matching contributions, are there any other types of contributions to a 401(k) plan? -TOP

A: Yes. An employer may make profit-sharing contributions to a 401(k) plan. Also, an employer may make certain contributions that are combined with elective contributions (and assigned to an employee's account) to help the plan pass the actual deferral percentage test. If an employee is not given a choice to receive such amounts in cash, then they may constitute qualified nonelective contributions, or QNECs. Like QMACs, these contributions are subject to the rules on vesting and distribution. 

Q: Are there limits on the amount that an employer may deduct as contributions to a 401(k) plan? -TOP

A: In general, an employer may not deduct an amount in excess of 25 percent of the compensation otherwise paid to beneficiaries under the plan during that year. This deduction limit includes employer contributions only, employee elective deferrals are not considered.

Q: What does the term "vesting" mean? -TOP

A: Vesting refers to an employee's right to the money that is in his or her 401(k) plan account. If an employee terminates employment, any nonvested money in his or her account is forfeited (not paid to the employee). Elective deferrals made by all employees must be immediately 100-percent vested (or "nonforfeitable"). However, nonelective employer contributions, including matching contributions, may be vested according to a schedule established by the plan. There are two types of vesting schedules: cliff vesting and graded vesting.

Q: What happens to an employee's vesting schedule if he or she quits and is subsequently rehired, say after a year? -TOP

A: If an employee experiences a one-year break in service, the employer may exclude years of service prior to the break until the participant completes one year of service following his or her return. A one-year break in service is defined as a calendar year, plan year or other period of 12 consecutive months designated by the plan during which the participant has not completed at least 500 hours of service. That rule must be disregarded for the following reasons: the employee's pregnancy, the birth of a child, the adoption of a child, and caring for a child immediately following a birth or adoption.

Q: Why might an employer choose to make discretionary non-elective contributions to its 401(k) plan?-TOP

A: The employer may choose to supplement the employee elective contributions and matching contributions with discretionary non-elective contributions based on profitability or employer performance. More frequently, a 401(k) plan containing only elective contributions will be supplemented by discretionary non-elective contributions. The profit sharing element of discretionary non-elective contributions provide significant performance incentives to participants.

  Q: How does the employer make a choice between allocating funds to matching contributions or discretionary contributions? -TOP

A: Matching contributions will be contributed only to participants who choose to make elective contributions, while discretionary nonelective contributions will be allocated to all eligible employees. With limited resources, the employer may opt to direct more dollars to matching contributions (rather than discretionary) to reward the employees who make elective contributions to the 401(k) plan.

  Q: How may qualified nonelective contributions be used in a 401(k) plan? -TOP

A: Qualified nonelective contributions (QNECs) may be a feature in a 401 (k) for a number of reasons:

1. The employer may wish to allow highly compensated employees (HCEs) the opportunity to defer a greater portion of their compensation by guaranteeing that the average deferral percentage for non-highly compensated employees (NHCEs) will be equal to at least the level of the QNEC.

Example. Employer C is concerned that participation in the 401(k) plan will be low for NHCEs. By making a QNEC equal to 3 percent of pay for all NHCEs, Employer C will enable HCEs to defer at least 5 percent of pay. The 401(k) plan in this example should easily be able to satisfy the actual deferral percentage (ADP) test (discussed in chapter 12).

2. The QNEC may also be used to correct a problem with the ADP test. If it looks likely that the ADP test will not be met, a QNEC may be used to increase the average deferral percentage for NHCEs. This will be, in many cases, a more viable alternative than refunding excess contributions to HCEs.

3. The QNEC may be used to provide top-heavy minimums for non-key employees in a top-heavy plan. Since non-key participants will generally have to be provided with a 3 percent of pay contribution

  Q: What happens to forfeitures under a 401(k) plan? -TOP

A: he disposition of forfeitures depends on the terms of the 401(k) plan. They may, for example, be allocated as if they were additional employer nonelective contributions. On the other hand, they can be used to reduce matching contributions. Some plans provide that forfeitures attributable to nonelective contributions are to be reallocated and those attributable to matching contributions are to be used to reduce such contributions.

  Q: How are the limits coordinated if the employer has a money purchase or target plan? -TOP

A: An employer that maintains a money purchase or target plan with modest contributions of 10 percent of pay or less may be able to add a 401(k) plan. However, considerable care should be exercised in reviewing the individual Section 415 limits.

  Q: May matching contributions be made on a discretionary basis in a safe harbor 401(k) plan under Code Section? -TOP

A: No. Unless an employer elects to make a nonelective contribution of 3 percent of compensation, an employer is required to make the matching contributions at the level set forth in Code Section 401(k)(12). Last day and/or minimum hours requirements for matching contributions are not permitted.

  Q: What is a discretionary nonelective contribution? -TOP

A: A discretionary nonelective contribution in a 401(k) plan is an employer contribution that is allocated on the basis of compensation or in some manner other than on the basis of elective contributions or employee after-tax contributions. Discretionary nonelective contributions do not need to be included in any of the special nondiscrimination tests for 401(k) plans, but they are subject to the general nondiscrimination rules under Code Section 401(a)(4). (See Chapter 11.) Discretionary nonelective contributions may sometimes be used to satisfy the ADP and ACP test. A participant's right to receive an allocation of a discretionary nonelective contribution cannot depend on whether he or she has made elective contributions.

Example: Emily earns $35,000 and elects to contribute 10 percent of her compensation for the year. Emily's employer provides a matching contribution of 25 percent of the deferral amount and a discretionary nonelective contribution of 5 percent of pay. Emily's total allocation for the year is as follows:

Elective contribution ($35,000 X 10%)  $3,500
Matching contribution ($3,500 X 25%) 875
Discretionary contribution ($35,000 X 5%) 1,750
Total contribution $6,125

  Q: Can an employer contribute unlisted stock or restricted stock in the 401(k)? -TOP

A: No, unlisted stock and restricted stock are not considered "qualified" investments, and fall into the same category of non-qualified items such as rare coins, paintings, beanie babies, Barbie Dolls, and other collectables. There is one exception: If the unlisted stock is valued by an independent CPA firm at least annually, and the employer guarantees to buy back the stock at a fixed price from a terminated employee, then in is possible to use it, but still not recommended. Our advice to the employer is consult with a pension attorney and get a written opinion before proceeding.

  Q: When a company's plan is top heavy and makes the 3% corrective contribution, when must it be made by? Also, if the corrective contribution is made after the plan year, how is it included in the 5500?? -TOP

A: IRS has not stated a deadline for top heavy contributions. Generally, the due date of the employer's return is considered the limit. TAG's opinion is that the top heavy minimum must be made within 12 months after the end of the plan year. This is the same 12 month rule that applies to deferrals and matching contributions in a 401(k) plan. It will be classified as a employer contribution for 5500 purposes. (TAG)

Q: What is cliff vesting? -TOP

A: The cliff vesting method provides that all nonelective and matching employer contributions made on an employee's behalf are zero-percent vested until the employee has completed five years of service and 100-percent vested after the employee has completed five years of service. Cliff vesting after periods of less than 5 years is also permitted.

Q: What is graded vesting? -TOP

A: The graded vesting method uses a phased-in schedule for vesting all nonelective and matching employer contributions made on an employee's behalf over a three-to-seven-year Period.

Vested Years
 of Service Percentage
2 or less 0%
3 20
4 40
5 60
6 80
7 or more 100

Q: What are Employee After-Tax Contributions? -TOP

A: This occurs when employees defer a portion of their salary that was already included as part of their taxable income into a defined contribution plan. Any earnings on this type of contribution grow tax-deferred and income taxes are not due on these earnings until they are withdrawn from the plan. After-tax contributions are not allowed in a 401(k) Pro plan. These contributions are subject to various compliance tests including the Actual Contribution Percentage (ACP) and the 415 limitation.

Q: What is an Employer Matching Contribution? -TOP

A: An employer match is the amount of money that the company contributes to the employee's account. These contributions are subject to various compliance tests, including ACP test and 415 limitation. They are made only to employees who contribute to the plan, and are equal to a certain percentage of the employee's deferral amount. For example, for every 3% that an employee defers to his account, the company could contribute an additional 3%. There are two types of employer match offered to e401k plans, Qualified Employer Match and Safe Harbor. The Employer Match under the Safe Harbor plan is immediately 100% vested.

  Q: What is the Maximum Employee Contribution Percentage? -TOP

A: The maximum employee contribution percentage is the maximum percentage of compensation that a participant may contribute to the plan. In 2002, the maximum allowed by the IRS is 100% of compensation or $40,000, whichever is less. This limitation includes employee deferrals as well as any employer contributions.

  Q: What is the Maximum Deferral Limit? -TOP

A: The maximum limit for employee deferrals. This limit is indexed annually for cost-of-living adjustments. It is $11,000 for the year 2002.

  Q: What is a Non-Elective Employer Contribution ? -TOP

A: This is an annual discretionary contribution made by the employer after an employee satisfies the plan's eligibility requirements. The amount is determined at the end of the plan year. Employer Discretionary contributions are based on the ratio of a employee's eligible compensation to the total compensation paid to all eligible employees for that particular year. To be eligible for discretionary profit sharing contributions, a participant must earn at least 501 hours of service for the plan year or be employed by the employer or related employer the last day of the plan year. The profit sharing amount is determined at plan year end. 

Types of Non-Elective Employer Contributions:

Discretionary Contribution - is determined annually and gives the company the flexibility to change the contribution amount each year.

Safe Harbor Contribution - is a stated amount between 3% - 15%. The standard formula of 3% is designed to satisfy certain compliance tests, and is always immediately vested. Safe Harbor contributions are immediately 100% vested and are subject to withdrawal restrictions.

Q: What is a Pre-Tax Contribution? -TOP

A: The salary amount employees defer, or contribute, into a defined contribution plan before Federal, and in most cases state, taxes are calculated on that money. Participants do not pay any income tax on this amount up to the IRS annual-maximum dollar limit. They also do not pay income tax on any earnings from this money until it is withdrawn from the plan account.

Q: What is the difference between the 415 limits for 401(k) plans (with an option of profit sharing) for 2001 and 2002. -TOP

A: For 2001:

For a 401(k) plan with a limitation year ending in 2001, the 415 limit is the lesser of 25% of compensation or $35,000.

Example: Jane has gross compensation of $40,000 her elective deferrals are $6,000 and she redirects $5,000 for child care reimbursement in the companies 125 plan. 415 limit for 2001: lesser of 25% of compensation ($10,000), or 25% of comp. Since the $6,000 is included in the contribution limit in 2001, she is only allowed to receive $4,000 in employer matching or discretionary profit sharing contributions.

For 2002: 

For a plan with a limitation year ending in 2002, the 415 limit is the lesser of 100% of compensation or $40,000. Additionally, the elective deferral does not count towards the 415 limit. 

Example: Jane has gross compensation of $40,000, her elective deferrals are $6,000, and she redirects $5,000 for child care reimbursement in the 125 plan. Her 415 limit for 2002: 100% of compensation ($40,000). Under EGTRRA, she is allowed to receive an additional $34,000 in employer matching and discretionary contributions.

Additional non-profit websites that include relevant unbiased information about 401k plans include: www.401kc.org 

  Q: If a participant's employment is terminated prior to the last day of the Plan Year, is the employee automatically entitled to either matching or profit sharing contributions? -TOP

A: No. If the plan document dictates, the employee may be required to work at least 1000 hours during the Plan Year, and/or be employed on the last day of the Plan Year to receive the contributions. TAG)

Q: What are the maximum contribution limits for all DC plans? -TOP

A: Maximum Benefit and Contribution Limits

Type of Limitation EGTRRA changes effective for year beginning in 2002 2002 1 2001 2000 1999 1998 1997 1996
401(k) Elective Deferrals $11,000 N/A $10,500 $10,500 $10,000 $10,000 $9,500 $9,500
2 Defined Benefit Plans $160,000 N/A $140,000 $135,000 $130,000 $130,000 $125,000 $120,000
3 Defined Contribution Plans $40,000 $35,000 $35,000 $30,000 $30,000 $30,000 $30,000 $30,000
Annual Compensation Limit $200,000   $170,000 $170,000 $160,000 $160,000 $160,000 $150,000
457(b)(2) and 457(c)(1) Limits $11,000 N/A $8,500 $8,000 $8,000 $8,000 $7,500 $7,500
Highly Compensated                         ($80,000 index) N/A $90,000 $85,000 $85,000 $80,000 $80,000 $80,000 Various
SIMPLE Retirement Accounts $7,000 N/A $6,500 $6,000 $6,000 $6,000 $6,000 N/A
SEP Coverage N/A $450 $450 $450 $400 $400 $400 $400
SEP Compensation $200,000 N/A $170,000 $170,000 $160,000 $160,000 $160,000 $150,000
Key employee officer threshold $130,000 N/A $70,000 $67,500 $65,000 $65,000 $62,500 $60,000
Tax Credit ESOP  N/A $800,000 $780,000 $755,000 $735,000 $725,000 $710,000 $690,000
Maximum Balance
Amount for Lengthening  N/A $160,000 $155,000 $150,000 $145,000 $145,000 $140,000 $135,000
of 5-Year ESOP Period
Excess Distribution Threshold N/A N/A N/A N/A N/A N/A $160,000 $155,000
Qualified Police and Firefighters' DB Benefit Limit N/A N/A N/A N/A N/A N/A $70,000 $66,000
Income Subject to  N/A $84,900 $80,400 $76,200 $72,600 $68,400 $65,400 $62,700
Social Security Tax
FICA Tax for  N/A 7.65% 7.65% 7.65% 7.65% 7.65% 7.65% 7.65%
employees and employers
Social Security Tax for  N/A 6.20% 6.20% 6.20% 6.20% 6.20% 6.20% 6.20%
employees and employers
Medicare Tax for  N/A 1.45% 1.45% 1.45% 1.45% 1.45% 1.45% 1.45%
employees and employers
FICA Tax for  N/A 15.30% 15.30% 15.30% 15.30% 15.30% 15.30% 15.30%
self-employed workers
Social Security Tax for self-employed workers N/A 12.40% 12.40% 12.40% 12.40% 12.40% 12.40% 12.40%
Medicare Tax for  N/A 2.90% 2.90% 2.90% 2.90% 2.90% 2.90% 2.90%
self-employed workers

1 not mandated by EGTRRA

2 Effective for limitation years ending in calendar year
3 Effective for limitation years beginning in calendar year


Q: In a 401(k) plan with profit sharing, if an eligible employee worked half-time (1000 hours), but terminated employment before the year end, would the employee still share in any profit sharing contributions at the end of the year even though they terminated employment before December 31? -TOP

A: Possibly.....According to our Standardized Plan Document, participants who are employed on the last day of the plan year, will always share regardless of the number of the hours of service completed during the Plan Year. For participants who are not employed on the last day of the plan year, the plan can be set up with any one of the following options:
1. plan does not permit the contribution, AND all contributions to the plan are fully vested. OR
2. participant must complete more than ___hours. (not more than 500) or____ months of service (not more than 3) OR
3. participants will share regardless of hours of service.

Q: Can a plan amend the way in which they handle forfeitures, from "added to employer contributions" to "used to reduce employer contributions"? -TOP

A: Yes. A plan could be amended to allow forfeitures to be used to be added to or reduce employer contributions.

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