To adopt a tax-advantaged 401(k) plan, you can use an IRS-approved master or prototype plan offered by a sponsoring organization or an individually designed plan.
Written Plan Requirement
To qualify, the plan you set up must be in writing and must be communicated to your employees. The plan's provisions must be stated in the plan. It is not sufficient for the plan to merely refer to a requirement of the Internal Revenue Code.
Master or Prototype Plans. Most qualified plans follow a standard form of plan (a master or prototype plan) approved by the IRS. Master and prototype plans are plans made available by plan providers for adoption by employers (including self-employed individuals). Under a master plan, a single trust or custodial account is established, as part of the plan, for the joint use of all adopting employers. Under a prototype plan, a separate trust or custodial account is established for each employer.
Plan Providers. The following organizations generally can provide IRS-approved master or prototype plans:
- Banks (including some savings and loan associations and federally insured credit unions).
- Trade or professional organizations.
- Insurance companies.
- Mutual funds.
Individually Designed Plan. If you prefer, you can set up an individually designed plan to meet specific needs. Although advance IRS approval is not required, you can apply for approval by paying a fee and requesting a determination letter. You may need professional help for this. Revenue Procedure 2012-6 in Internal Revenue Bulletin 2012-1 may help you decide whether to apply for approval. Internal Revenue Bulletins are available on the IRS website at irs.gov. They are also available at most IRS offices and at certain libraries.
User Fee. The fee mentioned earlier for requesting a determination letter does not apply to certain requests made in 2003 and later years, by employers who have 100 or fewer employees who received at least $5,000 of compensation from the employer for the preceding year. At least one of them must be a non-highly compensated employee participating in the plan. The fee does not apply to requests made by the later of the following dates:
- The end of the 5th plan year the plan is in effect.
- The end of any remedial amendment period for the plan that begins within the first 5 plan years.
The request cannot be made by the sponsor of a prototype or similar plan the sponsor intends to market to participating employers.
Participants can choose (elect) to have you contribute part of their before-tax compensation to the plan rather than receive the compensation in cash. This contribution is called an “elective deferral” because participants choose (elect) to set aside the money, and they defer the tax on the money until it is distributed to them.
Alternatively, your 401(k) plan can have an automatic enrollment feature. Under this feature, you can automatically reduce an employee's pay by a fixed percentage and contribute that amount to the 401(k) plan on his or her behalf unless the employee affirmatively chooses not to have his or her pay reduced or chooses to have it reduced by a different percentage. These contributions qualify as elective deferrals. The IRS has more information about 401(k) plans with an automatic enrollment feature.
Limit on Elective Deferrals
There is a limit on the amount an employee can defer each year under these plans. This limit applies without regard to community property laws. Your plan must provide that your employees cannot defer more than the limit that applies for a particular year. For 2013, the basic limit on elective deferrals is $17,500. If, in conjunction with other plans, the deferral limit is exceeded, the difference is included in the employee's gross income.
Catch-Up Contributions. A 401(k) plan can permit participants who are age 50 or over at the end of the calendar year to also make catch-up contributions. The catch-up contribution limit for 2013 is $5,500. Elective deferrals are not treated as catch-up contributions for 2013 until they exceed the $17,500 limit, the ADP test limit of Internal Revenue Code section 401(k)(3), or the plan limit (if any). However, the catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts:
- The catch-up contribution limit.
- The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.
Treatment of Contributions. Your contributions to a 401(k) plan are generally deductible by you and tax free to participating employees until distributed from the plan.
Participating employees have a nonforfeitable right to the accrued benefit resulting from these contributions. Deferrals are included in wages for Social Security, Medicare, and federal unemployment (FUTA) tax.
Reporting on Form W-2. You must report the total amount deferred in boxes 3, 5, and 12 of your employee's Form W-2. See the Form W-2 instructions.
Treatment of Excess Deferrals
If the total of an employee's deferrals is more than the limit for 2013, the employee can have the difference (called an excess deferral) paid out of any of the plans that permit these distributions. He or she must notify the plan by April 15, 2014 (or an earlier date specified in the plan), of the amount to be paid from each plan. The plan must then pay the employee that amount by April 15, 2014.
Excess Withdrawn by April 15. If the employee takes out the excess deferral by April 15, 2014, it is not reported again by including it in the employee's gross income for 2014. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10 percent tax on early distributions.
If the employee takes out part of the excess deferral and the income on it, the distribution is treated as made proportionately from the excess deferral and the income. Even if the employee takes out the excess deferral by April 15, the amount is considered contributed for satisfying (or not satisfying) the nondiscrimination requirements of the plan, unless the distributed amount is for a non-highly compensated employee who participates in only one employer's 401(k) plan or plans.
Excess Not Withdrawn by April 15. If the employee does not take out the excess deferral by April 15, 2014, the excess, though taxable in 2013, is not included in the employee's cost basis in figuring the taxable amount of any eventual benefits or distributions under the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.
Reporting Corrective Distributions on Form 1099-R. Report corrective distributions of excess deferrals (including any earnings) on Form 1099-R. For specific information about reporting corrective distributions, see the Instructions for Forms 1099, 1098, 5498, and W-2G.
Tax on Excess Contributions of Highly Compensated Employees. The law provides tests to detect discrimination in a plan. If tests, such as the actual deferral percentage test (ADP test) (see IRC section 401(k)(3)) and the actual contribution percentage test (ACP test) (see IRC section 401(m)(2)), show that contributions for highly compensated employees are more than the test limits for these contributions, the employer may have to pay a 10 percent excise tax. Report the tax on Form 5330. The ADP and ACP tests do not apply to safe harbor 401(k) plans.
The tax for the year is 10 percent of the excess contributions for the plan year ending in your tax year. Excess contributions are elective deferrals, employee contributions, or employer matching or nonelective contributions that are more than the amount permitted under the ADP test or the ACP test.
Notice 98-1 provides further guidance and transition relief relating to the nondiscrimination rules under sections 401(k) and 401(m).
Amounts paid to plan participants from a qualified plan are called distributions. Distributions may be nonperiodic, such as lump-sum distributions, or periodic, such as annuity payments.
Distributions from 401(k) Plans
Generally, distributions cannot be made until one of the following occurs:
- The employee retires, dies, becomes disabled, or otherwise severs employment.
- The plan ends and no other defined contribution plan is established or continued.
- In the case of a 401(k) plan that is part of a profit-sharing plan, the employee reaches age 59½ or suffers financial hardship. For the rules on hardship distributions, including the limits on them, see section 1.401(k) - 1(d)(2) of the Income Tax Regulations.
Caution. Certain distributions listed above may be subject to the tax on early distributions discussed later.
Qualified Domestic Relations Order (QDRO). These distribution restrictions do not apply if the distribution is to an alternate payee under the terms of a QDRO.
Tax Treatment of Distributions
Distributions from a qualified plan minus a prorated part of any cost basis are subject to income tax in the year they are distributed. Since most recipients have no cost basis, a distribution is generally fully taxable. An exception is a distribution that is properly rolled over as discussed next under Rollover.
The tax treatment of distributions depends on whether they are made periodically over several years or life (periodic distributions) or are nonperiodic distributions.
Rollover. The recipient of an eligible rollover distribution from a qualified plan can defer the tax on it by rolling it over into a traditional IRA or another eligible retirement plan. However, it may be subject to withholding as discussed under Withholding Requirement, later.
Eligible rollover distribution. This is a distribution of all or any part of an employee's balance in a qualified retirement plan that is not any of the following:
- A required minimum distribution. See Required Distributions, below.
- Any of a series of substantially equal payments made at least once a year over any of the following periods:
- The employee's life or life expectancy.
- The joint lives or life expectancies of the employee and beneficiary.
- A period of 10 years or longer.
- A hardship distribution.
- The portion of a distribution that represents the return of an employee's nondeductible contributions to the plan. See Tip, below.
- A corrective distribution of excess contributions or deferrals under a 401(k) plan and any income allocable to the excess, or of excess annual additions and any allocable gains.
- Loans treated as distributions.
- Dividends on employer securities.
- The cost of life insurance coverage.
Tip. A distribution of the employee's nondeductible contributions may qualify as a rollover distribution. The transfer must be made either (1) through a direct rollover to a defined contribution plan that separately accounts for the taxable and nontaxable parts of the rollover or (2) through a rollover to a traditional IRA.
Withholding Requirement. If, during a year, a qualified plan pays to a participant one or more eligible rollover distributions (defined earlier) that are reasonably expected to total $200 or more, the payor must withhold 20 percent of each distribution for federal income tax.
Exceptions. If, instead of having the distribution paid to him or her, the participant chooses to have the plan pay it directly to an IRA or another eligible retirement plan (a direct rollover), no withholding is required.
If the distribution is not an eligible rollover distribution, defined earlier, the 20 percent withholding requirement does not apply. Other withholding rules apply to distributions such as long-term periodic distributions and required distributions (periodic or non-periodic). However, the participant can still choose not to have tax withheld from these distributions. If the participant does not make this choice, the following withholding rules apply:
- For periodic distributions, withholding is based on their treatment as wages.
- For non-periodic distributions, 10 percent of the taxable part is withheld.
Estimated Tax Payments. If no income tax is withheld or not enough tax is withheld, the recipient of a distribution may have to make estimated tax payments.
Tax on Early Distributions
If a distribution is made to an employee under the plan before he or she reaches age 59½, the employee may have to pay a 10 percent additional tax on the distribution. This tax applies to the amount received that the employee must include in income.
Exceptions. The 10 percent tax will not apply if distributions before age 59½ are made in any of the following circumstances:
- Made to a beneficiary (or to the estate of the employee) on or after the death of the employee.
- Made due to the employee having a qualifying disability.
- Made as part of a series of substantially equal periodic payments beginning after separation from service and made at least annually for the life or life expectancy of the employee or the joint lives or life expectancies of the employee and his or her designated beneficiary. (The payments under this exception, except in the case of death or disability, must continue for at least 5 years or until the employee reaches age 59½, whichever is the longer period.)
- Made to an employee after separation from service if the separation occurred during or after the calendar year in which the employee reached age 55.
- Made to an alternate payee under a qualified domestic relations order (QDRO).
- Made to an employee for medical care up to the amount allowable as a medical expense deduction (determined without regard to whether the employee itemizes deductions).
- Timely made to reduce excess contributions under a 401(k) plan.
- Timely made to reduce excess employee or matching employer contributions (excess aggregate contributions).
- Timely made to reduce excess elective deferrals.
- Made because of an IRS levy on the plan.
Reporting the Tax. To report the tax on early distributions, file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. See the form instructions for additional information about this tax.
A qualified plan must provide that each participant will either:
- Receive his or her entire interest (benefits) in the plan by the required beginning date (defined later), or
- Begin receiving regular periodic distributions by the required beginning date in annual amounts calculated to distribute the participant's entire interest (benefits) over his or her life expectancy or over the joint life expectancy of the participant and the designated beneficiary (or over a shorter period).
These distribution rules apply individually to each qualified plan. You cannot satisfy the requirement for one plan by taking a distribution from another. The plan must provide that these rules override any inconsistent distribution options previously offered.
Minimum Distribution. If the account balance of a qualified plan participant is to be distributed (other than as an annuity), the plan administrator must figure the minimum amount required to be distributed each distribution calendar year. This minimum is figured by dividing the account balance by the applicable life expectancy.
Minimum Distribution Incidental Benefit Requirement. Minimum distributions must also meet the minimum distribution incidental benefit requirement. This requirement ensures the plan is used primarily to provide retirement benefits to the employee. After the employee's death, only “incidental” benefits are expected to remain for distribution to the employee's beneficiary (or beneficiaries).
Required Beginning Date. Generally, each participant must receive his or her entire benefits in the plan or begin to receive periodic distributions of benefits from the plan by the required beginning date.
A participant must begin to receive distributions from his or her qualified retirement plan by April 1 of the first year after the later of the following years:
- Calendar year in which he or she reaches age 70½.
- Calendar year in which he or she retires.
However, the plan may require the participant to begin receiving distributions by April 1 of the year after the participant reaches age 70½ even if the participant has not retired.
If the participant is a 5 percent owner of the employer maintaining the plan or if the distribution is from a traditional or SIMPLE IRA, the participant must begin receiving distributions by April 1 of the first year after the calendar year in which the participant reached age 70½.
Distributions After The Starting Year. The distribution required to be made by April 1 is treated as a distribution for the starting year. (The starting year is the year in which the participant meets (1) or (2) above, whichever applies.) After the starting year, the participant must receive the required distribution for each year by December 31 of that year. If no distribution is made in the starting year, required distributions for 2 years must be made in the next year (one by April 1 and one by December 31).
Distributions After Participant's Death. Special rules cover distributions made after the death of a participant.