What is a 401K Plan & Types of 401k Plans

A 401(k) plan is a qualified retirement plan that meets the standards set forth in the Internal Revenue Code (IRC) for tax-favored status. An employee can contribute part of his wages either pre-tax or post tax depending on the options offered in the plan. In some plans, the employer also makes contributions commonly referred to as “matching” contributions. The match is usually based as a percentage of the employee’s personal contribution. Employer contributions are deductible on the employer’s federal income tax return to the extent that the contributions do not exceed the limitations described in section 404 of the IRC. The tax deferred wages or elective contributions of the employees are also not subject to income tax withholding at the time of deferral. The extent of wages that can be made as elective contributions (tax deferred) is determined by the IRC.

There are different types of 401k Plans – traditional 401(k) plans, self-directed 401(k) plan, safe harbor 401(k) plans, Tiered Profit Sharing 401(k) plan and SIMPLE 401(k) plans. Different rules govern each of these plans.

Traditional 401(k) plan

In a traditional 401(k) plan, besides the elective deferral contributions that an eligible employee would make, employers as well have the option to make a contribution on behalf of the participants. Employers have the option to ensure that only loyal employees benefit from the contributions that it makes on behalf of the employees. If an employee leaves the organization before a pre-specified duration, the matching contribution made by the employer on behalf of the employee may be forfeited.

Traditional 401(k) plans also require that employers do not discriminate between employees. Employers have to ensure that the allowed elective deferral contributions and matching contribution made by employers are the same for all employees.

In a traditional 401(k) plan, employer has the option of altering the amount of employer contributions each year, according to business conditions

Self Directed 401(k)

Self-directed 401(k) plan operates on similar lines as Traditional 401(k) plan paving way for pre-tax savings and automated paycheck deductions. It varies in terms of investment options wherein the employee himself acts as the fund manager and has a much broader array of investment options at his disposal to choose from. The employee is not restricted to the meager list of mutual fund options offered by the employer, and can choose from a wide spectrum of stocks, bonds, mutual funds and options significantly deviating from traditional options.

Safe Harbor 401(k) plan

Unlike a traditional 401(k) plan, in a safe harbor 401(k) plan employer contributions are non-forfeitable. They are fully vested when made. Employers can make contributions even for those eligible employees who do not make personal elective deferral contributions.

In a safe harbor plan the employer contribution cannot exceed 5 per cent of the employee’s compensation. Employers can match each eligible employee’s contribution, dollar for dollar, up to 3 per cent of the employee’s compensation. If the employer is still willing to contribute more, he can contribute up to 50 percent of the elective deferral contribution that the employee makes in excess of 3 per cent of his salary, but not greater than 5 per cent of the employee’s compensation. Alternatively, the employer can make a non-elective contribution equal to 3 per cent of compensation to each eligible employee’s account.

A safe harbor 401(k) plan is also not subject to annual non-discrimination tests related to elective deferral contribution and matching contributions that apply to traditional 401(k) plans

Tiered Profit Sharing 401(k) plan

The plan meets the needs of businesses rolling in profit and having 50 or less employees. The employees are rewarded by classifying them in unique company wide groups. The roles performed by distinct employee groups having different salary structures form the base of such classification. The owner apportions varying profit share for each group to reward them according to their contribution to company’s success. The plan benefits employees immensely as well as objectively manages the profit sharing cost.

Simple 401(k) plan

This plan aptly fits the bill for owners employing a hundred or fewer employees who have been compensated a minimum of $5000 individually. Employer and Employee contributions are essentially fully vested. The employer must make either:

  1. A matching contribution up to 3% of each employee’s pay, or
  2. A non-elective contribution of 2% of each eligible employee’s pay.

The plan as well is free from the ambit of IRS’s non-discrimination testing.