401(k), 403(b), and 457(b) Retirement Plans
The tax code provides for several types of tax-advantaged retirement plans, such as the IRA. Other, more complicated plans, can be offered by employers to their employees. The most common types of these plans is based on the 401(k) plan, named for the section of the tax code that governs it, and includes the 403(b) and 457(b) plans, which conform to similar tax rules, but the primary difference is the type of employer, such as a business, government, school or organizations that are tax exempt under IRC §501(c):
- 401(k) plans can be established by any nongovernment employer or by a government if the plan was established before May 1986.
- 403(b) plans, otherwise known as tax-sheltered annuities, can be established by public educational employers or tax-exempt organizations.
- 457(b) plans can be established by state and local governments or by tax-exempt organizations.
Because these plans are mostly similar, the following discussion will refer to 401(k) plans, but the rules also apply to 403(b) and 457(b) plans. A major advantage of the 401(k) plan for the self-employed over other retirement plans is that they allow the greatest contribution for salaries that are significantly less than $250,000. However, as with all contributions to retirement plans, contributions are deductible against marginal taxes but not payroll taxes, which limit their benefit for lower income employees.
A prominent requirement of 401(k) plans is a nondiscrimination requirement, in that owners or highly compensated employees cannot be favored by the plan, which ensures that profit sharing and matching provisions are equitable. To enforce this rule, the appropriate forms in the Form 5500 Series must be filed annually.
An employer can also set up a Roth 401(k) plan, where contributions are treated similarly to contributions to Roth IRAs. The Roth 401(k) is set up as a designated Roth account that can only be contributed by employees. The contributions are not tax-deductible, but the earnings grow tax-free and qualified withdrawals that satisfy tax rules are also completely tax-free.
The employer sets up the plan, which can receive contributions from both employer and employee. Employees can contribute up to 100% of income if it is less than the statutory maximum amount. The employer must set up the 401(k) plan by year-end, and any employer contributions must also be made by year-end. However, employees and self-employed business owners can make contributions as late as their filing deadline, including extensions.
A 401(k) plan may allow loans, but the loans cannot exceed the lesser of 50% of the account value or $50,000, and must be repaid within 5 years. Furthermore, if the taxpayer's employment is terminated, then the loan must be repaid within 60 days after the termination; otherwise, it will be treated as a distribution. Distributions will usually be taxable and may be subject to a 10% tax penalty if the taxpayer is younger than 59½. Most plans also charge a loan origination fee and may charge an annual service fee for as long as the loan is outstanding.
If an employee leaves an employer, then the 401(k) should be rolled over to an IRA, which will give the taxpayer more control over the plan, including investment opportunities, and will reduce fees. Furthermore, if the employer decides to change plan providers, the participants cannot make any transactions in their retirement plan during this transfer, the blackout period, including withdrawals.
Secure Act 2.0
The Secure Act 2.0, passed at the end of 2022, makes it easier for employers to help workers open emergency savings accounts, assist employees who are repaying student loan debt and allow part-time workers access to retirement plans in 2 years instead of 3. There are also new benefits to both Roth IRAs and Roth 401(k)s, including moving leftover money from a 529 college savings account to a Roth I.R.A. Certain rules must be followed to avoid taxes and penalties, and there are some income restrictions. However, some provisions start in different tax years.
Secure Act 2.0 Changes for Employees with 401(k) Plans:
- Increases the required minimum distribution (RMD) age from 72:
- to 73 in 2023
- to 75 in 2033
- The penalty for not taking an RMD on time has been reduced from 50% of the amount that should have been withdrawn to 25%, and to 10% for IRAs if corrected.
- Employers could allow their employees to make 1 withdrawal, up to $1000 annually from their 401(k) or IRA, for certain emergency expenses without owing the 10% additional penalty for nonqualified distributions.
- An emergency is defined as an unforeseeable or immediate financial need related to the employee or his family.
- Employees can choose to repay the amount within 3 years, but if they choose not to, then they cannot make another emergency withdrawal for 3 years.
- Starting in 2025, the catch-up contribution limits for taxpayers aged 60 to 63 increases from $7500 per year to at least $11,250.
- The new rule says that the limits would increase to the greater of $10,000 or 50% more than the regular catch-up amount that year.
- But since the catch-up amount already = $7500,
- 50% more = $7500 + $3750 = $11,250
- Taxpayers earning more than $145,000 must put the catch-up money in a Roth 401(k).
- Starting in 2025, this wages threshold will be adjusted annually for inflation, rounded down to the lowest multiple of $5,000.
- So high income taxpayers will have to pay taxes on their catch-up contribution.
- Lower-income taxpayers may choose a pre-tax or after-tax contribution.
- The new rule says that the limits would increase to the greater of $10,000 or 50% more than the regular catch-up amount that year.
- Starting in 2024:
- Allow employees to make qualified student debt payments eligible for employer matches to a retirement account.
- Allows a one-time penalty-free withdrawal from a 401(k) or an IRA for an emergency, defined as an unforeseeable or immediate financial need related to the employee or his family.
- eliminates required minimum distributions from 401(k) Roth accounts.
- So, Roth accounts will be treated the same as Roth IRAs in regard to RMD’s.
Secure Act 2.0 Changes for Employers with 401(k) Plans:
- Employers must allow longer-term part-time employees to participate, including those with 1 year of service of at least 1,000 hours, or 2 consecutive years with 500 hours of service each year.
- Employers will be permitted to automatically enroll workers into emergency savings accounts, linked to employees’ retirement accounts.
- Contributions can be up to 3% of their salary, up to a maximum of $2500.
- These emergency savings accounts are like Roth accounts; contributions are taxed but withdrawals are tax-free.
- New employer plans created after 2024:
- Requires employers to automatically enroll workers into 401(k) and 403(b) plans once they become eligible while also allowing them to opt out if they so choose.
- The initial contribution rate must be at least 3% but not more than 10%.
- Contributions must increase 1% each year until reaching at least 10%, but not more than 15%.
- Plans created before 2025 do not have to follow these new rules.
- small businesses with no more than 10 workers
- new businesses operating for less than 3 years
- church and government plans.
Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (SECURE Act)
Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (SECURE Act) has changed the law regarding qualified tax-deferred retirement accounts:
- beneficiaries of tax-deferred retirement plans must receive the full distribution within 10 years after the death of the employee or account holder;
- the age for starting required minimum distributions has been increased from 70½ to 72;
- distributions from retirement plans can be penalty-free if used to pay for expenses of a birth or an adoption;
- pension and benefit plan administrators must disclose the plan's lifetime income stream to the beneficiaries;
- part-time employees may participate in 401(k) plans if they worked at least 500 hours annually for a minimum of 3 consecutive years and are at least 21 years of age at the end of the 3-year period that must start after 2020.
Contributions to a 401(k) plan take the form of salary-reduction deferrals. The contributions are made under a salary reduction agreement, or the employee contributes a specified percentage of wages to the plan.
The employer can make 3 types of contributions:
- a matching contribution that is based on a percentage of the employee's contribution;
- the employer can automatically contribute a certain percentage of the employee's income, usually 2% to 3%, regardless of whether the employee also contributes, which allows the employer to accurately project annual contributions; or
- the employer can make a profit-sharing contribution, which is a fixed dollar amount, that is not based on the employee's wage. Contrary to its designation, a profit-sharing contribution can be made even if the business does not earn a profit.
Like all retirement plans, 401(k) plans have a statutory maximum amount that can be contributed each year, which is indexed for inflation. There is a statutory limit for the employee contribution and for the maximum contribution, so the most that an employer can contribute is determined by the difference.
Maximum Employer Contribution = Maximum Overall Contribution Limit − Employee Contribution
Additional Requirements: Employer Contribution ≤ 25% × Employee Wage
Limitation for the Self-Employed = 20% × Self-Employment Gross Income
An additional catch-up contribution, adjusted annually for inflation, is allowed for taxpayers aged 50+ by year-end.
|Tax Year||Maximum Employee Contribution||Catch-Up Contribution||Employee Contribution + Catch-Up Contribution||Maximum Account Contribution, |
Including Employer Contribution
|Maximum Account Contribution + |
|2020 - 2021||$19,500||$6500||$26,000||$57,000||$63,500|
|2015 - 2016||$18,000||$6,000||$24,000||$53,000||$59,000|
Catch-up contributions cannot exceed the lesser of the contribution limits or the amount of the participant's compensation over the elective deferrals that were not catch-up contributions. So if a 50-year-old employee earned $20,000 for the year and contributed $17,000 as an elective deferral to his 401(k), then he can only defer $3000 more as a catch-up contribution.
Elective deferrals are not included in the employee's gross income but they are subject to Social Security, Medicare, and federal unemployment taxes. Employees have a nonforfeitable right to the accrued benefit of their elective deferrals.
401(k) plans can also have automatic enrollment, where a specified percentage of each employee's wages is contributed to the plan, as long as each employee is given notice of their right to receive cash or have the amount contributed by the employer to the plan. The automatic enrollment feature protects employers from nondiscrimination restrictions if the plans include mandatory matching or nonelective employer contributions.
The terms of the 401(k) plan may reduce the maximum contribution to less than the maximum statutory contribution if the plan specifies that the maximum contribution = a percentage of the employee's wages. However, the employer cannot condition other benefits on whether the employee chooses elective deferrals except for matching contributions. So, for instance, an employer cannot offer a health plan that is contingent on whether the employee chooses elective deferrals.
Partnership plans that allow variable contributions are treated as 401(k) plans by the IRS; therefore, such plans are subject to annual elective deferral limits and the nondiscrimination rules.
Any excess salary deferrals and the associated earnings must be withdrawn by April 15 of the following year; otherwise, the excess amount will be taxable and the salary reduction plan could be disqualified. The taxpayer will receive Form 1099-R for any excess deferral and the allocable earnings.
Elective Deferrals for 401(k) Plans
A qualified retirement plan can allow participants to choose whether the employer will contribute some of their before-tax compensation to the plan rather than to the employees, which is called an elective deferral. However, since the deferred arrangement is only allowed for a profit sharing plan, the 401(k) plan must also be based on profit sharing.
The 401(k) plan must have certain provisions. The plan cannot have a provision that requires an employee to complete more than 1 year of service before he can participate. The plan may provide that the employer make a matching contribution that is a percentage of any elective deferral made by the employee to the 401(k). A plan may also provide for nonelective contributions that are not matching contributions for participating employees. The employee compensation that is used to calculate the contributions is limited the retirement plan DB wage base, adjusted annually for inflation:
|2015 - 2016||$53,000||$265,000|
A SIMPLE 401(k) plan can be set up by employers who had 100 or fewer employees and who earned at least $5000 during the preceding year. The SIMPLE 401(k) plan does not have to comply with the nondiscrimination and top-heavy plan requirements, which facilitates its maintenance.
Eligible Automatic Contribution Arrangement
A 401(k) can provide for automatic enrollment, where, unless the employee chooses otherwise or chooses a different percentage, can have part of his compensation reduced by a fixed percentage that is contributed to the 401(k). The automatic enrollment provision will make it more likely that the plan will pass nondiscrimination testing and will encourage employees to save for retirement, since it requires a proactive selection on the part of the employee.
The eligible automatic contribution arrangement (EACA) allows an employer to choose a fixed percentage of compensation for the elective deferral of up to 10% that will only change if the participant changes the percentage or decides not to defer any compensation. The plan must allow participants to withdraw the automatic contribution if it is done no later than 90 days after the 1st elective contributions and the participant withdrawals all the EACA default contributions and the associated earnings. However, any withdrawals except for amounts from designated Roth accounts are includible in the employee's income but are not subject to the 10% tax penalty for early withdrawals.
The SECURE Act provides a safe harbor for 401(k) plans that reduces compliance testing if the employer contributions are fully vested when contributed and it also increases the maximal automatic elective deferral from 10% to 15%.
A written notice must also be given to each employee before each plan year so that they know of their rights and that they have sufficient time to change the arrangement under EACA. The notice must include their right to change the percentage or to not have any part of their compensation deferred and how contributions will be invested if there are no directions from the employee.
Qualified Automatic Contribution Arrangement
There is also a qualified automatic contribution arrangement (QACA) that provides a safe harbor for the automatic enrollment provision, in that a QACA will not be subject either to the ADP test nor the top-heavy requirements. To qualify for the QACA, the employer must make mandatory contributions and the employer must specify a default elective deferral that:
- is applied uniformly,
- does not exceed 10% of the employee's compensation,
- and the contribution percentage must be at least 3% in the 1st plan year for a particular employee until the year end of the next year, then in the next 3 plan years, the percentage must increase to 4%, 5%, then to at least 6% in all subsequent plan years.
The employer must make either matching or nonelective contributions for all non-highly compensated employees. Matching contributions must either be equal to 100% of elective deferrals, up to a limit of 1% of compensation or 50% of elective deferrals that can range from 1% to 6% of compensation. The matching contributions can be more generous than the above rules, but not less, nor can the matching contributions be less than those given to highly compensated employees, including the owners of the business. Nonelective contributions must be equal to at least 3% of compensation, even for those employees who chose not to participate in the plan but would otherwise be eligible. Accrued benefits must be 100% vested for all participants who complete 2 years of service. The employer must provide information about the QACA to each employee before each plan year with the same type of information and requirements contained in the notice for the automatic contribution arrangement.
Qualified Roth Contribution Program
A qualified plan can allow a participant to designate all or a portion of the elective deferrals as an after-tax Roth contribution that is maintained in a separate designated Roth account, much like a Roth IRA. After-tax Roth contributions are, as the name suggests, included in the taxable income of the participant; however, contributions and earnings are distributed tax-free. The limit on the designated Roth contribution equals the overall limit on contributions minus any elective deferrals of before-tax income. Except for the fact that designated Roth deferrals are taxed for the year for which the contribution is attributed, Roth deferrals are subject to the same tax rules as pretax elective deferrals. However, only the employee contribution can be designated to a Roth account. The employer portion is always a pre-tax contribution. This is also true for Solo 401(k) plans.
A distribution from a designated Roth account is tax-free only if it is a qualified distribution, which is a distribution received by the participants after reaching age of 59½ or the participant became disabled or the distribution was made because of the employee's death, and the distribution was made after the 5 tax year period that began with the 1st tax year in which a designated Roth contribution was made. If the account received a rollover from another designated Roth account, then the 1st tax year is the one for which the previous designated Roth account was established. Since September 28, 2010, rollovers could be made from any retirement plan to a designated Roth account in the same plan; however, a designated Roth distribution can only be rolled over into another designated Roth account or to a Roth IRA. Rollover amounts are not counted when determining if contribution limits have been exceeded.
A distribution from a 401(k) plan is not allowed until at least one of the following occurs:
- the employee retires or severs employment, becomes disabled, or dies;
- the plan ends and no other defined contribution plan is established or continued;
- if the plan is part of a profit-sharing plan, then distributions can be made if the employee reaches 59½ or suffers financial hardship; or
- the distribution is a qualified reservist distribution to a military reservist or member of the National Guard called to active duty for either at least 180 days or an indefinite period.
Plan withdrawals before age 59½ are subject to special tax rules. If the withdrawals are not qualified, then a 10% tax penalty may apply to the amount withdrawn, in addition to other taxes that would otherwise be due on the withdrawals. There is a mandatory withholding rate of 20% for lump sums and other distributions that are eligible for rollover if the distribution was paid directly to the taxpayer instead of being rolled directly over to another qualified retirement account. Taxpayers born before January 2, 1936 can use averaging for any lump-sum distributions.
A plan may also allow in-service distributions that are made while the plan is still active, but, besides being restricted by tax rules, such as being at least 59½, the plan may also only allow in-service distributions after a certain numbers of years of being a participant or the distributions may be limited in frequency or to certain situations, such as paying for college.
Required Minimum Distributions (RMDs)
The taxpayer must take required minimum distributions (RMDs) by April 1 of the year after reaching age 72, then continue to take RMDs by each December 31 thereafter, including the 1st year, even if an RMD was taken on April 1. This includes Roth accounts in 401(k) plans, but not Roth IRAs, even though Roth accounts are funded with after-tax dollars. However, money withdrawn from 401(k) Roth accounts is not taxed.
If the taxpayer continues to work and does not own at least 5% of the business, then RMDs from the 401(k) account with the current employer can be postponed until after leaving that employment. However, RMDs from other 401(k) accounts from prior employers must be taken starting at age 72.
The amount of the RMD is based on IRS life expectancy tables, published in Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), and on the total amount of retirement funds in all retirement accounts except for funds held in a Roth IRA. Withdrawals from retirement accounts can exceed the RMD, but stiff penalties may apply if withdrawn amounts are less than the RMD.
There are 2 tests to ensure that the employer does not contribute more to highly compensated employees than is allowed under the qualified retirement plan: the actual deferral percentage (ADP) test [IRC §401(k)(3)] and the actual contribution percentage (ACP) test [IRC §401(m)(2)]. Any excess over that allowed by the 2 tests is subject to a 10% excise tax, which is reported on Form 5330, Return of Excise Taxes Related to Employee Benefit Plans. If the retirement plan fails either test and it is not corrected by the next plan year-end, then the plan may become disqualified.
If nondiscrimination rules are violated, then not only will the employer be subject to penalties, but the plan could be disqualified unless any excess contributions plus the allocable earned income are distributed back to the highly compensated employees or business owners by a specified time. Complying with the nondiscrimination requirements for 401(k) plans is easier with the safe harbor 401(k) and the SIMPLE 401(k) plans.
Safe Harbor 401(k) Plan
A safe harbor 401(k) plan does not have to satisfy either the ADP test or the ACP test. To qualify for the safe harbor plan, the employer must make matching or nonelective contributions. Matching contributions must be equal to either 100% of elective deferrals, up to 3% of compensation or 50% of elective deferrals, from 3% of the 5% of compensation, and the matching contribution rate for highly compensated employees, including owners, cannot exceed the rates for the other employees.
A nonelective contribution can also be made that must be at least 3% of every eligible employee's compensation, even if the employee chose not to defer any income.
These mandatory matching or nonelective contributions are subject to special withdrawal restrictions, but they must be immediately 100% vested. Written notice of the rights and obligations of the plan must also be given to all eligible employees annually, well before the plan year.
SIMPLE 401(k) Plans
For a business with many employees, the 401(k) plan is difficult and expensive to set up, compared to SEP and SIMPLE IRA plans. For the business with no more than 100 employees, there is the SIMPLE 401(k) plan, which is easier to set up and administer. The 401(k) plan with SIMPLE contribution provisions has easier nondiscrimination tests, since satisfying the SIMPLE contribution requirements also satisfies the 401(k) nondiscrimination requirements. However, there are several requirements:
- the employer cannot have more than 100 employees with compensation of at least $5000;
- there is a 2-year grace period for growing businesses that exceed 100 employees to switch to another retirement plan allowing more employees, such as the regular 401(k) plan;
- the employer must use the calendar year; and
- no other qualified plan can be offered by the employer for employees eligible to participate in the SIMPLE plan.
Unlike the regular 401(k) plan, the employer must make either a nonelective contribution of 2% or a matching contribution of up to 3% of each eligible employee's pay. Employees are fully vested in all contributions. However, employee elective deferrals and catch-up contributions are lower for a SIMPLE 401(k) them for a regular 401(k) plan:
|Tax Year||Maximum Employee Contribution||Catch-Up Contribution||Employee Contribution + Catch-Up Contribution|
|2020 - 2021||$13,500||$3000||$16,500|
|2015 - 2018||$12,500||$3,000||$15,500|
Although discrimination rules are simpler than the regular 401(k) plan, Form 5500, Annual Return/Report of Employee Benefit Plan must still be filed annually.
The SIMPLE 401(k) plan may also allow loans and hardship withdrawals, although the administrative burden on the employer will be greater.
Solo 401(k) Plans
Solo 401(k) (aka individual 401(k), one-participant 401(k), solo-K, uni-K) plans are for business owners without any common law employees other than a spouse. The business owner can contribute to the solo 401(k) as both an employee and an employer. The employee contribution is subject to the same limits as for the traditional 401(k) plan, including catch-up contributions. The employer nonelective contribution cannot exceed 25% of compensation as defined in the plan, if the business owner is an employee of his own S or C corporation. However, self-employed individuals, including partners in a partnership or members in a limited liability company, must calculate the employer portion by calculating the compensation after subtracting ½ of the self-employment tax and by subtracting the contribution itself. The result of this calculation allows an employer contribution equal to 20% of net earnings after subtracting the ½ of the self-employment tax. Because contribution limits are per person rather than per plan, contribution limits are reduced by the amount contributed to other 401(k) plans by another employer.
Example: Calculating the Employer Contribution for an Owner-Employee of an S or a C Corporation
You are at least 50, and you earn $60,000 in wages from your S corporation in 2015. You can defer $18,000 as a regular elective deferral + $6000 in a catch-up contribution as an employee of your S corporation. Additionally, another $15,000 can be contributed as an employer for a total of $39,000.
Example: Calculating the Employer Contribution for a Self-Employed Taxpayer, Partner, or LLC Member
Using the same facts as the above example, the maximum employee contribution = $24,000. However, the employer contribution is more limited:
- Net Profit Reduced by ½ of SC Tax = $60,000 − $8477.73 = $51,522.27
- Employer Contribution = $51,522.27 × 20% = $10,304.45
- Total Contribution = Employee Contribution + Employer Contribution = $24,000 + $10,304.45 = $34,304.45
Because a solo 401(k) plan is for single individuals, discrimination testing is not required, but the business owner must file Form 5500-SF if the account has at least $250,000.
403(b) Plans: Special Provisions
There are special tax rules that apply to 403(b) plans. A special 403(b) catch-up provision provides that tax-free contributions to 403(b) plans can be increased by $3000 for each employee if they have completed 15 years of service. However, there is a lifetime limit of$15,000 on the extra deferrals and the extra deferrals are also limited by the lifetime limit on elective deferrals = $5000 × years of service. Furthermore:
- If a rollover from a 403(b) plan to another qualified plan is made, then any lump-sum distribution from the qualified plan will be ineligible for either special averaging or capital gains treatment for those born before January 2, 1936.
- There are no required minimum distributions on benefits that accrue before 1987 until the taxpayer reaches age 75.