There is no such thing as a “one size ﬁts all” 401k plan. Why? Employer goals for a 401(k) plan can vary greatly. Some employers want to maximize owner contributions at the lowest overall cost while others want to incentivize employees to save a portion of their paycheck for retirement. The process of matching 401(k) specifications to employer goals is called plan design.
There are 6 major features a 401(k) plan must define during the design process - eligibility, compensation, contributions, vesting, distributions and loans. Each of these features are described below. Use this checklist to choose the 401(k) specifications for your plan based on this information. Once the checklist is complete, a professional 401(k) provider can use it to help draft a formal plan document to govern your 401(k) plan.
Employers may allow new employees to enter the plan immediately or require them to meet minimum age and service conditions first. Employers may also limit when newly eligible employees enter the plan. Generally, employers with a transient work force favor more restrictive eligibility requirements. On the other hand, minimal or no eligibility requirements are used by employers who want their 401(k) plan to help recruit top employee talent or wish to help employees save as early as possible.
You can also exclude certain employees from plan participation altogether as long as annual coverage testing can pass.
The law permits you to exclude certain types of compensation for plan purposes without issue, including compensation earned prior to plan entry and fringe beneﬁts. You can also exclude other types of compensation (e.g., bonuses, overtime) if special annual testing is passed.
A 401(k) plan can permit employee and employer contributions. Any employer contributions must be allocated to participant accounts pursuant to a formula in the plan document.
a. Employee Contributions
401(k) deferrals are pre-tax contributions made to a plan at the election of an employee, in lieu of receiving such amounts as cash compensation. Roth deferrals are similar to 401(k) deferrals, only they are contributed by employees on an after-tax basis.
An automatic enrollment feature allows you to enroll employees in your plan without the employees’ aﬃrmative election, as long as the employees have the right to “opt out” of contributing or change the amount of automatic deferral.
A Qualiﬁed Automatic Contribution Arrangement (QACA) is a special type of automatic enrollment feature that also satisﬁes safe harbor contribution requirements (see Safe Harbor Contributions).
b. Safe Harbor Contributions
A safe harbor 401(k) plan is a type of 401(k) that automatically satisﬁes ADP/ACP testing requirements. It will also automatically satisfy top heavy minimum contribution requirements for a year in which the only contributions made to the plan are elective deferrals (pre-tax or Roth) and safe harbor contributions (i.e., no profit sharing contributions).
Eligible safe harbor contributions include:
- 4% matching contribution
- 3.5% matching contribution (QACA safe harbor plans only – see Employee Contributions section)
- 3% non-elective contribution
These contributions are non-discretionary (required) contributions. They must be subject to 100% vesting (QACA contributions may be subject to a 2 year cliff vesting schedule) and may not be subject to any allocation conditions.
c. Matching Contributions
A plan may provide for a matching contribution based on the elective deferrals made by participants. The matching formula may be discretionary, so you can determine the match rate each year.
If the matching contribution is funded after the close of the year, you can require participants to satisfy certain allocation conditions in order to receive a contribution. For example, you can require participants to work a certain number of hours during the plan year (up to 1,000 hours) and/or be employed on the last day of the year.
d. Nonelective (Profit Sharing) Contributions
With a profit sharing contribution, an employer has the ﬂexibility to determine the amount of the contribution annually. This way, the employer is able to contribute more in years of high proﬁtability, and to contribute less when business is not as good, without having to amend the plan’s contribution formula.
There are three principle proﬁt sharing allocation formulas:
- Pro rata – allocates a uniform contribution percentage amongst participants
- Integrated – provides a greater allocation on compensation earned in excess of the “integration level” (usually the Social Security taxable wage base)
- New Comparability – permits diﬀerent allocation rates based on employee class assuming nondiscrimination testing is passed
If the proﬁt sharing is funded after the close of the year, you can require participants to satisfy certain allocation conditions in order to receive a contribution.
When a participant terminates, they are only entitled to the vested portion of their account balance. Any unvested portion of their account must be forfeited to the plan. The plan can use these forfeitures to pay plan expenses or reduce future employer contributions.
401(k) and most safe harbor contributions must always be 100% immediately vested. Other contributions cannot be subject to a vesting schedule that is less generous than a 3-year cliﬀ (1-2 years = 0%, 3 years = 100%) or 6-year graded (20% each year after 2 years) schedule.
Regardless of service, a participant must become 100% immediately vested when they reach your plan’s “normal retirement age.” The most commonly used retirement age today is 65.
Generally, employers with transient work force favor lengthier vesting schedules in order to use forfeitures.
Often, plans will only permit a lump sum form of distribution when a participant separates from service and is entitled to a distribution. Under the lump sum option, a participant must take their entire vested account balance in a single distribution. Other distribution forms available include installment payments and partial payments.
You can permit a participant to take a distribution while still employed. These are called “in-service” distributions. These distributions can be available upon the attainment of a certain age (59 ½ or greater) or a “hardship” event. Eligible hardship events are deﬁned by the law.
A plan may permit the involuntary cash-out of small account balances. Balances under $1,000 may be distributed in cash to the participant. Balances under $5,000 may be involuntarily rolled into an IRA for the beneﬁt of the participant.
You can allow or disallow loans. Loans are often very popular with employees but add administrative complexity for the employer, who often must sign oﬀ on loan requests and deduct loan payments from payrolls.
401(k) plan design does not need to be overwhelming
A 401(k) plan document can be hundreds of pages in length. That can make the prospect of 401(k) plan design scary. It doesn’t have to be. There are only 6 basic decisions that must be made during the plan design process. Once these decisions have been made, a professional 401(k) provider can write a plan document to formalize the design.