401(k) And Qualified Plans: Contributions
A qualified plan may be funded by both employer and employee contributions. Contributions are mandatory for some plans and discretionary for others, but the limits on employer contributions are the same for all defined-contribution plans.
Profit-Sharing and Stock-Bonus Plans
Contributions to profit-sharing and stock-bonus plans are typically based on business profits and are made on a discretionary basis. This means that the employer decides each year whether to contribute to the plan. An employer, however, may choose to contribute to the plan without regard to profits.
Contributions to a money-purchase pension plan are fixed and are not based on business profits. For instance, if the plan stipulates that each eligible employee receive a contribution in the amount of 10% of eligible compensation, each eligible employee must receive the contribution regardless of whether the employer made profits for the year.
An employer who adopts a money-purchase pension plan must take care not to over- or under-contribute to the plan. The funding limit is stated in the plan and must not be exceeded. For instance, an employer that elects to make a 10% contribution to the plan may not exceed this amount for the year. On the other hand, employers who under-fund a money purchase plan could owe penalties up to 100% of the shortfall. In addition to paying this penalty, the employer must meet the funding requirement. Employers that fund the plan in excess of the plan limit will owe a 10% penalty on the excess amount.
The aggregate employee and employer contributions made to an employee's account must not exceed $51,000. Any employee's compensation in excess of the compensation cap is not considered when computing plan contributions. The compensation cap is $255,000 .These limits are indexed for inflation and the IRS sends a notice in the last quarter of every year indicating whether the limits will increase for the next year.
Within IRS-established limits, the employer is eligible to receive a tax deduction for contributions made to the plan. The following example illustrates how the contribution limits apply.
Example: IRS-Established Contribution Limits
XYZ Corporation has decided to make a 25% contribution for each eligible employee for the 2013 tax year. Employees received W-2 wages in the following amounts:
Mark - $260,000
Jane - $160,000
Mary - $80,000
Jim - $40,000
Each employee's contribution is allocated as follows:
|Employee||W-2 Wages||Contribution Received||Comments|
An employer may chose among several formulas to calculate contribution allocations.
- Pro-rata - This formula results in each eligible employee receiving the same percentage of his or her eligible compensation. The pro-rata formula is demonstrated in the example above, with XYZ Corporation.
- Social security integration - This formula awards higher-paid employees with a larger percentage of their compensation. The employer assigns to the qualified plan an amount that is a percentage of the accumulated total of all eligible employees' compensation. Using a special formula, the employer then allocates a contribution percentage to each eligible employee. The allocation must be done according to specific IRS-provided requirements; otherwise, the plan may be disqualified.
For the employees and the figures in Example 1, XYZ determines that the total contribution to the plan will be $110,000. Instead of allocating 25% to each employee, XYZ decides to allocate the $110,000 among the employees using the Social Security integration formula. As a result, higher-paid employees will receive a higher percent (based on eligible compensation) than lower-paid employees.
A qualified plan can include a cash or deferred arrangement (CODA) under which employees can choose to have part of their before-tax compensation allocated to the plan rather than receives the compensation in cash. This contribution is called an elective-deferral contribution because employees choose (elect) to set aside the money, and they defer receiving the money until it is distributed to them. A plan with this type of arrangement is known as a 401(k) plan. A 401(k) plan can also include a Roth feature, allowing employees to make salary deferral contributions to Roth 401(k) accounts on an after-tax basis.
Deferral Contribution Limits
An employee may elect to defer 100% of compensation up to a dollar limit for that year (see chart below):
|Tax Year||Elective-Deferral Contribution Limit|
Deferral contributions in excess of these limits are excess deferrals, which must be removed from the employee's 401(k) plan account within certain time frames. Excess contributions require special administrative handling and will be assessed penalties if not removed within a specific time frame.
A plan may implement additional contribution limits; it may, for instance, limit each employee's elective-deferral contribution to a certain percent of compensation.
Eligible employees who are at least age 50 by the end of the year may make additional contributions, which are referred to as "catch-up contributions." The catch-up contribution limits for different tax years are as follows:
|Tax Year||Catch-Up Contribution Limit (for eligible employees age 50 and older)|
The combined elective deferral and employer contribution cannot exceed $51,000, plus catch-up contributions.
If the 401(k) plan includes a Roth feature, aggregate salary deferral contributions to both the traditional and Roth components cannot exceed the amounts indicated in the charts above.
Employer contributions must be made to each employee's account by the employer's tax-filing deadline (including extensions).
An elective-deferral contribution must be transmitted to the employee's account as soon as the contribution can be reasonably segregated from the employer's general assets. The deadline, however, is the 15th business day of the month immediately after the month in which the contributions either were withheld or received by the employer ( 7 business days after the amount has been withheld, for small plans with less than 100 employees).
For their contributions made to a qualified plan, employers are allowed a tax deduction, which they claim on the business's income tax return. Employers, however, should not make contributions in excess of the deductible limit, as the excess amounts may not be tax deductible and could result in penalties being owed (to the IRS).
The deduction for contributions cannot be more than 25% of the total compensation paid (or accrued) during the year to eligible employees participating in the plan. When figuring the deduction limit, the following rules apply:
- Elective deferrals are not subject to the limit.
- Compensation includes elective deferrals.
- The maximum compensation that can be taken into account for each employee is $255,000.
ABCD Inc. adopted a money-purchase pension plan and elected to make a 10% contribution to the plan each year. Eligible employees earn compensation as follows:
Example: Deducting 401(k) Plan Contributions
WXYZ Corporation adopted a 401(k) plan and will make a profit-sharing contribution of 10% of eligible compensation to the plan. Compensation and elective-deferral contributions are as follows:
|Employee||Gross W-2 Wages||Deferral Contribution||W-2 Wages Less Deferral|
Compensation, for purposes of determining deduction limits, includes elective deferrals. WXYZ profit-sharing contribution will be $43,000 ($430,000 x 0.1 = $43,000) to be allocated among employees in accordance with the plan's chosen allocation formula.
Deduction Limit for Self-Employed Individuals
The examples used in this module use W-2 wages, which are paid to employees. Self-employed individuals, including apartments in a partnership, must use a special formula to determine their compensation for plan purposes. For assistance, these individuals may consult with a tax professional and refer to IRS Publication 560, which can be found at the IRS website.
If plan contributions exceed the deductibility limit for the year, the employer may carry over and deduct the difference in later years and combine it with contributions for those years. The combined deduction in a later year is limited to 25% of the participating employees' compensation for that year.
Investing Plan Assets
A qualified plan may direct the investments of the plan assets for employees. Others may allow the employees to direct their own investments by selecting from a list of investments provided by the plan.
The U.S. Department of Labor provides that the party responsible for directing the investment of plan assets is responsible for the consequences of the investment decisions. If the employee is allowed to choose from a number of investments, the employee is also responsible for the consequences of investment decisions. If the plan makes the investment decisions, the plan has a fiduciary responsibility for investment decisions.
If allowed to make their own selections, employees are entitled to receive a broad range of information about the investment choices available. Thus, a plan that intends to relieve plan officials of fiduciary duties over investments must inform employees of that fact. According to the U.S. Department of Labor, the information that must be provided to employees includes the following:
- A description of each investment option including the investment goals and the risk and return characteristics
- Information about designated investment managers
- An explanation of when and how to make investment instructions and any restrictions on when the employee can change investments
- A statement of the fees that may be charged to the employee's account when he or she changes investment options or buys and sells investments
- Information about the employee's shareholder voting rights and the manner in which confidentiality will be provided on how the employee votes his or her shares of stock
- The name, address and phone number of the plan fiduciary or other person designated to provide certain additional information on request
Permissible investments for qualified plans include publicly traded securities, real estate and money market funds. Some plans even allow investing in options. The plan document is required to state the investment choices for plan assets.
401(k) And Qualified Plans: Distributions