A 401(k) plan is also known as a cash or deferred arrangement (CODA).
Under a 401(k) plan, participants have the option of either receiving an amount of
cash or having the cash set aside in a qualified retirement plan. By
electing to have the cash set aside in a 401(k) plan, participants reduce
their
gross income and defer tax on this amount until the cash is distributed.
This cash or deferred election would include a salary reduction agreement
between employees and their employer. A contribution under this agreement is known
as an elective contribution and is treated as a contribution by the
employer which is taxable to an employee only when it is distributed, usually when
they retire or terminate employment.
The amount of elective contributions, also called elective deferrals,
which can be excluded from income for 2005 is $14,000. Elective
contributions are also subject to any employer-provided limit, and, for
highly compensated employees, the limit calculated under the actual deferral
percentage (ADP) test. When employees reach age 50, if the employer's plan
allows, they may make an additional “catch-up” contribution for 2005 of
$4,000 beyond these limits. Total employer contributions, including elective
deferrals (but not including catch-up contributions) may not exceed 100% of
compensation or, for 2005, $42,000, whichever is less.
Another important aspect of these plans is
the limitations on distributions. First, amounts in the plan attributable to
elective deferrals are not available to employees before one of the following
events: retirement (or other separation from service), disability,
attainment of age 591/2 , hardship, or plan termination. And eligibility
rules for a hardship withdrawal are very stringent. Distribution must be
necessary to satisfy an immediate and heavy financial need.
Depending on the terms of the employer's 401(k) plan, employees may be able to
make additional after-tax contributions. Although, these won't reduce taxable pay, the investment earnings from the contributions are exempt from
tax while in the 401(k) plan.
Employers must test whether elective contributions made by highly
compensated employees are discriminatory when compared with contributions
made for non-highly compensated employees. If the amount of contributions
made for the nonhighly compensated is “inadequate”
according to the ADP test, some part of the contributions on behalf of the
highly compensated may have to be paid out (returned) to them.
A 401(k) plan may contain a
matching contribution feature, under which the employer will “match,” up to
a specified limit, an employee's elective contribution. The amount of
matching contributions together with after-tax employee contributions for
highly compensated employees must meet a nondiscrimination test similar to
the ADP test.
