401(k) Plans – A General Description
A Section 401(k) Plan is kind of deferred compensation plan in which an employee can elect to have the employer contribute a portion of his or her wages to the plan on a pre–tax basis. These deferred wages are not subject to income tax withholding at the time of deferral, and they are not reflected on your Form 1040 since they were not included in the taxable wages on your Form W-2. However, they are included as wages subject to social security, Medicare, and federal unemployment taxes.
The amount that an employee may elect to defer to a 401(k) plan is limited. During 2017, an employee generally cannot elect to defer more than $18,000 for all 401(k) plans in which the employee participates, and in addition, participants age 50 or older are eligible to make an additional “catch-up contribution” of $6,000. These are statutory limits that are subject to cost-of-living adjustments each calendar year. These deferral limits however are subject to further restriction based on the annual operation of the Plan as explained below.
Realizing 401(k) Plan tax benefits requires that these Plans provide substantive benefits for rank-and-file employees, not just the highly compensated employees of the sponsoring employer. These requirements are referred to as nondiscrimination rules and cover the level of plan benefits (elective deferrals) for rank-and-file employees compared to the highly compensated employees. A Section 401(k) Plan is subject to annual testing to assure that the amount of contributions made on behalf of the rank-and-file employees is proportional to contributions made on behalf of the highly compensated employees.
If the highly compensated employees for a year defer at rates higher than what is deemed proportional to the rank-and-file overall rate, then in order to satisfy the nondiscrimination rules, a corrective distribution is made to each affected highly compensated employee.
To encourage participation among the rank-and-file employees, some employers offer to match employees’ deferrals. However, matching contributions on the part of the employer is not a guarantee that the Plan will satisfy the annual testing each year, but may serve as an incentive to increase the participation rates of the rank-and-file employees.
The amount of corrective distribution is taxable in the year of receipt. For example, correction for the 2016 testing will occur in 2017 and will be taxable in 2017.
In conclusion, satisfying the nondiscrimination test is dependent on the willingness of the rank-and-file employees to elect to defer a portion of their wages. Raising the awareness of the tax deferral benefits among the rank-and-file employees can yield higher participation rates, and thereby may allow the highly compensated employees to defer without correction.
See the article on Safe Harbor 401(k) Plans for an explanation of the method to guarantee that all elective contributions remain tax deferred until distributed.