A 401(k) is type of employer sponsored retirement plan that qualifies for tax advantaged treatment under the Internal Revenue Code. More specifically, it is a type of defined contribution plan that permits employees/participants to contribute a portion of their pay into a qualified account, where it can then be invested. The employer/sponsor may also make contributions into participant accounts in the form of matching or non-elective contributions. Employer/sponsor contributions are tax deductible on the employer’s federal tax return. The participants may contribute with pre-tax dollars or may make Roth contributions with after-tax dollars. Once in the account, pre-tax contributions enjoy tax deferred growth, while Roth contributions grow tax-free.
Types of Contributions
Elective Contributions
Elective contributions, or elective salary deferrals as they are commonly called, are made when an employee directs to have the employer deduct and contribute a portion of his compensation to the plan. Elective contributions are always 100% vested.
Matching Contributions
A matching contribution is an employer contribution allocated on the basis of an employee’s elective contribution. For example, an employer might decide to match 100% of employee deferrals, up to the first 3% of deferred compensation. An employer may attach a vesting schedule to matches.
Non-elective Contributions
A non-elective contribution, or “profit-sharing” contribution, is a discretionary contribution an employer allocates on the basis of compensation or in a manner other than on the basis of elective contributions.
The Mechanics & Costs of a 401(k) Plan
Non-Discrimination Testing
To preserve its qualified status, each year a 401(k) plan must pass “nondiscrimination” tests established by IRS regulations. This is to ensure that the plan is benefiting a broad spectrum of employees, as opposed to only benefiting highly compensated and key employees. There are several nondiscrimination tests, but the three which most typically require some plan design consideration for employers are the ADP, ACP, and Top-Heavy tests.
Safe Harbor Plans
A safe harbor plan is not subject to ADP and ACP Testing and thus enables owners and other HCEs and key employees to receive the maximum permissible benefits under the plan. Provided no additional non-elective contributions are provided, Top-Heavy requirements will also be satisfied under a safe harbor plan. To avoid testing, a safe harbor plan requires an employer to make contributions that vest 100%immediately, and which typically take one of the following forms: (1) a non-elective contribution equal to 3% of compensation to all eligible employees; or (2) a dollar-for-dollar matching contribution up to the first 3% of compensation deferred, and a 50 cent on the dollar match up to the next 2% of compensation deferred; or (3) a dollar-for-dollar matching contribution of up to100% of the first 4% of compensation deferred.
How 401(k) Plans are Managed
Most employers contract with third parties to assist in managing their 401(k) Plans. Employers typically outsource record keeping (maintaining an accurate accounting of contributions) as well as ministerial administrative functions (sending out participant notices, process distributions and loan requests). An employer will also outsource a third party administrator to test the plan and file any regulatory forms. Often the same company will provide both services. Some plans hire investment advisors, though frequently the financial professionals servicing plans are brokers and, therefore, not involved in any fiduciary capacity.
Understanding 401(k) Plan Costs
Fees in a 401(k) plan are usually functions of the plan size and the number of participants. The more assets, the less expensive a plan should be. Fees can be paid directly by the sponsor, charged to participant accounts as a percent of the assets, or charged as a flat fee to participant accounts. Sometimes the costs are paid using a combination of these sources and methods. In other instances, the fees are wrapped up and “hidden” in the investment expenses. As with any type of investment account, the mutual fund or other investments all carry expense charges, which are deducted before investors see their returns. The costs may increase depending on the size of the fund and its management team, the complexity of the investment strategy, and, critically, the commissions or fees the fund pays.
As noted above, in some instances all or a most of a 401(k)’s associated fees might be included in the investment expenses. Thus, the same investment may cost more in one plan than it does in another. The impact on retirement savings is significant.
For information on how to improve your existing plan or to get started, please reach out to info@5thstreetadvisors.com and connect with our team.