A 401(k) plan is a qualified (i.e., meets the standards set forth in the Internal Revenue Code (IRC) for tax-favored status) profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan under which an employee can elect to have the employer contribute a portion of the employee’s cash wages to the plan on a pre-tax basis. These deferred wages (elective deferrals) are not subject to federal income tax withholding at the time of deferral and they are not reflected as taxable income on your Form 1040, U.S. Individual Income Tax Return.
The amounts deferred under your 401(k) plan are reported on your Form W-2, Wage and Tax Statement. Although elective deferrals are not treated as current income for federal income tax purposes, they are included as wages subject to Social Security (FICA), Medicare, and federal unemployment taxes (FUTA). 401(k) plans are permitted to allow you to designate some or all of your elective deferrals as “Roth elective deferrals” that are generally subject to taxation under the rules applicable to Roth IRAs.
Two of the advantages of participating in a 401(k) plan are:
Elective deferrals to the plan and investment gains are not subject to federal income taxes until distributed from the plan.
Elective deferrals are always 100% vested.
To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan’s provisions.
There are several types of 401(k) plans available to employers - traditional 401(k) plans, safe harbor 401(k) plans and SIMPLE 401(k) plans. Different rules apply to each.
Traditional 401(k) plans. A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested. Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements.
Safe harbor 401(k) plans. A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.
SIMPLE 401(k) plans. The SIMPLE 401(k) plan was created so that small businesses could have an effective, cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to traditional 401(k) plans. As with a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. Employees who are eligible to participate in a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.
Two annual limits apply to contributions:
A limit on employee elective deferrals; and
An overall limit on contributions to a participant’s plan account (including the total of all employer contributions, employee elective deferrals and any forfeiture allocations).
Deferral limits for 401(k) plans
The limit on employee elective deferrals (for traditional and safe harbor plans) is:
$18,000 in 2015 and 2016
The $18,000 amount may be increased in future years for cost-of-living adjustments
Generally, you aggregate all elective deferrals you made to all plans in which you participate to determine if you have exceeded these limits. If a plan participant’s elective deferrals are more than the annual limit, find out how you can correct this plan mistake.
Deferral limits for a SIMPLE 401(k) plan
The limit on employee elective deferrals to a SIMPLE 401(k) plan is:
$12,500 in 2015 and 2016
This amount may be increased in future years for cost-of-living adjustments
Plan-based restrictions on elective deferrals
These restrictions may further reduce the maximum allowable elective deferrals:
Your plan's terms may impose a lower limit on elective deferrals
If you are a manager, owner, or highly compensated employee, your plan might need to limit your elective deferrals to pass nondiscrimination tests
Catch-up contributions for those age 50 and over
If permitted by the 401(k) plan, participants who are age 50 or over at the end of the calendar year can also make catch-up contributions. The additional elective deferrals you may contribute is:
$6,000 in 2015 and 2016 to traditional and safe harbor 401(k) plans
$3,000 in 2015 and 2016 to SIMPLE 401(k) plans
These amounts may be increased in future years for cost-of-living adjustments
You don’t need to be “behind” in your plan contributions in order to be eligible to make these additional elective deferrals.