[Sylvia Ahn, Financial Advisor]
As Certified Public Accountants (CPAs), understanding the basics of 401(k) plan design and compliance is crucial in advising clients on effective retirement planning options. A 401(k) plan is a qualified retirement savings plan that allows employees to defer a portion of their salary pre-tax or as Roth after-tax contributions, helping them save for retirement while providing potential tax benefits. Here’s an overview of the essentials regarding 401(k) plan design and compliance.
1. Overview of 401(k) Plans
A 401(k) plan is named after the section of the Internal Revenue Code (IRC) that outlines its rules. It allows employees to contribute a portion of their salary into individual retirement accounts, which grow tax-deferred until withdrawal. Employers can also make contributions, such as matching or profit-sharing, which incentivizes employee participation and retention. Key benefits of 401(k) plans include:
Tax Benefits: Employee contributions are typically pre-tax, reducing taxable income. Roth contributions are made after-tax, allowing tax-free withdrawals in retirement.
Employer Incentives: Employers receive tax deductions for contributions and can attract and retain talent by offering competitive retirement benefits.
Flexibility: Plan designs are customizable to meet various needs, including eligibility requirements, vesting schedules, and contribution limits.
2. Key Elements of 401(k) Plan Design
Designing a 401(k) plan involves several critical components:
Eligibility and Entry Requirements: Employers can set conditions for employee participation, often based on age and service. The law restricts these requirements to a maximum of one year of service and an age threshold of 21. Entry dates may vary from daily to annually.
Types of Contributions: Employee contributions can be pre-tax or Roth after-tax. Employers can offer various contributions, including matching, non-elective, and profit-sharing. There are also catch-up contributions for participants aged 50 or older.
Vesting Schedules: Vesting refers to the percentage of employer contributions an employee is entitled to if they leave the company. Vesting schedules can be immediate, graded (e.g., 20% per year over six years), or cliff (100% after a certain period).
Distributions and Withdrawals: Plans specify events that trigger distributions (e.g., retirement, disability, death). In-service withdrawals and loans are also possible, subject to plan rules and IRS regulations.
3. Compliance Considerations
Maintaining compliance with IRS and Department of Labor (DOL) regulations is critical for 401(k) plans to retain their tax-qualified status. Key compliance areas include:
Nondiscrimination Testing: Plans must pass annual tests to ensure they do not disproportionately benefit highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). The two main tests are:
Actual Deferral Percentage (ADP) Test: Compares the average deferral rates of HCEs and NHCEs.
Actual Contribution Percentage (ACP) Test: Compares employer matching and after-tax contributions for both groups.
Limits on Contributions: The IRS sets annual limits on employee contributions ($23,000 for 2024, with additional catch-up contributions for those aged 50+). Total contributions, including employer and employee contributions, are capped at the lesser of 100% of an employee’s compensation or $69,000 for 2024.
Top-Heavy Testing: A plan is considered top-heavy if key employees own more than 60% of plan assets. In such cases, employers must make minimum contributions (usually 3% of compensation) to non-key employees.
Compensation and Taxes: Plan documents must define eligible compensation in a nondiscriminatory manner. Pre-tax contributions reduce current taxable income, while Roth contributions do not affect current income but offer tax-free withdrawals if certain conditions are met.
4. Special Plan Features
a. Safe Harbor Plans: These plans are designed to automatically meet certain nondiscrimination requirements by making specified employer contributions. Safe harbor plans can avoid ADP/ACP testing and are beneficial for small businesses or plans with highly compensated employees.
b. Automatic Enrollment: Encourages participation by automatically enrolling eligible employees at a default contribution rate. This feature can come with additional tax credits for small employers and often includes automatic escalation of contribution rates over time.
5. The Role of CPAs in 401(k) Plans
As trusted advisors, CPAs play a crucial role in helping businesses design, implement, and maintain compliant 401(k) plans. This involves:
Advising on plan design to meet both employer objectives and regulatory requirements.
Ensuring compliance through regular testing, monitoring contribution limits, and maintaining accurate plan documentation.
Assisting in tax planning and reporting, particularly in handling excess contributions, nondiscrimination testing failures, or changes to plan provisions.
Conclusion
401(k) plans are powerful tools for retirement savings, offering significant benefits to both employers and employees. By understanding the basics of plan design and compliance, CPAs can guide their clients in maximizing these benefits while avoiding potential pitfalls. Staying informed about regulatory changes and new opportunities, such as those presented by the SECURE Act and SECURE 2.0, will help you provide proactive and effective advice to your clients.
As a financial advisor specializing in setting up 401(k) plans, I offer several services to help you and your clients optimize their retirement strategies:
Complimentary Plan Review: Not sure if your current 401(k) plan is meeting all compliance requirements or if it’s designed to maximize benefits for your employees and your business? I offer a complimentary review of existing 401(k) plans to identify areas for improvement, potential cost savings, and ways to enhance compliance and tax efficiency.
Customized Plan Design Services: Whether you are looking to set up a new 401(k) plan or want to restructure an existing one, I provide tailored solutions that align with your business goals. From safe harbor plans to profit-sharing contributions, I can help you design a plan that maximizes tax benefits while meeting your company’s unique needs.
Employer-Focused Retirement Planning: As a business owner, offering a competitive 401(k) plan can help attract and retain top talent while providing significant tax advantages. I can guide you through the process of setting up a cost-effective retirement plan that reduces your tax liability and meets your company’s financial objectives.
Educational Workshops and Seminars: To help your clients better understand their retirement planning options, I offer educational workshops and seminars on 401(k) plan design, compliance, and benefits. These sessions can be customized to address specific client needs and can be a valuable addition to your firm’s service offerings.
I am here to help you and your clients navigate the complexities of 401(k) plans and make informed decisions that enhance their financial future. These plans may seem like a complicated process to implement to clients. CPA and financial advisor can work together to mitigate this process much easier and seamless for the clients to secure their financial future.
Sylvia Ahn/Principal Financial Group
Financial/Investment Advisor
AIF (Accredited Investment Fiduciary)
(714)469-3553