Qualified Retirement Plan
Highlights
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Types of Plans
401k Plans
• Introduction
• Contribution Limits
• 401(k) and Match Non-Discrimination Tests
• Required Contributions
• Safe-Harbor 401(k)
• Negative 401(k) Elections
• Administration: Bundled v. Unbundled
• DOL Regulation 404(c)


INTRODUCTION
A 401(k) plan is a special type of profit sharing plan that allows employees to voluntarily defer receipt of a portion of their pay and contribute to a retirement plan. A 401(k) plan offers flexible and fully tax deductible employer contributions such as a matching contribution or profit sharing contribution together with tax sheltered growth of plan assets.

The employee will benefit by the accumulation pre-tax contributions and investment income to the plan.

In short:
  • Employees elect to make pre-tax contributions(link) to the plan rather than taking the contributions in cash
  • The employee does not pay current federal and California state income taxes on their elective deferrals
  • The participant does pay FICA and FUTA taxes on their contributions
  • Contributions accumulate tax-deferred (Link) until withdrawn from the plan
  • Contributions do not incur taxes for capital gains, dividends and interest income as long as the funds remain in the 401(k) plan
401(k) profit sharing plans may offer employee 401k deferrals and rollovers, employer profit sharing contributions, matching contributions, top-heavy minimum contributions and safe-harbor contributions.

A matching contribution is an employer contribution based upon 401(k) deferrals made by the employee. If the employee does not contribute, they do not receive a contribution. A profit sharing contribution is made to all eligible participants regardless of whether they contribute 401(k) deferrals.

Pacific Retirement Plans can assist the employer in establishing a 401(k) plan with multiple fund families, daily valuation, Internet and 800-number access. We can evaluate 401k testing problems and suggest changes that may permit owner/employee's to make a greater contribution to the plan.

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CONTRIBUTION LIMITS
Contributions to individual employees are limited as follows:
  • 401(k) salary deferrals are limited to $18,000 for the calendar year. For individuals that attain age 50 during the year the limit includes a $6,000 401(k) catch-up contribtuion for a maximum of $24,000 for 2016.
  • Annual contributions (profit sharing, 401(k) deferrals, match, and forfeitures) are limited to the lessor of:
    1. $53,000 (for 2016), $59,000 with 401(k) Catch-up, or
    2. 100% of compensation
401(k) Profit Sharing plan limits

Total employer contributions (profit sharing and match) to the plan cannot exceed 25% of total eligible compensation for the employer.

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401(k) AND MATCH NON-DISCRIMINATION TESTS
401(k) deferrals by highly compensated employees are limited based on the actual deferrals of non-highly compensated employees.

The 401(k) and match non-discrimination tests are commonly known as the average deferral percentage (ADP) and average contribution percentage (ACP) tests, respectively.

A highly compensated employee (HCE) is any employee who:
  1. owned more than 5% of the employer in the current or prior plan year;
  2. is a family member of the 5% owners; or
  3. earned more than $120,000 (as adjusted for inflation) in the preceding plan year.
A non-highly compensated employee (NHCE) is any employee who is not a HCE.

Generally, the average 401(k) deferral of all HCEs is limited to 2% points higher than the average 401(k) deferral of all NHCEs. For example:

  Average 401(k) Deferral of NHCEs    Average Deferral of HCEs limited to:  
0%0%
2%4%
4%6%
8%10%


The non-discrimination test that applies to matching contributions is the same as described above for 401(k) deferrals.

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REQUIRED CONTRIBUTIONS

Normally, a 401(k) plan does not require any employer contribution. However, if the plan becomes top heavy, then an employer contribution of 3% of compensation may be required.

A top-heavy plan is a plan in which 60% of the benefits/assets for the preceding five years belong to key employees. Generally, a key employee is an employee who meets one of the following criteria:
  1. An officer earning $170,000 (as adjusted for inflation) or more;
  2. More than 5% owner (including family members of a 5% owner); or
  3. A 1% owner earning $150,000 or more.
If a key employee defers into the 401(k) plan when it is top heavy, the employer is required to make a 3% (of compensation) top heavy minimum contribution for all non-key employees who are active participants in the plan at year-end.

A profit sharing or safe-harbor contribution of at least 3% of pay will satisfy the top-heavy minimum.

Attention Silicon Valley, Internet, or other start-up companies: Employees who have stock options are considered to own the stock for which they have vested options. This applies regardless of whether the employee exercises the option.

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SAFE-HARBOR 401(k)

ELIMINATES 401(k) & MATCH NON-DISCRIMINATION TESTING!

Effective for plan years beginning in 1999, both the 401(k) and matching non-discrimination testing can be passed automatically. The employer must make a specific type of Profit Sharing (PS) or Matching contribution. These contributions can also be used for other qualification requirements, such as cross-testing, and top heavy minimum!

In general, a plan may dispense with 401(k) and matching testing by providing either:
  1. a PS contribution equal to 3% of compensation for all eligible non-highly compensated employees (NHCE), or
  2. a Matching contribution equal to 100% of 401(k) deferrals up to 3% of compensation, plus 50% of 401(k) deferrals between 3% to 5% of compensation for NHCE.
This effectively results in a 4% pay-matching rate for employees who defer 5% or more of their pay.

These contributions must be fully vested and subject to the same distribution restrictions as 401(k) salary deferrals.

The plan can also provide a matching contribution for highly compensated employees (HCE) at the same or lower rate than that prescribed for the NHCE. This will not adversely affect the 401(k) safe harbor. However, if the plan wants to also avoid ACP testing, only deferrals up to 6% of pay can be matched and the total matching amount must be limited to 4% of pay.

Examples:

A law firm has 4 partners and 8 other employees. The 4 partners are the only HCE. The 4 partners wish to defer $18,000, which represents 6.79% of pay. However, only 2 of the 8 NHCE make salary deferrals and the ADP for the NHCE group is only 1.25%.

For 2016, the partnership adopts the 401(k) safe-harbor matching contribution. If each of the 2 NHCE making salary deferrals has pay of $50,000 and defers 5% of pay, then the total cost to the partnership is 4% of pay or $4,000. This allows the partners to increase their deferrals from $6,625 to $18,000 each.

Take the same situation as above, except the partnership has a cross-tested profit sharing allocation, which provides a 13.67% rate of contribution for partners and 5% rate for employees. The same 3% allocation that is used to eliminate the ADP requirement can also be used to pass the cross-tested non-discrimination testing. Each partner receives total profit sharing and salary deferral contributions of $53,000 (13.2% of $265,000 plus $18,000 deferral).

The plan must notify participants of their rights and obligations under the plan 30 to 90 days prior to the start of the plan year before eliminating non-discrimination testing. This notice should identify whether the match or non-elective contribution will be made. Most plans will require amendments before the beginning of the plan year to which the safe-harbor is intended to apply.

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NEGATIVE 401(k) ELECTIONS

The Internal Revenue Service (IRS) and the President recently endorsed negative election programs, which require workers to be enrolled automatically in a 401(k) plan unless they specifically decline to participate. This is commonly known as the "McDonald's Election" since it was first implemented by the fast food giant.

The IRS' example follows:

Under Plan A, a newly hired employee is immediately eligible to participate in the plan. If the employee does not affirmatively elect to receive cash or have a specified amount contributed to the plan, his or her compensation is automatically reduced by 3% and this amount is contributed to the plan. An election not to make a salary reduction contribution or to contribute a different percentage of compensation can be made at any time.

At the time an employee is hired, the employee receives a notice of the following:
  • explanation of the automatic salary deferral election,
  • the employee's right to elect to have no salary deferral contributions made to the plan,
  • the employee's right to alter the amount of contributions,
  • the procedure for altering the amount of contribution.
The employee is subsequently notified annually of his or her salary deferral percentage and the employee's right to change the percentage.

The plan provides that both salary deferrals and matching contribution will be invested according to the employee's election. If the employee makes no election, the employer will automatically invest the employee's contributions in the trust's balanced fund, which includes both diversified equity and fixed income investments.

The Department of Labor has advised the Treasury and the Internal Revenue Service that, ERISA 404(c) relief will not be available when the employee is merely apprised of investments that will be made on his or her behalf in the absence of instructions to the contrary.

Basically, the employer needs to decide two items:
  1. the default percentage, and
  2. the default investment option.
It appears that the defaults outlined in the IRS' example would be the best place to start.


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ADMINISTRATION: Bundled, Unbundled, or the best of both worlds?


Bundled
A bundled plan is where a mutual fund company, insurance company, or brokerage firm that is the asset custodian and/or trustee also performs the administration duties such as preparing the IRS Form 5500, non-discrimination testing, etc., and prepares the participant statements.

Advantages:
  • Very low cost to employer for administration fees
  • One stop shopping
  • Daily valuation with 800-numbet and/or Internet access for participants
  • Benefit statements sent directly to employees' home
Disadvantages:
  • High asset fees may apply - approximately 1% of assets annually or more
  • May be limited to one family of mutual funds
  • One stop shopping - if employer is dissatisfied with either the assets or the administration, the entire plan must be moved to rectify
  • No local contact - many bundled plans are administered outside of California
  • Plan design - most bundled plans cannot offer age-weighted, new comparability, or class-based types of profit sharing allocation features
Unbundled
An unbundled plan normally involves two or three parties:
  1. third party administrator (TPA) such as Pacific Retirement Plans, Inc.,
  2. asset custodian, such as mutual fund company, insurance company, or brokerage firm, and
  3. Broker (optional).
Basically, the TPA does all the record keeping from preparing quarterly participant benefit statements to plan design, compliance and Form 5500 preparation.

Advantages:
  • Low asset fees
  • Multiple fund families for investments
  • Local contact
  • Plan design - we can design a plan to the exact specifications that the employer wants, such as an age weighted, new comparability, or class based types of profit sharing allocation feature, etc.
Disadvantages:
  • Higher administration fees
  • No daily valuation, 800-number, or Internet access
  • Monthly, quarterly, or semi-annual benefit statements usually not sent directly to employees' home address.
Semi-bundled
A semi-bundled plan offers the best of both worlds, at a reasonable cost in terms of employer fees.

Basically, the asset provider/custodian, usually a mutual fund company or insurance company, does the record keeping and participant benefit statements and the TPA concentrates on plan design, compliance and Form 5500 preparation.

Advantages:
  • Low cost to employer for administration fees
  • Low asset fees if limited to one family of mutual funds
  • Daily valuation with 800 number and/or Internet access for participants
  • Benefit statements sent directly to employees' home
  • Plan design - we can design a plan to the exact specifications that the employer wants, such as an age weighted, new comparability, or class based types of profit sharing allocation feature, etc.
  • Local contact
Disadvantages:
  • Higher asset fees if multiple fund families are desired


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DEPARTMENT OF LABOR REGULATION 404(c)

Regulation 404(c):
  • Shifts most investment liability from employer/trustee to participants
  • Is optional
  • Applies to all defined contribution plans - not just 401(k) plans
  • Education vs. Investment advice
  • 404(c) notice must be in plan document and Summary Plan Description
  • 404(c) applies to brokerage accounts in addition to a menu of mutual funds
Protecting sponsor from investment loss liability

There are three basic conditions necessary for the plan to meet, so that fiduciaries can be relieved of liability for plan investment losses. They are:
  1. The participants must have a "broad range of investment alternatives." These would include cash, bonds, and equities.
  2. The participants must have the opportunity to give investment instructions with a "frequency which is appropriate in light of the market volatility" of the investment alternatives. This means that at least quarterly valuations are required.
  3. The participants must have the opportunity to obtain "sufficient information to make informed decisions with regard to investment alternatives available under the plan."
It must be emphasized that even when all the conditions are met, the fiduciaries retain the responsibility for the prudent choice of designated investment alternatives and the responsibility to monitor those investment alternatives and to monitor the administration and management of the plan on an ongoing basis.

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