401(k) Plans
R. F. Willeford, MBA, CPA/CFP
Without legislative grace, an employee generally cannot elect to choose some kind of benefit in lieu of receiving their normal compensation. (Under the constructive receipt doctrine, the mere fact that the employee could have received the compensation makes it taxable.) IRS Code §401(k) specifically gives an employee the right to elect to defer part of their compensation. This elective deferral is made by signing a Salary Deferral Agreement form provided by the employer. For additional discussion re Deferrals see below.
In the past, Highly Compensated Employees (HCE) were limited in the amount of deferrals they could make. They were limited based on how much the Non-Highly Compensated Employees (NHCE) deferred. This limitation was calculated based on an Average Deferral Percentage (ADP) and Average Contribution Percentage (ACP) test.
The HCE owner/doctor can avoid the ADP/ACP limits if they are willing to use a Safe Harbor 401(k) plan.
A. SAFE HARBOR 401(k)
The Safe Harbor elements include:
 | The employer must make either a Safe Harbor Matching Contribution or NonElective Contribution, described below. |
| This contribution must be 100% vested immediately. |
| There can't be an "end of year" employment rule or a 1,000 hour service requirement to get the Safe Harbor Match or NonElective Contribution. (This is similar to the rules under the Prototype plan, and this does not apply to other "regular" contributions to the Plan by the employer. So any includible participant is covered.) |
| The employer must decide before the beginning of each year what the match/contribution will be for the year. (Practically speaking, this will be the same each year.) |
| The employer must notify the participants of the safe harbor provisions between 30 and 90 days before each new year. |
Safe Harbor Matching Contribution
This will be used only for Prototype integrated pension/profit sharing 401(k) plans. We do not have many of these. Such plans will use a "basic matching formula" where the employer matches each employee's elective deferrals up to 3% of compensation and then 50% match on elective deferrals from 3% to 5% of compensation. Thus the maximum match would be 3% + 1/2*(5% - 3%) = 4%.
Advantage: The employer only matches if an employee
makes a deferral.
Disadvantage: This Match does not ever satisfy
the Top Heavy 3% minimum contribution requirement.
Safe Harbor NonElective Contribution
The employer makes a contribution of 3% of compensation for each includible NHCE (non-highly compensated employee) -- regardless of whether they make a deferral.
Advantage: This contribution (technically, not a
"match") does count towards satisfying the Top Heavy 3%
contribution if the plan is not integrated with social security. This
helps with age-based and cross-tested plans, but not Prototype plans.
Disadvantage: Each employee gets the
contribution whether or not they choose to make a deferral.
B. ELECTIVE DEFERRALS
Effect on other Plan contributions
The maximum amount that an employer can contribute to a retirement plan is 25% of covered compensation. The employee deferrals are not included in this 25% calculation. The "covered compensation" is based on gross pay before deducting any deferrals.
An individual can defer up to 100% of their net wages (after deducting Social Security) but not more than the "§402(g) limit", which is currently $13,000 per calendar year for 2004 and is adjusted annually by the IRS. For age 50 and older, you can make an additional $3,000 "catch-up" deferral.
Timing/Amount of Deferrals
An individual can't make or receive retirement plan contributions greater than $41,000 for years beginning in 2004. Employee deferrals and employer contributions are included in this figure. Any catch-up amount is in addition to this figure.
A person can only defer salary not yet earned. I.e., you can't normally "make up" deferrals on wages already taken. So, if the doctor wants to defer $10,000, he must still have at least that much compensation to withhold the deferral from. The same with any other employee. We have provided maximum flexibility by allowing an employee to specify a percent to defer on an annual vs. pay period basis. Also, they can make a change on 30 days notice. Thus someone can effectively catch up, as long as they have sufficient compensation remaining in the year to cover the deferral.
Example: Suppose an employee makes $24,000 per year and wants to defer $1,000 for the year. They could wait 10 months without making a deferral and defer a total of $1,000 in the last two months out of their remaining $4,000 compensation.
