Once 401(k) planning is complete and the plan has been established within your organization, you will naturally assume certain responsibilities in operating said plan. If an individual has been hired to help set up the plan, that arrangement may have also included help in its operation. If this is not the case, you’ll need to decide whether you will manage the plan yourself or if you will hire a professional or a financial institution (such as a bank, insurance company, or mutual fund provider) to handle some or most aspects of its operation for you.
We have elaborated on some of the elements included in the operation of a 401(k) retirement plan below. The information provided here is in line with the information provided by the Internal Revenue Service (IRS).
Operating a 401(k) plan
As part of 401(k) planning, it is important to consider its operation once the plan is established. This means considering:
Participation
Typically, a plan will include a mix of both employees and employers (owners and managers). However, employees might be excluded from an organization’s plan if they:
- Are not yet aged 21
- Haven’t yet completed a year in employment with the organization
- Are covered by a collective bargaining agreement that does not provide for participation in the plan, if retirement benefits were the subject of good faith bargaining.
It’s important to note that employees cannot be excluded from retirement plans simply because they are older employees.
401(k) contributions
Employers will need to decide their organization’s contribution (if any) to participants’ accounts in the plan.
Traditional 401(k) plan
There will be further options available if employers decide to contribute to the plan. It’s possible to:
- Contribute a percentage of each employee’s compensation to the employee’s account (a nonelective contribution)
- Match the amount given by willing employee contributions (within the limits of current law)
- Do both
To give an example, an employer might decide to add 50% to an employee’s contribution. This results in a 50-cent increase for every dollar that goes into the employee’s retirement savings. Using a matching contribution formula will provide additional employer contributions only to employees who make deferrals to the 401(k) plan.
In organizations which utilize nonelective contributions, employers will make a contribution for each eligible participant, whether or not these participants decide to make a salary deferral to their 401(k) accounts.
Under a traditional 401(k) retirement savings plan, an employer has the flexibility of changing the amount of nonelective contributions each year, according to business conditions.
Safe harbor 401(k) plan
Under this type of plan, employers are able to match contributions made, dollar-for-dollar, up to 3% of the employee’s compensation and 50 cents on the dollar for the employee’s contribution that exceeds 3% (but not 5%) of the employee’s compensation. Alternatively, an employer can make a nonelective contribution equal to 3% of compensation to each eligible employee’s account. Each year, the employer must make either matching contributions or the nonelective contributions.
Automatic enrollment 401(k) plan
Under an automatic enrollment 401(k) plan with a qualified automatic contribution arrangement, the plan is exempt from the annual IRS testing requirement that a traditional 401(k) plan must perform. The initial automatic employee contribution must be at least 3% of compensation. Contributions may also have to automatically increase so that, by the fifth year, the automatic employee contribution is at least 6% of compensation.
Automatic employee contributions cannot exceed 10% of compensation in any year. Employees are permitted to change the amount of their contributions or choose not to contribute, but must do this by making an affirmative election.
Employers must make at least either:
- A matching contribution of 100% for salary deferrals up to 1% of compensation and a 50% match for all salary deferrals above 1% but no more than 6% of compensation; or
- A nonelective contribution of 3% of compensation to all participants.
SIMPLE 401(k) plan
Employer contributions to a SIMPLE 401(k) retirement plan are limited to either:
- A dollar-for-dollar matching contribution, up to 3% of pay; or
- A nonelective contribution of 2% pay for each eligible employee.
No other employer contributions can be made to SIMPLE 401(k) plans, and employees cannot participate in any other retirement plans of the employer.
The maximum amount that employees can contribute as of 2022 is $14,000. An additional catch-up contribution is allowed if the employee is age 50 or over. The additional amount as of 2022 is $3,000.
Contribution limits
Total employer and employee contributions to all of an employer’s plans are subject to an overall annual limitation. Within an organization, this will be the lesser of:
- 100% of the employee’s compensation, or
- $61,000 (as of 2022)
The amount employees can contribute under a traditional, safe harbor, or automatic enrollment 401(k) plan is limited to $20,500 as of 2022. These same pension plans will allow an additional catch-up in the amount of $6,500 in this same year.
Vesting
Employee salary deferrals are immediately 100% vested, meaning the money that an employee has put aside through salary deferrals cannot be forfeited. When an employee leaves an organization, they are entitled to those deferrals – as well as any investment gains (or minus losses) on said deferrals.
In safe harbor and SIMPLE 401(k) plans, all required employer contributions are always 100% vested. Traditional 401(k) plans can be designed so that employer contributions become vested over time according to a vesting schedule.
Nondiscrimination
Realizing 401(k) plan tax benefits requires that plans provide substantive benefits to ordinary employees, not just business owners and managers. These are referred to as nondiscrimination rules and cover the level of plan benefits for employees compared to owners and managers.
Traditional 401(k) plans are subject to annual testing to ensure that the amount of contributions made on behalf of employees is proportional to contributions made on behalf of owners and managers.
Safe harbor and SIMPLE 401(k) plans are not subject to annual nondiscrimination testing.
Investing 401(k) monies
Once employers have decided on the type of 401(k) plan their organization will use, they will be able to consider their investment options. One decision that will need to be made when designing a plan is whether to permit employees to direct the investment of their accounts or whether these should be managed on their behalf. Employers that choose the former will also have to decide what investment choices to make available to the participants.
Depending on the plan chosen, an employer might want to hire an individual to either determine the investment options to make available or to manage the plan’s investments. Continuous monitoring of investment options ensures selections remain in the best interests of the organization’s plan and its participants.
Disclosing 401(k) retirement plan information to participants
Plan disclosure documents keep participants of this type of pension plan informed about the basics of plan operation. It also alerts them to changes in the plan’s structure and operations, and provides them with the opportunity to make decisions and to take action with respect to their accounts.
The summary plan description (SPD), the basic descriptive document, is a plain-language explanation of the plan and must be comprehensive enough to inform participating employees of their rights and responsibilities under the plan. It also informs them of the plan’s features and what they can expect of it. It must include information about:
- When and how employees become eligible to participate in the organization’s 401(k) plan
- The contributions to the plan
- How long it takes to become vested
- When employees are eligible to receive their benefits
- How to start filing a claim for those benefits; and
- Basic rights and responsibilities participants have under the Federal retirement law, the Employee Retirement Income Security Act (ERISA)
SPDs should include an explanation about the administrative expenses that will be paid by the plan. This document must be given to participants when they join the plan and to beneficiaries when they first receive benefits. They must also be redistributed periodically during the life of the plan.
A summary of material modification (SMM) informs participants of changes made to this type of pension plan, or to the information required to be in the SPD. The SMM or an updated SPD must be automatically furnished to participants within a specified number of days after the change.
An individual benefit statement (IBS) shows the total plan benefits earned by an employee, vested benefits, the value of each investment in the account, information describing the ability to direct investments, and (for plans with participant-direction) an explanation of the importance of a diversified portfolio. Plans that provide for participant-directed accounts must furnish individual account statements on a quarterly basis. Plans that don’t provide for participant direction must furnish statements annually.
A summary annual report (SAR) is a narrative of the plan’s annual return or report, the Form 5500, filed with the Federal government. It must be furnished annually to participants.
A blackout period notice gives employees advance notice when a blackout period happens, typically when plans are changing recordkeepers or investment options, or when plans add participants due to corporate mergers or acquisitions. During these blackout periods, participants’ rights to direct investments, take loans, or obtain distributions are suspended.
Reporting to government agencies
As well as the disclosure documents that provide information to participants, plans must also report certain information to government entities.
Form 5500 series
Plans are required to file an annual return or report with the Federal government. Depending on the number and type of participants any one plan covers, most 401(k) plans must file one of two forms:
- Form 5500, Annual Return/Report of Employee Benefit Plan, or
- Form 5500-EZ, Annual Return of One-Participant (Owners and Spouses) Retirement Plan
For 401(k) plans, the Form 5500 is designed to disclose information about the plan and its operation to the IRS, the US Department of Labor, plan participants, and the public.
Most one-participant plans (sole proprietor and partnership plans) with total assets of $250,000 or less are exempt from the annual filing requirement. A final return or report must be filed when a plan is terminated regardless of the value of the plan’s assets.
Form 1099-R
Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. is given to both the IRS and recipients of distributions from the plans during the year. It’s used to report distributions (including rollovers) from a retirement plan.
Distributing plan benefits
Benefits in a 401(k) plan are dependent on a participant’s account balance at the time of distribution. When they’re eligible to receive a distribution, employees can elect to:
- Take a lump sum distribution of their account
- Roll over their account to an IRA or another employer’s retirement plan
- Purchase an annuity.
Compliance
Even when plans are operated with the best intentions at heart, there is still a chance that mistakes will happen. The US Department of Labor and the IRS have correction programs to help 401(k) plan sponsors correct plan errors, protect participants, and keep plans’ tax benefits. The programs are structured to encourage employers to correct errors early. Utilizing an ongoing review program makes it easier to spot and correct mistakes in plan operations.