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401k Plans Are Defined Contribution Plans The Plan Sponsor The Plan Vendor Third-party Administrators Auto Enrollment Employee Contributions Employer Contributions 401k Investments 401k Investing and Tax-deferred Saving Withdrawals and 401k Loans ERISA Participant Rights Protections IRS Compliance Testing Safe Harbor 401k Plan Administration

401k Plans Are Defined Contribution Plans A 401k plan is what's called a defined contribution retirement savings plan. In defined contribution plans... -- The amount contributed to each participant's account is set ("defined") -- either by the plan participant or by the employer, and as either a flat rate or a percentage of pay. AND... -- The amount each participant will receive upon retirement is left up to the effect of investment performance on the contributions. Other defined contribution retirement savings plans include SEPs, Simple IRAs, Profit Sharing Plans, and Money Purchase Plans. The 401k is by far the most popular. Defined contribution plans differ from traditional pension plans, called defined benefit plans, which specify specific amounts of money (the "benefit") employees will receive when they retire rather than the periodic contribution amounts that will be put into the plan to ensure that final benefit amount. In 401k plans... -- Each participating employee decides the amount to be withheld each month from his or her pay as a 401k contribution. -- The employer withholds these amounts BEFORE calculating income taxes on the employee's pay. -- The employer forwards the money to a third party administrator, who invests the employees' contributions per specific instructions provided by the employees. -- Some employers choose to add to participants' 401k contributions through employer matching contributions. back to top

The Plan Sponsor 401k plans must be "sponsored" by an employer. Their very IRS-mandated operation -- i.e., that contributions are pulled from employees' pay BEFORE are taxes -- is predicated upon the plans being run through the employer. 401k plan sponsorship does not, however, mean the employer must contribute financially to its 401k plan. Please see employer contributions below for information on contribution options -- including the option not to contribute -- open to plan sponsors. The Internal Revenue Code allows for retirement savings plans that DO NOT require employer sponsorship; these include annuities and Individual Retirement Accounts (IRAs), but the 401k plan is by far the most popular: -- 401k plans are extremely convenient for plan participants. Participants simply establish the contribution level they want, then the employer has the amount pulled from the participant's pre-tax pay each period and forwarded to the 401k investments the participant has selected. Participants save money they might spend if it was ever issued to them and left up to them to deposit in their retirement account. -- 401k plans allow for significantly higher annual contribution levels than IRAs or annuities. -- Higher contribution levels mean a greater impact on lowering participants' current income taxes. -- Higher contribution levels mean more money being set aside -- and allowed to compound -- for retirement. -- 401k plans can include loan features that allow participants to borrow from their retirement savings; IRAs and most annuities do not offer the  possibility of loans. Plan sponsorship generally entails the employer appointing an in-house person to act as liaison between the plan's vendors and the company's employees. This person is the plan administrator (not to be confused with the outside vendor, if any, providing the overall plan administration; in the case of run-it-yourself 401k plans such as MDB401k, there is no such outside vendor). back to top

The Plan Vendor 401k plans are supplied by a vendor, who typically supplies the 401k plan itself and all its related documentation. The vendor deals with the IRS and related governing agencies in making sure the startup plan is consistent with current regulations. Often the vendor supplies 401k administration services, too. Sometimes the vendor even supplies its own lineup of 401k plan investments. -- Administration for a 401k plan can be legally supplied almost any party -- the plan vendor, the plan sponsor, or any third party -- so long as the plan is run in accordance with current regulations. -- Investments for a 401k plan can be supplied by the plan vendor or by another party, the investment custodian. back to top

Third-party Administrators (TPAs) Administration for a 401k plan can be legally supplied almost any party -- the plan vendor, the plan sponsor, or a third party -- so long as the plan is run in accordance with current regulations, among them IRS compliance testing stipulations. -- Third-party administrators (TPAs) are often contracted by 401k vendors or by the 401k plan sponsors themselves to handle a 401k plan's month to month administration. -- Plan sponsors (i.e., the employers) supply the third-party administrators with payroll and related 401k participation data (such as loan and distribution requests) each month. The TPA processes the data and instructs the plan sponsor regarding forwarding 401k monies to the appropriate investment custodian(s). -- MDB401k is like a plan sponsor's personal third-party administrator residing within the employer's desktop PC. The software handles all plan administration off the payroll and related data the plan sponsor feeds it and supplies the plan sponsor with instructions regarding forwarding monies to the appropriate investment parties (i.e., Mydiscountbroker.com). -- Go to Key Reasons to Choose MDB401k for a brief comparison of 401k plan administration via traditional third-party administrators and via MDB401k. back to top

Auto Enrollment The 401k "auto enrollment" procedure allows employers to AUTOMATICALLY enroll an employee in the 401k plan as soon as the employee meets the plan's eligibility requirements. Employees can elect to decline enrollment at any time. -- The employer must set the auto enrollment contribution level in advance; 3% to 5% of compensation is the typical auto enrollment contribution level chosen. -- The employer must set an auto enrollment investment selection ahead of time; a money market fund is the most typical auto enrollment investment. -- Employers must, at least annually, notify all employees that the company 401k uses the auto enrollment feature and how an employee can cease participation in the plan or put a block on being enrolled automatically in it. -- Employers must immediately notify auto-enrolled employees of their new 401k participation status. -- Any employer contributions being made to traditionally-enrolled participants' accounts must also be made to auto-enrolled participants' accounts. -- Auto-enrolled plan participants must have the opportunity to change their default investment selection and/or contribution rate. -- If an automatically-enrolled employee soon after cancels his or her participation in the plan, any money put into the plan on the person's behalf must stay in the plan until the person's employment is terminated, or the employee reaches age 65.  At that point, the employee has the same withdrawal choices (IRA rollover, rollover into another employer's qualified retirement plan, or distribution) as any 401k participant of the same age and employment status. Automatic enrollment is also called passive enrollment and negative enrollment; the default contribution and investment designations are called the plan's negative elections. The IRS has only recently approved negative elections and certain legalities outside of the IRS's scope remain unclear. It is prudent to consult a legal advisor before adopting automatic enrollment for your 401k plan. back to top

Employee Contributions Contributions to a 401k account can come from employees and/or their employers.  Employee contributions are withheld from the participant's pay BEFORE income tax withholding is calculated. Thus, 401k contributions are pre-tax contributions. -- Employees can also transfer their money into their current 401k from their previous employer's 401k in the form of a rollover. Consolidating accounts can simplify oversight and management of a comprehensive investment strategy under the direction and control of the plan participant. -- Participating in a 401k plan can reduce a person's lifetime income tax burden, because income taxes aren't assessed on 401k contributions until the money is withdrawn from the plan, usually years down the road, during retirement, when the participant is likely in a lower income tax bracket. Employees cannot contribute more than 15% of their annual earnings to their 401k account. Additionally, they cannot contribute more than $10,500 (for year 2000) of their annual earnings to their 401k account, a limit adjusted each year by lawmakers. -- These limits apply to employee contributions only. -- Employer contributions to an employee's account can take the total annual contribution amount much higher. -- Returns earned on 401k investments are never included in these annual contribution limits and can be a substantial source of growth for a 401k account. back to top

Employer Contributions Contributions to a 401k account can come from employees and/or their employers. Employers choose whether or not to contribute to their employees 401k accounts. If they choose to contribute, they can do so in any of three ways: -- In a flat fixed-dollar amount to each participant's account (e.g., $500 to each participant's account annually) -- At a fixed rate of each participant's pay (e.g., each participant gets an amount equal to 3% of his or her salary).  This is called a profit sharing contribution. -- At a rate that depends on how much the employee contributes to the 401k plan, This is called a matching contribution. Because matching contributions depend on the employee's level of participation (25¢ for every dollar the employee contributes, for example), they encourage employees to join the 401k, contribute as much money as they can, and stay with the company over the years. -- Employers are NOT required to contribute to their employees' 401k accounts in any way. Employer contributions are completely voluntary on the part of the employer (unless being used to satisfy a plan imbalance, in which case qualified nonelective contributions might be made to, say, all nonhighly compensated employees' accounts). Any employer qualified nonelective contributions are 100% vested to employees when made. Employer matching and profit sharing contributions, on the other hand, do not have to immediately become the property of the employees. Instead, employers can impose a vesting schedule by which the 401k participants gain full ownership of employer contributions incrementally, over time. For example... -- An employer chooses to make matching contributions of 25¢ to each dollar plan participants contribute. -- The employer stipulates that people who have participated in the plan two years or less only get 25% ownership of these employer-provided matching contributions. People who have participated in the plan three years get 50% ownership of the matching contributions. People who have participated in the plan four years get 75% ownership of the matching contributions, and people who have participated in the plan five years or more get 100% ownership of matching contributions. This schedule of ownership is an example of a vesting formula. It is relevant if a participant leaves the plan before reaching fully vested status. Any non-vested employer contributions revert back to the plan and can be used to pay matching contributions owed to other participants. -- The  Internal Revenue Code places dollar amount ceilings and other restrictions on matching and vesting formulas. back to top

401k Investments Certain types of investments are "qualified" under the Internal Revenue Code to receive 401k contributions. These include: -- Mutual fund investments (stocks, bonds and money market funds). Mutual fund investments are by far the most popular 401k investments. -- Publicly traded stocks and bonds (excepting municipal or tax free bonds) -- Bank collective funds -- Insurance company investments Every 401k plan must offer a minimum spectrum of investments, as defined in the Internal Revenue Code. -- Most plans offer between five and 15 investment choices. -- Returns earned on 401k investments are automatically reinvested in the participants' accounts, increasing the account value over time. -- Removing investment returns from a 401k, just like removing any other money from a 401k account, constitutes a withdrawal and is subject to the penalties and withholdings of such. back to top

401k Investing and Tax-deferred Saving All 401k contributions -- employee, employer and even returns earned on 401k investments -- are exempt from income taxation (in most cases state, in all cases federal) so long as the money remains in the plan. Delaying income taxation can have a dramatic positive effect on the compounding growth of an account: -- An investor can amass nearly THREE TIMES as much money in a 401k tax-deferred investment over a 30 year period as in a  taxable savings plan or investments earning the same rate of return but whose returns are reduced each year by income taxation. -- When money is taken out of a 401k plan -- for ANY reason except a 401k loan or rollover into an IRA or new employer's 401k plan -- it is considered income and taxed as such. back to top

Withdrawals and 401k Loans Although 401k plans are meant to be long term savings vehicles, participants cannot leave money in a 401k account indefinitely: -- Plan participants generally MUST begin taking withdrawals from their 401k accounts when they reach age 70 1/2. -- Plan participants CAN begin taking withdrawals from their 401k accounts as soon as they reach age 59 1/2. -- Earlier withdrawals can be made without penalty if the participant dies or incurs a qualifying permanent disability. -- At any time, a plan participant leaving the company can remove his or her 401k money without subjecting it to early withdrawal penalties by rolling the money over into a Rollover IRA or new employer's qualified retirement savings plan (401k or other). Outside of these instances, there are only two ways for participants to withdrawal money from a 401k account while employed: hardship withdrawal and 401k loan.   HARDSHIP WITHDRAWAL   401k LOAN does NOT have to be paid back must be paid back within the agreed-upon time (within six months if the participant leaves the company) no interest bears interest (market rate, or thereabouts) substantial federal early withdrawal penalties no federal early withdrawal penalties, unless the loan goes into default one year suspension of 401k participation upon taking out of a hardship withdrawal no participation suspension substantial long-term negative effect on the compounding growth of the 401k account less substantial long-term effect on the compounding growth of the 401k account -- but still a significant negative effect sometimes asset liquidation fees sometimes assets liquidation fees plan participant generally ends up with about 1/2 of the amount withdrawn (the reminder goes to taxes and federal early withdrawal penalties) plan participant generally ends up with most of the amount withdrawn withdrawn money taxed as income for the year no tax consequences (unless participant defaults on loan) must be included in all 401k plans does NOT have to be included in 401k plans generally involve nominal administrative processing costs generally involve nominal administrative processing costs all other resources must have been exhausted for person to qualify qualifications much less stringent Hardship withdrawal and 401k loans can increase a plan's popularity even if participants never take advantage of the features, because employees don't feel participation means sending their money into some never-to-be-seen-again abyss. Retirement, after all, may be decades away. back to top

ERISA Participant Rights Protections Two bodies of legal work comprise the framework for 401k plans: the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA). ERISA sets standards for, among other things... -- Participant eligibility -- Investment choice -- Plan funding/bonding -- Vesting of employer contributions -- Disclosure of plan and investment and investing-related information to current and prospective plan participants and their beneficiaries ERISA aims to ensure that retirement monies actually exist at employees' retirements by preventing fund mismanagement by administrators, trustees and others. An employer interested in purchasing an ERISA bond for the company's 401k typically buys a bond that covers 10% of the plan's total assets. ERISA bonds are very economical and easy to buy --- most insurance agents offer these bond's to small companies at & very low annual rates. Fiduciary Liability Insurance Fiduciary liability insurance is different than an ERISA bond. Fiduciary liability insurance is a completely discretionary purchase on the part of the employer; it provides broad coverage for all persons who are de facto "fiduciaries" of the company's plan. A fiduciary is someone who provides investment advice to the plan for a fee, and/or has discretionary control or authority over the administration of the plan, and/or who has authority or control over plan assets. (note: NASD Registered Representatives are not considered fiduciaries; they earn commissions on plan assets and typically do not charge fees for investment advice.) Fiduciary liability insurance is very inexpensive; the cost is approximately five 5 percent of the coverage limits purchased, unless the company offers its own stock as an investment option, which increases the premium. Coverage is broad, and the only exclusions are for deceptive practices and fraud, which is covered by the ERISA bond. Providers of fiduciary liability insurance coverage include American International Group (AIG); Chubb Executive Risk; Lloyd's of London; Reliance Insurance; and Travelers Property Casualty. back to top

IRS Compliance Testing To prevent employers from designing 401k plans that economically benefit only highly-paid personnel, lawmakers wrote compliance test mandates into the rules governing 401k plans. -- In general, no plan can be set up in a way that discriminates "as to the availability of rights, benefits and features" available to different employees under the plan. Specifically... -- Every 401k must pass mandated compliance testing every year. The tests compare the participation rates of different classes of employees (see below). -- Beginning in 1999, employers can choose to skip the tests and instead make a requisite contribution to their so-called non-highly-compensated employees' 401k accounts. This is called the safe harbor method of plan administration. -- Employers can decide as late as 30 days before the end of each plan year whether or not to take the safe harbor route. However, if, as its safe harbor contribution, the employer wants to make matching contributions rather than the flat 3% of compensation contribution (explain), the employer must define the matching formula well ahead of those 30 days; in fact, any safe harbor matching contribution must be defined and communicated to employees no later than 30 days before the START of the applicable plan year so employees have plenty of time to adjust their contribution rates accordingly.. Not correcting a failed year-end compliance test can mean substantial penalties and possibly even disqualification of the plan's tax-exempt status. Test failures can be VERY expensive in terms of IRS penalty fees, man-hours spent trying to correct the problems and lost rapport with your employees, who may have to amend and refile their income tax forms -- and often pay additional income taxes, too. The most common compliance tests are the ADP test, ACP test, multiple-use test and top-heavy test. -- The ADP test (Actual Deferral Percentage test) compares the percentage of salaries that different classifications of employees are diverting into the 401k plan. -- The ACP test (Actual Contribution Percentage test) compares the percentage of employer contributions being diverted into the 401k accounts of different classifications of employees. -- The multiple-use test compares the results of the ADP and ACP tests. -- The top-heavy test looks at how much higher-paid employees' money dominates the 401k plan. back to top

Safe Harbor 401k Plan Administration 401k compliance tests are designed to ensure 401k plans have a threshold balance, at minimum, of participation of rank-and-file employees in relation to highly-paid employees. The IRS offers an alternative means of achieving 401k plan balance: The safe harbor method of plan operation lets 401k plans skip their annual 401k discrimination testing so long as the sponsoring employer meets certain employer 401k contribution requirements designed to ensure broad participation in the company plan and provides 100% immediate vesting of the contributions. -- To qualify a 401k plan as a safe harbor plan, an employer must make matching contributions that fulfill the below requirements or make nonelective contributions equal to 3% of each eligible employee's compensation. -- Nonelective contributions are made to all eligible employees, regardless of if the employees participate in the company 401k plan. Matching contributions, on the other hand, being based upon salary deferral amounts, are made only to active 401k participants' accounts. -- If the employer chooses to make safe harbor matching contributions, those contributions must meet two requirements: First, each non-highly-compensated employee must receive a dollar-for-dollar match on salary deferrals up to 3% of compensation and a 50¢ to the dollar match on salary deferrals from 3% to 5% of compensation. Second, the rate of any matching contributions being made to highly compensated employees cannot exceed that being made to non-highly compensated employees. The employer must provide annual information to employees explaining the 401k plan's safe harbor provisions and benefits, including that safe harbor contributions can not be distributed before termination of employment and that they are not eligible for financial hardship withdrawal. Employers can decide as late as 30 days before the end of each plan year whether or not to take the safe harbor route. However, if, as its safe harbor contribution, the employer wants to make matching contributions rather than the flat 3% of compensation contribution, the employer must define the matching formula well ahead of those 30 days; in fact, any safe harbor matching contribution must be defined and communicated to employees no later than 30 days before the START of the applicable plan year so employees have plenty of time to adjust their contribution rates accordingly. Your MDB401k system includes such notification within your customized 401k plan's Summary Plan Description, a document that's updated at least annually for all eligible employees. -- If you don't choose the safe harbor method of 401k plan administration, we encourage you to use your customized 401k plan administration software's point-and-click compliance testing every month to keep well apprised of your plan's health. back to top

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