401(k) Plan

Employee contributions

Whether an employee elects to make pre-tax contributions or Roth after-tax contributions to the 401(k) plan, careful attention must be paid to the elective deferral limits. In 2024, an employee can't contribute more than $23,000 (up from $22,500 in 2023) of his or her salary to a 401(k) plan. Participants who are age 50 or older may also make additional "catch-up" contributions of up to $7,500 in 2024 (unchanged from 2023). Other limits also apply (discussed later).

Employer contributions

To encourage employee participation, some employers offer to "match" employee contributions under a specific formula. For example, you might decide to match 50 cents on every dollar contributed by employees up to a maximum of 10% of each employee's salary. As an employer, you also have the option of making discretionary contributions ("nonelective contributions") to employee accounts. These contributions are subject to specific tests to ensure that they don't discriminate in favor of highly compensated employees (see Questions & Answers for the definition of highly compensated employee).

Your employer contributions are income tax deductible

Your business may currently deduct (from business income) employer contributions it makes to the 401(k) plan.

Employer contributions are discretionary

A 401(k) plan offers a certain amount of flexibility. When you establish a 401(k) plan, you choose whether you want to contribute to your employees' 401(k) accounts. If you decide to contribute, you can match all or a portion of your employees' contributions. You also have the flexibility to decide whether to make discretionary profit-sharing contributions each year.

Employees can contribute with pre-tax dollars

Your employees can elect to receive a portion of their compensation in cash, or instead defer those dollars into your 401(k) plan on a pre-tax (salary-reduction) basis. The contribution is taken directly from the employee's salary and invested in the plan before any taxes are withheld. This means that the amount each employee defers to the plan is not included in his or her gross income. The employee pays less current income tax because his or her taxable income is lower than it would otherwise be. Employee pre-tax contributions are generally taxable when distributed from the plan.

Employees can make after-tax Roth contributions

If your plan permits, your employees can elect to designate all or part of their elective deferrals as Roth 401(k) contributions. Your employees' Roth contributions are made on an after-tax basis. Roth 401(k) contributions don't provide any up-front tax benefit, but they're always tax free when distributed from the plan. Earnings on Roth contributions are also tax-free if paid to the employee in a qualified distribution.

Earnings accrue tax deferred

Investment earnings on your contributions and your employees' contributions accumulate tax deferred while inside your 401(k) plan. Earnings aren't taxed to your employees until they take a distribution from the plan, and earnings on Roth contributions are tax free if paid to the employees in a qualified distribution.

Employees have the option of receiving the cash immediately from you rather than deferring it to the plan

A 401(k) plan provides flexibility to your employees. Employees aren't required to make contributions to the plan. If they do contribute, however, they can change the amount of their contribution, or even cease contributing altogether.

Employees may find it easier to save for retirement

Because employees make 401(k) contributions through payroll deductions, they may find it easier to save. The money is "out of sight, out of mind."

Plan loans can be made available to plan participants

You may structure your 401(k) to allow employees to borrow as much as one-half of the vested benefits in their 401(k) plan account, to a maximum of $50,000.

In-service withdrawals can be made available to plan participants

An employee's ability to access his or her own elective deferrals to a 401(k) plan is limited by federal law. You can, however, structure the plan to allow certain in-service withdrawals. For example, you can let your employees withdraw their pre-tax contributions, and any investment earnings on those contributions, after they turn age 59½.

You can also let your employees withdraw money from the plan while they're still employed if they can demonstrate an "immediate and heavy financial need," have exhausted all other available distribution options (and, possibly, loan options) from their retirement plans, and have no other resources they can use to meet that need (e.g., they can't borrow from a commercial lender and have no other available savings). This is known as a hardship withdrawal. Examples of immediate and heavy financial need include the need to:

• Pay medical bills for your employee, the employee's spouse, children, other dependents, or primary plan beneficiary
• Pay costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments)
• Pay post-secondary tuition and related educational expenses for your employee, the employee's spouse, children, other dependents, or primary plan beneficiary (a maximum of 12 months)
• Prevent an eviction from or foreclosure of the employee's principal residence
• Pay funeral expenses for the employee, the employee's spouse, children, other dependents, parent, or primary plan beneficiary
• Repair damage to the employee's principal residence after certain casualty losses
• Pay for expenses and losses (including loss of income) incurred as a result of a disaster declared by the Federal Emergency Management Agency, such as a hurricane or wildfire (provided the employee's principal residence or place of employment is located in the federally declared disaster area)
• Pay income tax and/or penalties due on the hardship withdrawal itself

In general, an employee can't take a hardship withdrawal to the extent the employee is eligible for a non-hardship withdrawal or a loan from your 401(k) plan or from any other retirement plan you sponsor.

If your plan permits after-tax (non-Roth) contributions you can generally let employees withdraw those dollars at any time. And if you make regular matching or discretionary employer contributions to the plan, you can generally let employees withdraw those contributions after an employee reaches a specified age, after the employee has been a plan participant for at least five years, after the contribution has been in the trust for a specified period of time (at least two years), after the employee becomes disabled, or after the employee incurs a hardship. Plans may permit hardship withdrawals to include qualified matching contributions (QMACs), qualified nonelective contributions (QNECs), and safe harbor contributions, as well as earnings on those amounts.

If your plan has discretionary (nonelective) profit-sharing contributions, it may be "integrated" with Social Security

Basically, this means that you can, within specific limits, allow your plan to pay more to higher-paid employees. This is because benefits provided by a qualified retirement plan and those provided by Social Security are viewed by the IRS as one retirement program. Because Social Security provides a higher percentage of salary benefit to lower-paid employees, the IRS may allow a 401(k) plan that has discretionary profit-sharing contributions to favor higher-paid employees within specific limits (this is known as permitted disparity).

Participants who are age 50 or older can contribute more than the limit

Individuals age 50 and older may make an additional yearly "catch-up" contribution to their 401(k) plans (over and above the regular employee elective deferral limit, and over and above the annual addition dollar limit). The catch-up contribution amount is $7,500 in 2024 (unchanged from 2023), and is indexed for inflation. The purpose of this provision is to help older individuals increase their savings as they approach retirement. Catch-up contributions can be either pre-tax elective deferrals or, if your plan permits, after-tax Roth contributions

Employees may qualify for the tax saver's credit

Certain low- and middle-income taxpayers may claim a partial, nonrefundable income tax credit ("Saver's Credit") for amounts contributed to 401(k)s and certain other retirement savings vehicles. The maximum annual contribution eligible for the credit is $2,000. In addition, the amount of the credit (if any) depends on your employee's adjusted gross income (AGI). Only joint returns with AGI of $76,500 or less, head of household returns of $57,375 or less, and single returns of $38,250 or less are eligible for the credit. Here are the credit rates based on 2024 AGI limits:

To claim the credit, your employee must be at least 18 years old and not a full-time student or a dependent on another taxpayer's return.

Your business may qualify for tax credits

If you establish a new 401(k) plan, your business may be eligible to receive certain income tax credits.

Employers with 50 employees or less may be eligible for a tax credit equal to 100% of qualified start-up costs. Employers with 51 to 100 employees may be eligible for a 50% credit. The credit maximum is $5,000 per year (based on the number of employees) for the first three years the plan is in effect.

In addition, employers may be eligible for a tax credit for employer contributions to employee accounts for the first five tax years of the plan's existence. The amount of the credit is a maximum of $1,000 for each participant earning not more than $100,000 in income (adjusted for inflation). Each year, a specific percentage applies. In years one and two, employers receive 100% of the credit; in year three, 75%; in year four, 50%; and in year five, 25%. The amount of the credit is reduced for employers with 51 to 100 employees. No credit is allowed for employers with more than 100 workers.

Rollovers are allowed

In general

You can, but aren't required to, let employees roll over assets from other retirement plans to your 401(k) plan. For example, you can allow participants to roll over pre-tax (but not after-tax) IRA funds to your plan. Pre-tax IRA funds generally include deductible contributions to the IRA, tax-deferred earnings, and rollovers of taxable dollars from other employer-sponsored plans. You can also let your participants roll over eligible taxable and nontaxable (after-tax) funds from another employer's qualified 403(b), governmental 457(b), or SIMPLE IRA plan to your 401(k) plan. The plan must receive after-tax contributions in a direct rollover and must account for those contributions (and any earnings) separately.

While you're not required to accept rollover contributions to your plan, you must let employees roll over eligible distributions from your plan to an IRA or another employer's retirement plan, if the other plan allows rollovers. Surviving spouses must also be given the option to roll over inherited 401(k) funds to the spouse's own IRA or employer plan account. Spouses who are sole beneficiaries of the plan may also treat the account as their own. Beneficiaries other than surviving spouses may be given the opportunity to directly roll over inherited 401(k) funds to an inherited IRA.

Special rules apply to Roth 401(k) contributions and earnings. Distributions from an employee's Roth account can only be rolled over to a Roth IRA or to a Roth account maintained in another employer's 401(k), 403(b), or 457(b) plan. And a Roth 401(k) account can only receive a rollover contribution from another 401(k), 403(b), or 457(b) Roth account (not from a Roth IRA).

A rollover can be direct or indirect. With a direct rollover, also known as a trustee-to-trustee transfer, the funds are moved directly from the 401(k) plan to an IRA or other employer plan. With an indirect rollover, the participant first receives the distribution from the plan, and then rolls it over to an IRA or to another eligible employer plan within 60 days. In either case, as long as the rollover follows all applicable rules, it will be treated as a tax-free transfer of assets. If an eligible rollover distribution is not directly rolled over/transferred to an IRA or another eligible retirement plan, you are required to withhold 20% from the taxable portion of the distribution for federal income tax purposes. (The participant will receive a credit for tax withheld when he or she files a federal income tax return for the year.)

• Required minimum distributions (RMDs)
• Certain periodic payments
• Hardship distributions
• Corrective distributions of excess deferrals, excess contributions, or excess annual additions (plus any income on those contributions)

In-plan conversions

A 401(k) in-plan Roth conversion (also called an "in-plan Roth rollover") allows employees to transfer the vested non-Roth portion of their 401(k) plan accounts (for example, employee pre-tax and after-tax contributions, company contributions, and any investment earnings) into a designated Roth account within the same plan. Employees have to pay federal income tax now on the amount they convert (reduced by any basis the employee has in the converted funds), but qualified distributions from their Roth accounts in the future will be entirely income tax free. Also, the 10% early distribution penalty generally doesn't apply to amounts converted (but that tax may be reclaimed by the IRS if an employee receives a nonqualified distribution from his or her Roth account within five years of the conversion).

Here are some additional points about in-plan Roth rollovers to consider:

• If an amount rolled over into a designated Roth account was subject to distribution restrictions prior to the rollover, then that amount will continue to be subject to the same distribution restrictions after the rollover.
• If an in-plan rollover is the employee's first Roth contribution to the plan, then the five-year period for determining qualified distributions begins on January 1 of the year in which the employee makes the in-plan rollover.
• Amounts that are otherwise nondistributable may be rolled over into a designated Roth account only via a direct rollover. Amounts that are otherwise distributable from the plan may be rolled over using either a direct rollover or an indirect (60-day) rollover (however, a 60-day rollover will be subject to 20% withholding).
• Your plan is not required to allow in-plan Roth rollovers. You may also limit the types of dollars that may be rolled over, and the frequency of rollovers.
• If your plan allows, an in-plan Roth direct rollover can include an employee's outstanding plan loan, if there is no change in the loan's repayment schedule. The taxable amount is generally the balance of the loan at the time of the rollover.

Creditor protection

Funds held in a 401(k) plan are fully shielded from your employee's creditors under federal law in the event of the employee's bankruptcy. If your plan is covered by the Employee Retirement Income Security Act of 1974 (ERISA), plan assets are also generally fully protected under federal law from the claims of both your employees and your creditors, even outside of bankruptcy (certain exceptions apply). State law may provide additional protection.

You will need professional assistance to establish and administer your 401(k) plan

Like other qualified plans, a 401(k) plan is subject to reporting and disclosure requirements under the Employee Retirement Income Security Act (ERISA). Therefore, you'll likely require professional assistance to establish and administer your plan.

Like all defined contribution plans, a specific benefit level isn't guaranteed

Unlike a defined benefit plan, a 401(k) plan doesn't guarantee a specific benefit at retirement. Participants' accounts are subject to market forces, so if plan investments perform badly, participants could suffer a financial loss.

Access to elective deferrals limited before termination of employment

In general, a 401(k) plan can distribute elective contributions and earnings to an employee only upon the employee's death, disability, separation from service, or attainment of age 59½. However, there are certain exceptions to this rule (in addition to the in-service withdrawals described above). See "Early distribution penalty" under "What are the tax considerations?" below.

Various contribution limits apply to 401(k) plans

Several rules and limitations involving contributions to 401(k) plans exist, including:

• Annual elective deferral limit: In 2024, employee elective deferrals (combined pre-tax and Roth) are limited to $23,000. Employees age 50 or older can make catch-up contributions of up to $7,500 in 2024 over and above the annual dollar limit.

• Section 415 annual addition limit: Annual additions (the aggregate of employee contributions plus any employer contributions you make on behalf of the employee plus any reallocated forfeitures — see Questions & Answers, below, for the definition of reallocated forfeitures) may not exceed the lesser of $69,000 in 2024 or 100% of the participant's compensation. Participants age 50 or older can make catch-up contributions of up to $7,500 in 2024 over and above this annual addition dollar limit. You must treat all qualified defined contribution plans you maintain as a single plan for purposes of calculating the annual additions limit.

• Annual deduction limit: The maximum annual deductible employer contribution that you can make on behalf of all plan participants (in addition to employee pre-tax salary deferrals) is 25% of the compensation paid to all participants.

Your 401(k) plan may not discriminate in favor of highly compensated employees

Basically, this means that your highly compensated employees (see Questions & Answers, below, for the definition of highly compensated employee) may not defer a substantially higher percentage of their compensation than non-highly compensated employees. In order to ensure that this is the case, your 401(k) plan is generally required to undergo annual nondiscrimination testing.

These tests compare the average contribution rates of your highly compensated employees and your non-highly compensated employees.

Your 401(k) plan may be subject to "top-heavy" requirements

A 401(k) plan is considered to be "top-heavy" if (as of the determination date) the total of the accounts of all key employees (generally the owners and officers of the business) exceeds 60% of the total of the accounts of all employees. If the plan is top-heavy, you must make a minimum contribution of 3% of pay to the accounts of all non-key employees. The top-heavy requirements generally do not apply to safe-harbor 401(k) plans, or to plans that include a qualified automatic contribution arrangement.

Have a plan developed for your business

You'll want a retirement plan specialist to develop a plan that meets all the necessary legal requirements. In addition, you'll want the plan to serve the needs of your business. Here are some of the issues to consider (this is by no means a comprehensive list):

• Determine the plan features most appropriate for your business: Carefully review your business, looking at factors such as your cash flow and profits, how much you and your employees will benefit from the plan, the tax deduction needed by your business, and employee population (tenure, age, salary, turnover), to determine plan features such as investment vehicles, employer match (if any), employee eligibility requirements, vesting, auto-enrollment, and safe-harbor provisions.
• Decide if you will allow only pre-tax employee contributions, or if you will also allow employees to make Roth after-tax contributions: Roth contributions may make administration of the 401(k) plan a bit more complex.
• Consider plan designs that reduce (or eliminate) the need to test for discrimination and top heaviness, including safe harbor 401(k)s and qualified automatic enrollment arrangements.
• Decide if employees will direct their own investments. If so, decide if your plan will comply with Section 404(c) of ERISA, in order to limit the liability of plan fiduciaries for losses employees may incur as a result of their own investment decisions.
• Choose the plan trustee (this may or may not be you): The assets of the plan must be held in a trust by a trustee. The trustee has overall responsibility for managing and controlling the plan assets, preparing the trust account statements, maintaining a checking account, retaining records of contributions and distributions, filing tax reports with the IRS, and withholding appropriate taxes.
• Choose the plan administrator: Administering the plan involves many duties, including managing the plan (determining who is eligible to participate in the plan, the amount of benefits, and when they must be paid) and complying with reporting and disclosure requirements. The plan administrator may also be responsible for investing plan assets and/or providing investment educational services to plan participants. The employer is legally permitted to handle these responsibilities in-house, but plan sponsors will frequently hire a third-party firm or financial services company to assist in performing recordkeeping and other functions of plan administration. Be sure to comply with ERISA's bonding requirements, if applicable.
• Be sure to familiarize yourself with your responsibilities and liability as a plan fiduciary (see section below on fiduciary responsibility).

Submit the plan to the IRS for approval

Once a plan is developed, the written document should be submitted to the IRS, unless it is a previously approved prototype plan. Since there are a number of formal requirements (for example, you must provide a formal notice to employees), a retirement plan specialist should assist you in this task. Submission of the plan to the IRS isn't a legal requirement, but it is highly recommended (for more information, see Questions & Answers, below). The IRS will carefully review the plan and make sure that it meets all of the legal requirements. If the plan meets all the requirements, the IRS will issue a favorable "determination letter." If the plan doesn't meet all the requirements, the IRS will issue an adverse determination letter indicating the deficiencies in the plan.

Adopt the plan during the year in which it is to be effective

You must officially adopt your plan during the year in which it is to become effective, so plan ahead and allow enough time to set up your plan before your company's year-end. A corporation "adopts" a plan by a formal action of the corporation's board of directors. An unincorporated business should adopt a written resolution in a form similar to a corporate resolution.

Provide a copy of the summary plan description, and other required disclosures, to all eligible employees

ERISA requires you to provide a copy of the summary plan description (SPD) to all eligible employees within 120 days after your 401(k) plan is adopted. A SPD is a booklet that describes the plan's provisions and the participants' benefits, rights, and obligations in simple language. On an ongoing basis you must provide new participants with a copy of the SPD within 90 days after they become participants. You must also provide employees (and in some cases former employees and beneficiaries) with summaries of material modifications to the plan. In most cases you can provide these documents electronically (for example, through email or via your company's intranet site). ERISA may require that you also provide additional information to participants. For example, if you allow employees to direct their own investments, specific detailed information about the plan and its investments must be provided on a periodic basis.

File the appropriate annual report with the IRS

Most qualified plans must file an annual report (Form 5500 series) with the IRS. Simplified reporting rules apply to certain single participant plans. A single participant plan is generally one that covers only an owner (and his or her spouse) or only partners (and their spouses). In general, single-participant plans aren't required to file a return for a plan year (other than the final plan year) if the total value of the plan's assets at the end of the plan year is less than $250,000.

Income Tax — Employer

Your employer contributions to a 401(k) can be deducted from income

If your business contributes to the 401(k) plan, it can currently deduct such contributions up to 25% of the total compensation of all participants. For purposes of calculating your maximum tax-deductible contribution, the maximum compensation base that can be used for any one plan participant is $345,000 in 2024 (up from $330,000 in 2023). Employee pre-tax salary deferrals are deductible in full separately from this 25% limit on other employer contributions.

Elective deferrals are subject to Social Security and federal unemployment payroll taxes

Employee elective deferrals (including pre-tax and Roth contributions), but not employer contributions, are subject to payroll taxes under the Federal Insurance Contribution Act (FICA), Federal Unemployment Tax Act (FUTA), and Railroad Retirement Act.

Your business may qualify for the small employer pension plan start-up tax credit

If you establish a new 401(k) plan, your business may be eligible for certain income tax credits. See details under "Your business may qualify for tax credits" above.

Income Tax — Employee Pre-tax and Employer Contributions

Plan contributions and earnings are income tax deferred

Your employee's pre-tax deferrals aren't currently includable in the employee's income — they're tax deferred, and included in income only when distributed from the plan. Likewise, your employee isn't taxed on any employer contributions you make to his or her 401(k) account until a distribution is taken from the plan. Similarly, investment earnings on employee pre-tax contributions and employer contributions grow tax deferred, and aren't subject to income tax until withdrawn.

Income Tax — Employee Roth Contributions

You can (but aren't required to) let your employees designate all or part of their elective deferrals as Roth 401(k) contributions. Because an employee's Roth contributions are made on an after-tax basis, there is no up-front tax benefit. They're included in your employee's gross income at the time the employee contributes to the 401(k) plan. And because they're made on an after-tax basis, an employee's Roth contributions are tax-free when distributed from the plan. Investment earnings on an employee's Roth contributions grow tax-deferred while they remain in the 401(k) plan. Whether they're subject to tax when distributed depends on whether the distribution is qualified or nonqualified.

Qualified distributions

If an employee receives a qualified distribution from his or her Roth account, the entire amount distributed, both the Roth contributions and investment earnings, is totally free from federal income tax. A qualified distribution is a payment from an employee's Roth account that meets both of the following requirements:

• The payment is made after your employee turns age 59½, becomes disabled, or dies, and
• The payment is made after the end of the five-year period that starts with the year the employee makes his or her first Roth contribution to your 401(k) plan

Nonqualified distributions

If a payment doesn't satisfy the conditions for a qualified distribution, the portion of the payment that represents the return of your employee's Roth contributions will still be tax-free, but the portion of the payment that represents earnings on those contributions will be subject to income tax and a potential 10% premature distribution penalty (unless an exception applies — see below).

Premature distribution penalty

A federal 10% premature distribution penalty may be assessed on the taxable portion of 401(k) plan distributions made prior to age 59½; however, there are numerous exceptions to this penalty. including:

• separation from service at age 55 or older
• disability or death of the account owner
• terminal illness of the account owner (a condition that will cause death within seven years as certified by a physician)
• unreimbursed medical expenses that exceed 7.5% of adjusted gross income
• certain substantially equal periodic payments
• distributions pursuant to a qualified domestic relations order
• certain corrective distributions of excess deferrals and excess contributions
• qualified reservist distributions
• up to $5,000 per account owner for the birth or adoption of a child
• federally declared disaster-related expenses of up to $22,000 (if the distribution is made within 180 days of the disaster occurring)
• distributions of up to $1,000 per year for personal or family emergencies (no further emergency distributions will be allowed for three years unless the funds are repaid or new contributions are at least equal to the distribution; effective in 2024)
• up to $10,000 or 50% of the account balance, whichever is less, in the case of domestic abuse of the account owner during the preceding one-year period (physical, psychological, sexual, emotional or economic abuse; effective in 2024)
• distributions used to pay for certain long-term care insurance policies (effective 2025)

Gift and Estate Tax — Employee

The entire vested value of a 401(k) plan death benefit is included in a deceased participant's gross estate for federal estate tax purposes.

Saver's Credit

Some low- and middle-income taxpayers may claim a federal income tax credit for contributing to a 401(k) plan (or to certain other employer-sponsored retirement plans).

Which employees must you include in your 401(k) plan?

Generally, plan participation must be offered to all employees who are at least 21 years of age and who worked at least 1,000 hours for the employer in a previous year. For eligibility purposes, one year of service generally means a 12-month period during which the employee has at least 1,000 hours of service. Two years of service may be required for participation in a discretionary employer contribution (if your plan has one) as long as the employee will be 100% vested immediately. The two-year service requirement can't be required for employee pre-tax or Roth contributions. Consequently, if your plan includes both employee contributions and discretionary employer contributions, you could have two eligibility requirements. If you want, you can impose less (but not more) restrictive requirements. Many 401(k) plans don't impose any age or service restrictions at all.

Plan participation must also be offered to all employees who are at least 21 years of age with three consecutive 12-month periods during each of which the employee has at least 500 hours of service (12-month periods beginning before January 1, 2021, do not count). Beginning with 2025 plan years, the service requirement reduces to two consecutive 12-month periods.

When does plan participation begin?

An employee who meets the minimum age and service requirements of the plan must be allowed to participate no later than the earlier of:

• The first day of the plan year beginning after the date the employee met the age and service requirements, or
• The date six months after these conditions are met

If you want, you can impose less (but not more) restrictive requirements.

What is a safe harbor 401(k) plan?

A safe harbor 401(k) plan is one that by design satisfies the ACP test that applies to employer matching contributions. The safe harbor requires that you make a fully vested contribution equal to either:

• A dollar-for-dollar match of all non-highly compensated employee deferrals up to 3% of compensation and 50-cents-on-the-dollar match of deferrals between 3% and 5% of compensation, or
• 3% of compensation for all non-highly compensated employees, regardless of whether these employees contribute to the plan

Employers using the safe harbor 401(k) rules must give each eligible employee a written notice of the employee's rights and obligations under the plan that satisfies specific content and timing requirements.

What is an automatic enrollment arrangement?

Your plan can provide that employees will automatically be enrolled in your 401(k) plan as soon as they become eligible. Your employee will then have to affirmatively elect not to participate in the plan. There are several different types of automatic enrollment arrangements.

A basic automatic enrollment arrangement must state that employees will be automatically enrolled in the plan unless they elect otherwise and must specify the percentage of an employee's wages that will be automatically deducted from each paycheck for contribution to the plan. The document must also explain that employees have the right to elect not to have salary deferrals withheld or to elect a different percentage to be withheld.

An eligible automatic contribution arrangement (EACA) is similar to the basic automatic enrollment plan but has specific notice requirements. An EACA can allow automatically enrolled participants to withdraw their contributions within 30 to 90 days of the first contribution.

A qualified automatic contribution arrangement (QACA) is a type of automatic enrollment arrangement that automatically passes IRS ACP discrimination testing requirements. The plan must include certain required features, such as automatic employee contributions (including annual increases), fully vested employer contributions [generally, the same as the contribution required in a safe-harbor 401(k) plan], and specific notice requirements.

What is a highly compensated employee?

For 2024, a highly compensated employee is an individual who:

• Was a 5% owner (i.e., an employee who owns more than a 5% interest) of the employer during 2023 or 2024, or
• Had compensation in 2023 in excess of $150,000 and, at the election of the employer, was in the top 20% of employees in terms of compensation for that year. (This limit rises to $155,000 when the look-back year is 2024.)

In general, to be qualified (i.e., tax exempt), a plan must meet employee coverage tests that demonstrate that the plan doesn't discriminate in favor of highly compensated employees. Under the most basic minimum coverage test, a plan may cover any or all of the highly compensated employees if it also covers a number of non-highly compensated employees that is at least equal to 70% of the percentage of highly compensated employees covered. For example, if the plan covers 100% of the highly compensated employees, then the plan must also cover at least 70% of the non-highly compensated employees of the employer; or if the plan covers only 50% of the highly compensated employees, then the plan must also cover at least 35% of the non-highly compensated employees of the employer (70% of 50% equals 35%).

When do employees vest in their 401(k) accounts?

Vesting is the process by which participants in a 401(k) plan or other retirement plan earn the right to nonforfeitable benefits under the plan. A 401(k) plan participant is always 100% vested in his or her elective deferrals, and any investment earnings on those amounts. Participants need not be immediately vested in your employer contributions (matching or discretionary contributions). But if your plan is subject to ERISA, then you must comply with that law's minimum vesting standards.

Those standards require that employer contributions either (1) vest 100% after three years of service ("cliff vesting"), or (2) vest 20% for each year of service beginning with the participant's second year of service and ending with 100% after six years of service ("graded" or "graduate" vesting). Of course, your vesting schedule can always be less (but not more) restrictive than ERISA's requirements.

What happens if an employee leaves employment before he or she is fully vested in your contribution?

The participant forfeits the non-vested portion of his or her account. In most 401(k) plans, forfeitures are reallocated to the accounts of the remaining participants. Also called reallocated forfeitures, these forfeitures can be used to reduce future employer contributions and/or administrative costs, as well. Forfeitures can't be allocated to an employee's Roth account.

Can an employee who contributes to a 401(k) plan also make tax-deductible contributions to a traditional IRA?

Possibly. In most cases, when a traditional IRA owner is not covered by an employer-sponsored retirement plan, his or her contributions to the traditional IRA are fully tax deductible for federal income tax purposes. However, when the traditional IRA owner (or his or her spouse) is covered by such a plan [including a 401(k) plan], the ability to make tax-deductible IRA contributions may be limited or even phased out entirely. The amount of the tax deduction (if any) would depend on the IRA owner's federal income tax filing status and modified adjusted gross income (MAGI) for the year. (Note that employees can generally make after-tax contributions to a traditional IRA regardless of how much they earn, and regardless of whether they or their spouse are covered by an employer sponsored retirement plan.)

Can an employee who contributes to a 401(k) plan also contribute to a Roth IRA?

Yes, participation in a 401(k) plan has no impact on an employee's ability to contribute to a Roth IRA. However, annual contributions to a Roth IRA may be limited depending on your employee's filing status and modified adjusted gross income (MAGI) for the year.

Do you have fiduciary responsibility for your employees' 401(k) accounts?

Self-directed plans and ERISA Section 404(c)

You (or the applicable plan fiduciary) have a fiduciary responsibility to exercise care and prudence in the selection and appropriate diversification of plan investments. Failure to meet that duty could result in your liability to the plan for any losses incurred. You may even have liability for imprudent investment choices by your employees if your plan allows participants to select the investments in their account ("self-directed plans"). However, you may be able to limit your liability for investment losses that occur as a result of a participant's exercise of investment control over his or her own account if you satisfy the requirements of Section 404(c) of ERISA. Section 404(c) requires that you:

• Allow participants to choose from a broad range of investments with different risk and return characteristics
• Allow participants to give investment instructions at least as often as every three months
• Give participants the ability to diversify investments generally and within investment categories, and
• Give each participant sufficient information to make informed investment decisions.

Default investments

If you adopt an automatic enrollment arrangement (for example, a QACA), you may have situations where a participant is contributing to the plan, but has not yet made an affirmative investment election. If your employee has not made an affirmative investment election you (or the applicable plan fiduciary) may have a fiduciary duty under ERISA to invest automatic enrollment contributions in a prudent manner for that participant, and you could be liable for investment losses if your plan's default investments are deemed imprudent. However, you can avoid this potential liability if your plan's default investments are qualified default investment arrangements (QDIAs) as defined by U.S. Department of Labor (DOL) regulations.

DOL regulations provide for four types of QDIAs:

• A product with a mix of investments that takes into account the individual's age or retirement date (for example, a life-cycle or target date fund)
• An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual's age or retirement date (for example, a professionally managed account)
• A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (for example, a balanced fund), and
• A capital preservation product for only the first 120 days of participation (an option for plan sponsors who want to simplify administration for employees who opt out of participation).

A QDIA must either be managed by an investment manager, plan trustee, plan sponsor or committee comprised primarily of employees of the plan sponsor, or be an investment company registered under the Investment Company Act of 1940. A QDIA generally may not invest participant contributions in employer securities.

Several additional requirements must also be satisfied:

• Participants must have been given an opportunity to provide investment direction, but have not done so
• A notice generally must be furnished to participants in advance of the first investment in the QDIA and annually thereafter
• Participants must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least quarterly
• DOL regulations limit the fees that can be imposed on a participant who opts out of participation in the plan or who decides to direct their investments
• The plan must offer a broad range of investment alternatives, as defined in the DOL's regulation under section 404(c) of ERISA

Investment education

If you sponsor a self-directed plan, you may assume an additional responsibility — participant education. A balance must be struck between providing not enough — or too much — investment educational support for plan participants. Too much and you could be considered to be providing investment advice, and become legally responsible for your employees' investment decisions. Employee education is an issue to be carefully considered when implementing a qualified retirement plan.

Must you obtain a favorable determination letter from the IRS in order for your plan to be qualified?

No, a plan does not need to receive a favorable IRS determination letter in order to be qualified. If the plan provisions (both the written provisions and as implemented) meet Code requirements, the plan is qualified and entitled to the appropriate tax benefits. Nevertheless, without a determination letter, the issue of plan qualification for a given year doesn't arise until the IRS audits your tax returns for that year. By that time, however, it is generally too late for you to amend your plan to correct any disqualifying provisions. Consequently, a determination letter helps to avoid this problem, because auditing agents generally won't raise the issue of plan qualification if you have a current favorable determination letter. Alternatively, pre-approved prototype plans are often used.

What happens if the IRS determines that your 401(k) plan no longer meets the qualified plan requirements?

The IRS has established programs for plan sponsors to correct defects. These programs are designed to allow correction with sanctions that are less severe than outright disqualification. If, however, you are unable to correct the defects in your program appropriately, your plan may be disqualified. Loss of a plan's qualified status generally results in the following consequences:

• Employees are taxed on their pre-tax contributions in the year they're made to the plan, rather than the year the contributions are paid from the plan
• Employees are taxed on employer contributions, and all plan investment earnings, in the year they vest rather than the year benefits are paid
• Your deduction for employer contributions must be taken in the year your employees vest in the contribution, rather than the year you made the contributions to the plan
• The plan trust would have to pay taxes on its earnings
• Distributions from the plan may be ineligible for special tax treatment and can't be rolled over tax free