Thank you for attending this session on 401(k) Plan Options for Small Businesses The information in this session isn’t official guidance. Now, let’s get started.

This is a short session, so let’s jump right into our discussion on 401(k) plans. Let’s talk about some of the features of 401(k) plans.

Everyone has probably heard of a 401(k) plan. With these plans, employees have the option to keep the compensation they earn or defer part of it into the 401(k) plan (also known as a deferral).

That means they either pay taxes now on the money they keep or defer the tax owed on that money until it is withdrawn from the plan. For example, if an employee deferred $5,000 into the plan in 2020, they wouldn’t pay taxes on it in 2020. Tax wouldn’t be owed on the $5,000 until it was withdrawn from the plan.

Another feature of 401(k)s is employer contributions. You can match a portion of the deferrals made by employees, you can make a fixed contribution, or you can make a discretionary contribution. The discretionary contribution is like a profit-sharing contribution that is determined each year.

A third feature of 401(k) plans is their flexibility. These plans can be adjusted to suit employer needs.

For example, these plans can provide loans and hardship distributions.

Also, you can choose different vesting schedules for different employer contributions, and you can also choose different eligibility requirements for different contribution types. For example, you might have one set of eligibility rules for deferrals and another set of rules for the match. And lastly, a 401(k) plan can be offered by an employer of any size – from 1 employee to millions of employees. Now, let’s look at the different types of 401(k) plans.

There are basically three different types of 401(k) plans – traditional, safe harbor and automatic contribution arrangements.

Roth 401(k)s aren’t covered in this session. Now, let’s talk about traditional 401(k) plans first.

These plans are the most flexible but require a lot of testing. They can also allow for very high levels of contributions.

For example, in 2021, an employee could make a salary deferral of up to $19,500 to a 401(k) plan.

If the employee was age 50, he or she could defer an additional $6,500 to the plan.

As we mentioned earlier you, as the employer, can contribute to a 401(k) plan, and your contributions can be fixed or discretionary every year. However, you don’t have to contribute money for your employees if you don’t want to.

You could choose to set up the plan, so you don’t have to provide a match for your employees.

However, traditionally, the employer does offer employees a match of some kind. For example, the match might be something like 25 cents on the dollar, up to four percent of pay. However, whatever match you choose to offer would have to be stated in the plan document, because you do have to follow the terms of the plan.

Total employer and employee contributions are going to be limited to the lesser of 100% of compensation or $58,000 for 2021.

That limit includes deferrals, matching contributions, and profit-sharing contributions.

Employer contributions can be deducted up to 25% of the combined compensation of all plan participants.

Earlier, we mentioned annual testing for 401(k) plans, so let’s discuss a few of the requirements.

The two tests exclusive to 401(k) plans are nondiscrimination tests, also known as the Actual Deferral Percentage Test (or ADP test) and the Actual Contribution Percentage Test (or ACP test). The ADP test requires you to take the amount deferred and divide it by the compensation earned for each participant to arrive at an ADP percentage for each employee.

Employees are then categorized into 2 groups: highly compensated employees (or HCEs)

and non-highly compensated employees (or NHCEs). You then compare the average percentages of the two groups.

If the HCEs defer too much, some of their deferrals must be returned to them. Additionally, the employer could make an additional contribution on behalf of the NHCEs, called a qualified non-elective contribution, or QNEC.

Other possible correction options are beyond the scope of this session. Remember that with this test, the deferral ability of the HCEs is going to be closely tied to how much the NHCEs defer.

Next, you have the ACP test, which is like the ADP test. You take the matching contribution provided to each employee and divide it by the compensation earned by each employee. The resulting percentage is the ACP percentage of each employee.

You would then: Classify employees as either HCEs or NHCEs; find the average of each group; and compare the average.

Let’s move on to safe harbor 401(k) plans. These plans are a good choice if you like the benefits of a 401(k) plan but don’t want the burden of annual nondiscrimination testing.

This plan is like a traditional 401(k), however it does require a minimum contribution.

HCEs can defer large amounts if minimum contributions are provided to NHCEs.

The required contribution can be a matching contribution or a fixed percentage of pay. The minimum matching contribution is a full match of the employee’s first 3 percent of salary deferrals and then 50 percent of the next two percent of deferrals for a total match of 4 percent of pay. Alternatively, the fixed contribution is 3 percent of compensation for each employee even if they don’t defer. You can choose either option, or you can be more generous.

Safe harbor contributions and employee deferrals are immediately 100% vested.

With safe harbor plans, you can’t use a gradual vesting schedule like you can in other plans.

Also, you must provide employees with an annual safe harbor notice that explains the essential plan features and how to enroll.

Now let’s talk about automatic enrollment 401(k) plans. An automatic enrollment plan could be a safe harbor or a traditional 401k plan.

Remember that this is an optional feature in plans, so it’s not required. With this type of plan, employees are automatically enrolled in the plan at a certain deferral percentage rate.

Employees are given the option to defer when hired, but the deferral form is never returned. In these situations, you have employees who are simply not saving for retirement and may be missing out on matching contributions.

With an automatic enrollment 401(k), you request the employee complete the elective deferral form and inform them that you have an automatic enrollment plan. If the form isn’t returned, you automatically enroll the employee in the plan at a specified percent (for example, three percent). If the employee doesn’t return the deferral election form, you enroll them at a specified percentage of pay. Alternatively, if the deferral form is returned, you would withhold according to the form.

Typically, the starting percentage for employees who don’t return their deferral forms is 3 percent. Some plans will increase this percentage every year, so the 2nd year it’s four percent, the 3rd year it’s five percent and so on.

A plan that is set up like this can significantly increase plan participation, which is beneficial for two reasons: It helps the plans pass nondiscrimination testing (if a traditional 401(k)); and it helps some employees save for retirement where they otherwise may not have. Let’s take automatic enrollment one step further.

You can use an automatic enrollment feature to avoid nondiscrimination testing. To do this, your automatic enrollment feature must start with a 3 percent deferral and automatically increase every year so employees contribute at least six percent of of their compensation by the 5th year. Also, with this type of automatic enrollment, the company is required to contribute to avoid nondiscrimination testing.

The required contribution, again, is either a match or a fixed percentage of compensation for all participants.

And if you choose the match, it must be a full match on the first one percent of deferrals plus a 50% match for the next 5% of deferrals. If you choose the fixed contribution, it must be 3% of compensation for all eligible employees.

We talked about a few of the basic rules for 401(k) plans. Remember, the plan document is always going to dictate how you should operate your plan, so be sure to complete the plan document properly.

If you visit our website at www.irs.gov/EP and select “Types of Retirement Plans” and then select “401(k) plans,” you’ll find a wealth of helpful information on these types of plans. While you’re there, take a look at our 401(k) Checklist and Fix It Guides.

We also have a lot of useful information under the 401(k) Additional Resources link. Specifically, you may want to check out Publication 4222, which is our 401(k) Plans for Small Businesses pub, as well as Pub 4674, which has more information on automatic enrollment 401(k) plans.

We hope you’ve learned a few things about the types of 401k plans.

Please send any questions to us at tege.outreach@irs.gov. Thank you for attending this session.