The plan may be designed to satisfy 401(k) safe harbor requirements which can eliminate nondiscrimination testing. The safe harbor requirements include certain minimum employer contributions and 100 percent vesting of employer contributions that are used to satisfy the safe harbor requirements. The benefit of eliminating the testing is that highly compensated employees can defer up to the annual limit without concern for what the non-highly compensated employees defer.
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Traditional 401(k) plans
More and more employees perceive 401(k) plans as a valuable benefit which has made them the most popular retirement plans today. Employees can benefit from a 401(k) plan even if the employer makes no contribution. Employees voluntarily elect to make pre-tax contributions through payroll deductions up to an annual maximum limit. The plan may also permit employees age 50 and older to make additional “catch-up contributions” up to an annual maximum limit.
The employer will often match some portion of the amount deferred by the employee to encourage greater employee participation, i.e., 25 percent match on the first four percent deferred by the employee. Since a 401(k) plan is a type of profit sharing plan, profit sharing contributions may be made in addition to or instead of matching contributions. Many employers offer employees the opportunity to take hardship withdrawals or borrow from the plan.
Employee and employer matching contributions are subject to special nondiscrimination tests which limit how much the group of employees referred to as “highly compensated employees” can defer based on the amounts deferred by the “non-highly compensated employees.”
In general, employees who fall into the following two categories are considered to be highly compensated employees:
- An employee who owns more than five percent of the employer at any time during the current plan year or preceding plan year (stock attribution rules apply which treat an individual as owning stock owned by his spouse, children, grandchildren or parents).
- An employee who received compensation in excess of the indexed limit in the preceding plan year. The employer may elect that this group is limited to the top 20 percent of employees based on compensation.