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A traditional 401(k) plan is a qualified employer sponsored plan under which employees can elect to contribute a portion of their wages to a retirement plan on a pretax and/or after tax basis up to a maximum allowed by law. Pretax contributions are commonly referred to as “Elective Deferrals”. After tax contributions are referred to as “Roth Deferrals” and were initially eligible to be a part of a 401(k) plan in 2006. Wages that are deferred on a pretax basis are not subject to federal income tax withholding at the time of deferral and the earnings accumulate tax free until the date distributed from the plan. The IRS will tax these benefits as part of the employee’s regular income only when the assets are distributed from the plan, typically after a participant retires or terminates employment. Whether withdrawals are made during a participant’s employment or while still employed, depends on the terms of the plan. Earnings on contributions made on an after tax basis are never taxed. Once either of these types of deferrals is contributed to a plan, they are immediately 100% vested.

Employer contributions can also be made and are usually in the form of matching and/or profit sharing. There are rules relating to these types of plans which require the contributions made under the plan to meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, certain annual tests, known as the ADP and ACP discrimination tests must be performed to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.

A profit sharing feature may be added to the plan document as well. Vesting schedules and end of year requirements can be applied to these employer contributions.

In general, a 401(k) plan is a low-cost solution for an employer to be able to provide retirement benefits to employees. There are many advantages to this type of plan for both the employer and employee and the employer should carefully consider their options before deciding which type of 401(k) plan to establish.

   

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