introduction to plan operations

R esource Guide Introduction to Plan Operations

2021

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Introduction to Plan Operations

Introduction

In many cases, the flexibility in design, monetary cost to the employer, and workforce appreciation leads to a defined contribution design. In fact, defined contribution plans are the most widely provided retirement benefit plan in the United States. Learning Objectives

1. Learn the basics about 401(k) plans

2. Explain how employees become eligible to participate in the plan

3. Understand how to apply the correct type of compensation

4. Define how employee contributions work

5. Explain employer contributions

6. Discuss plan distributions

Section 1: Types of Defined Contribution (DC) Plans

You’ll remember that a defined contribution plan is a qualified retirement plan under IRC §401(a) in which contributions from employees and/or the employer are allocated to eligible employees’ individual accounts. The individual account balance includes the contributions and any attributed investment gains or losses, less any investment and administrative fees unless the plan sponsor elects to pay all or part of the fees associated with the plan.

As noted earlier, defined contribution plans do not promise a specified benefit at retirement as do defined benefit plans – rather, it is the contribution or contribution formula that is “defined.” Within the defined contribution plan category, there are five common plan types: profit sharing, including 401(k) plans, money purchase pension, target benefit, and employee stock ownership plans.

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Defined Contribution Plan Types

Very Flexible Plans - Generally, employer contributions are discretionary

Less Flexible – Some Guaranteed Benefit Element

401(a) Stock Bonus Plan (form of a PSP)

401(a) Profit Sharing Plan 401(a) Money Purchase Plan

401(a) Target Benefit Pan (form of a MPP)

• Employer funded only

• Line a PSP but funded by or invests in employer stock


• Most common DC plan design

• Most new plans PSP

• Very flexible design


• These plans are not common

• Most plans were closed or frozen by the mid nineties

• New plans are very uncommon

401(k) Profit Sharing Plan

• Form of a 401(a) PSP that also allows employees to make voluntary contributions

And, while there are numerous types of defined contribution plans, in this module we’ll focus on 401(k) plans because these are the most common type of plans.

In this module we’ll help you identify and understand the primary options available when designing a 401(k) plan. Understanding these options will enable you to design a plan which best aligns with your objectives.

Key Takeaways: • Learn about the core design features of a 401(k) plan. • Evaluate how various design options support the employer’s goals and

strategies as well as meet employees’ expectations. • Translate design options into a clear plan design strategy and

implementation process.

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Profit-sharing Before there were 401(k) plans, a common DC plan design was the profit-sharing plan, which as the name suggests, allows employers to share profits with their employees for the purpose of helping them save for retirement. Many of today’s 401(k)s are actually profit-sharing plans by original design.

In those plans, contributions to a profit-sharing plan are tax deductible to the employer, subject to limits set by the Internal Revenue Service, although the organization need not actually have profits in order to make a contribution to a profit-sharing plan in any given year. Because contributions to a profit-sharing plan generally are not mandatory for any given year, employers have the flexibility to reduce, or forego making contributions altogether in years when profits (or cash flow) are down or nonexistent.

In fact, the most common contribution formula (the amount of the employer profit-sharing contribution to the plan) in a profit-sharing plan is a discretionary formula under which the employer determines first, whether to contribute and second if it chooses to contribute, the amount.

The profit-sharing formula must be set forth in the plan document – the legal document that governs the operation of the plan. We’ll cover this in more detail in a separate module. Typical plan language for a discretionary contribution would be similar to: “the company will contribute to the trust for each plan year an amount it determines in its discretion.”

A less common approach among profit sharing plans is to include a more definite contribution formula, such as fixed percentage of compensation or a fixed percentage of profits.

Example: a plan’s contribution formula might state that each plan year, the employer will contribute an amount that equals 5 percent of its net profits. Regardless, the contribution formula must be explicitly described in the plan document.

The 401(k)

An IRC Sec. 401(k) plan is a profit sharing or stock bonus plan with an employee funding feature known as a “cash or deferred arrangement” or CODA. The CODA allows participants to contribute a portion of their salary as pre-tax employee salary deferrals. Through the profit-sharing portion of the plan, sponsors may make employer matching contributions based on the employees’ salary deferrals.

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While Section 401(k) was not added to the Internal Revenue Code until 1978, CODAs have been in existence much longer, though generally only in situations dealing with annual bonuses.

401(k) Profit Sharing Plan Design Elements

Next we’ll examine a number of key design considerations for 401(k) plans. As you will see, there is considerable flexibility within each of these elements to match the design to your specific benefit objectives.

A. Employee Eligibility B. Compensation definitions C. Employee Contribution Options D. Employer Contribution Options E. Profit-Sharing Contributions F. Vesting G. Distributions H. Rollovers

A. Employee Eligibility

Plan eligibility requirements define which employees must be covered by the plan. Under the terms of the plan document, and within statutory limits set forth in ERISA and the Internal Revenue Code, an employer may (but is not required to) exclude certain individuals from participating in the plan.

Employers are responsible for ensuring that all eligible plan participants participate in plan benefits. The excluded employees and conditions of eligibility can be different for each contribution feature in the plan. For example, you could allow certain individuals to make immediately make employee contributions to the plan but not be eligible to receive a matching contribution until a future date.

Excluding employees from eligibility In general, employer may not design eligibility requirements to exclude groups of employees unless the employees fall within either a statuary exclusion or a class exclusion.

Statutory exclusions Statutory exclusion are groups of employees defined by law that employers are permitted to exclude from participation in the retirement plan. The statutory exclusion rules are found in the Internal Revenue Code, and permit exclusion from eligibility based on:

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Age: Employees less than 21 years of age may be excluded from the retirement plan based upon their age.

Service: Employers may exclude employees with less than one year of service without regard to the age of the employee. Beginning in 2024, certain long-term part-time employees (those who complete at least 500 hours of service in 3-consecutive years) must be eligible to defer (see the separate long-term part-time supplement in the resources). Up to 2 years of service may be required for matching or profit-sharing contributions if the plan provides for immediate 100% vesting of these contributions.

Collective bargaining representation: Employers may exclude employees that belong to a union and are covered by a collective bargaining agreement - if the union negotiates retirement benefits as part of the collective bargaining agreement.

Legal Residency Status: Nonresident aliens, employees who have not established legal permanent U.S. residency may be excluded.

Class exclusions In addition to the statutory exclusions just noted, plans may exclude any other class of employees, provided the plan is nondiscriminatory. The plan must identify the group of employees for exclusion from participation and must annually be tested for nondiscrimination.

The test for nondiscrimination is the minimum coverage rules under IRC Sec. 410(b), described in more detail in another module of this course. For example, a plan could exclude an entire division form all or a portion of the plan as long as it passes the coverage rules each year. Note, however, that the class exclusions cannot be used to impose an age or service condition that exceeds the statutory maximum age and service provisions. Measuring Service for Plan Eligibility There are two methods for measuring service with an employer for plan eligibility purposes—the hours of service method and the elapsed time method.

Under the hours of service method, you must count hours, and a year of service is a 12-month period during which the employee works a requisite number of hours for the organization. You cannot require more than 1,000 hours (IRC. Sec. 410(a)(3)(a)). In addition to actual hours worked, hours must also be credited for certain nonperformance of services, such as back pay awards and for time on maternity or paternity leave or in active military service.

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This method is useful for employers with a substantial number of hourly-paid workers. To streamline administration, plans are permitted to use shortcuts to determine hours of service, called equivalencies. Equivalencies, such as 1 day of work equals 8 hours, avoid the need to count actual hours worked. This is particularly helpful for employees where actual hours are not maintained, such as the case with many salaried employees.

Under the elapsed time method, you don’t count hours worked or credited. Instead the plan calculates the employee’s period of service which begins on the employee’s employment commencement date and continues until the employee experiences a period of severance. For example, if the eligibility requirement is one year of service, then 12 months after starting work, the employee will be credited with a period of service and it does not matter how many hours were worked during this period. (Treas. Reg. 1.410(a)-7(c)(2)(i)). This method is useful for businesses with primarily full-time salaried employees.

Note that the plan document must state the method of measuring service for eligibility. Last day requirement In addition to eligibility conditions to enter the plan, a plan can also impose a “last day” requirement or a year of service requirement in order for an individual to be eligible to receive an employer contribution for that year.

The last day requirement simply means the plan participant must be employed on the last day of the plan year in order to share in any employer contributions. Similarly, the year of service requirement means the employee must complete a year of service (usually 1000 hours of service) during the plan year. For example, an employer may not want an employee to share in the matching contribution or profit-sharing contribution for the year in which he or she terminates employment. Note, however, that these cannot be used for the salary deferral component of the plan since those contributions are made to the plan each pay period.

If you will be using these provisions with respect to matching contributions, coordination is needed with respect to the timing of making the matching contributions to the plan. For example, if a plan requires employment at the end of the year to receive a matching contribution, but the matching contribution is made and allocated as of each period, then you would need to address the situation that arises where a match has been allocated to a participant who is ultimately not entitled to the match because he or she terminated employment during the year.

As with a class exclusion, a plan must satisfy the minimum coverage rules each year to determine if the exclusion of the employees in a particular year are not discriminatory.

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Plan entry dates Another key component of eligibility is establishing plan entry dates for eligible employees - the dates when an eligible employee must be allowed to begin participation. The plan entry date is important because it generally defines the date that employees are eligible to start making salary deferral contributions. Employee salary deferral contributions may also trigger employer matching contributions under the plan which may affect overall plan cost.

IRC Sec. 410(a)(4) sets forth the rules for plan entry dates. Essentially, a plan is not qualified under the IRC unless it provides that an employee who is otherwise eligible to participate under the terms of the plan commences participation no later than the EARLIER OF:

1. the first day of the first plan year beginning after the date on which the employee satisfied the plan’s minimum age and service requirements; or

2. the date six months after the date on which the employee satisfied the minimum age and service requirements.

Note, a plan can be drafted to allow eligible employees to enter the plan earlier. It is common for plans to allow eligible employees to enter the plan on the first day of the month following the month in which the eligibility requirements are met or on the day the eligibility requirements are met.

B. Definition of Compensation

Overview The term “compensation” is critical to plan design because among other things, it is the formula that is used to determine benefits – and often the cost of benefits - under the plan. In the case of a 401(k) plan, those employee deferrals are “compensation” and plan sponsors have considerable flexibility in definition what that compensation is.

A plan can use a different definition of compensation for different purposes as long as they are not discriminatory. For example, a plan may use one definition of compensation to allocate employer profit- sharing contributions and a different one for salary deferral purposes. However, flexibility increases the complexity of an already very complex area – which explains why compensation is often one of the top plan compliance concerns.

Regardless of choice, the definition(s) of compensation used for the plan must be specified in the governing plan documents. As plan sponsor you are ultimately responsible for making sure the party administering the plan (e.g., CPA, record keeper, or third-party administrator) is using the appropriate definition of compensation in its calculations.

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Let’s turn to the different definitions of compensation that you will be required - or permitted - to use for various plan purposes.

At a high level, there are core uses of compensation: Section 415 compensation; Section 414(s) compensation; and the compensation used for all other benefit determinations.

415 compensation and 414(s) compensation are named that because that is the IRC section where these terms are defined. Plans can be designed to use the same definition of compensation for all 3 of these purposes. But is common for plans to have different definitions for different purposes.

IRC Section 415 compensation Section 415 compensation generally serves as the starting point for all other definitions. IRC Section 415(c) sets forth the definition of compensation (also referred to as “gross” compensation) that must be used for determining:

• Annual limits on contributions and benefits under IRC Section 415; • Which employees are highly compensated employees (HCEs); • Which employees are key employees for top-heavy analysis; • Whether the top-heavy minimum contribution has been satisfied; and • A sponsor’s maximum tax-deductible contribution for a year.

There are four permissible definitions of compensation under IRC Section 415:

1. Current includible compensation (all wages, salaries, fees and other amounts includible in gross income);

2. A slight variation of this definition is also permitted 3. W-2 compensation (generally wages reported on form W-2) – this is what most

plans use; and 4. Wages for income tax withholding (form W-2 but smaller than gross income) –

this is the second most commonly used definition.

Regardless of which of the base definitions is used, any deferrals that are excluded from taxable income must be added back, including pre-tax elective deferrals to a 401(k) or 403(b) plan as well as amounts excluded from income due to a cafeteria plan contributions. IRC Sec. 414(s) compensation IRC Sec. 414(s) compensation is used for nondiscrimination testing. A plan must use a definition of compensation which meets the requirements of IRC Sec. 414(s) when testing the following with respect to the plan (also referred to as “testing” compensation):

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1. Contributions for a design-based safe harbor plan or a safe harbor 401(k) plan;

2. A participant’s actual deferral ratio and actual contribution ratio used in performing the actual deferral percentage (ADP) and actual contribution percentage (ACP) nondiscrimination tests in a 401(k) plan;

3. Whether contributions and benefits are nondiscriminatory under Sec. 401(a)(4) (other than the minimum contribution component of the gateway test mentioned previously for cross-tested plans); and

4. Contributions under a design-based safe harbor plan with permitted disparity provisions.

It is important to note, any definition of compensation that satisfies IRC Section 415(c) is considered a safe harbor and thus will automatically satisfy IRC Section 414(s).

The regulations permit modifications to the IRC Sec. 415 definition of compensation to arrive at an alternative 414(s) safe harbor definition of compensation. The 415 definition can be modified to exclude the pre-tax deferrals (e.g., deferrals to the 401(k) plan) that were required to be included in the definition of 415 compensation. Another common adjustment is reducing 415 compensation by the following:

a) Reimbursements or other expense allowances; b) Cash and noncash fringe benefits; c) Moving expenses; d) Deferred compensation; and e) Welfare benefits

Plans are also permitted to use any other definition of 414(s) compensation as long as it’s reasonable and nondiscriminatory. A plan using such an alternative would need to then test the alternative to ensure it’s nondiscriminatory. For this testing, the alternative definition is compared to a safe harbor definition of compensation to ensure the alternative definition does not discriminate in favor of highly compensated employees.

Because 414(s) compensation is used for nondiscrimination testing, many plans (but not all) are drafted to allow the plan administrator to use any definition that satisfies 414(s). It is viewed as an operational provision and therefore isn’t required to be defined in the plan document. Compensation used for determining plan benefits You have flexibility in defining compensation that is used for benefit purposes. The definition must be reasonable and generally cannot favor highly compensated employees. A plan using 415 compensation or using a definition that satisfies 414(s) satisfies these requirements.

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The definition of compensation that is used to determine benefits must be set forth in the plan document. The definition can apply to determining the following:

• Employer contributions and how they are allocated (if the plan is not a design-based safe harbor);

• The maximum permitted employee elective deferrals within a 401(k) plan; and • The amount and allocation of employer matching contributions.

Applying the proper definitions of plan compensation is one of the trickiest parts of administering a plan correctly. 401(k) administration mistakes related to employee compensation can result in disqualification of the plan and result in a need to make employer contributions being made to the plan. You must ensure the correct payroll data is being transmitted to providers and that the providers know what adjustments, if any, need to be made for the various definitions used in the plan.

For these reasons, plan sponsors normally adopt safe harbor definitions of compensation for various plan purposes and limit the number of compensation definitions used to minimize recordkeeping errors. While having a uniform definition of compensation for all purposes is desirable, in many cases it’s difficult to do with a 401(k) plan. Compensation for deferral purposes commonly requires adjustments that you might not want to use for other contributions.

Example: an employee elects to defer 4% of compensation. Does that include bonuses? And if an employee has imputed income or taxable reimbursements, is a deferral taken out of these amounts? You might want to allow employees to defer out of all compensation, but not count bonuses for purposes of any profit-sharing contributions. Or you exclude non-cash amounts such as taxable fringe benefits from deferrable compensation but want to use these amounts for other purposes. These are all generally allowed, but it’s easy to see why proper plan specifications and data are essential.

C. Employee Contributions (Salary Deferrals) Having discussed the criteria for establishing eligibility for plan participation, and the role of compensation, we’ll turn to the calculation and determination of contributions.

The defining characteristic of a 401(k) plan is that it permits employees to contribute (defer) a portion of their compensation into the plan. There are two types of deferrals a plan can permit: pre-tax deferrals and Roth deferrals.

With pre-tax deferrals, the employee is able to defer taxation on the amounts contributed to the plan and only pay taxes when the amounts are withdrawn (including the earnings on those contributions). With Roth deferrals, the deferrals are made on an after-tax basis and are therefore not taxed when distributed. Regardless of which type of deferral is made, the earnings

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on the deferrals accumulate on a tax-deferred basis, or potentially with no taxes due on qualified Roth distributions. These rules will be covered in more detail.

An employee’s election to defer compensation is usually done through a salary reduction agreement or election. The employer then deposits to the plan an amount equal to the employee’s election and reduces the compensation paid to the employee in the same amount.

Deferrals are generally are made to a 401(k) plan based on a percentage of the employee's compensation, though some plans permit the employee to contribute a specific dollar amount each pay period. An employee cannot be required to complete more than a year of service to be to be eligible to make salary deferral contributions.

There are, however, legal limits on how much an individual can defer for a particular year, and plans are permitted to impose a lower limit, and this is typically done to help with nondiscrimination tests (covered later).

For participants under age 50, the statutory annual deferral limit under IRC Sec. 402(g)(1) (i.e., the “402(g) limit”) is the lesser of 100 percent of compensation or $19,500 for 2021, or up to $26,000 for those age 50 or older (through “catch-up” contributions, which are discussed elsewhere). These limits are increased periodically based on cost-of-living adjustments.

The 402(g) limit is an individual, not a per plan limit. Therefore, if an individual participates in two or more plans that are subject to the annual deferral limit, all annual deferrals must be added together for the purpose of determining whether the limit has been exceeded for the year.

Roth deferrals Most plans also allow participants to elect to treat all or a portion of their salary deferrals as designated Roth contributions. In fact, PSCA data recently found that a Roth option is now available at 70 percent of companies, across all plan sizes. Roth contributions must be:

a) Specifically designated as Roth contributions, b) Made to accounts that are separately tracked within the plan, and c) Made on an after-tax basis.

With Roth contributions, all applicable federal, state, and local taxes are first withheld from pay, and then the contribution is deducted. Thus, the contribution to the plan is on an after-tax basis. Like pre-tax contributions, the employer and employee are required to pay FICA and FUTA taxes on after-tax Roth contributions.

An employee can make both pre-tax deferral and after-tax Roth deferrals if permitted by the plan. However, the annual IRC 402(g) limit is based on all deferrals regardless of whether they are pre-tax or Roth deferrals. On the other hand, Roth contributions to a

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401(k) are not subject to the adjusted gross income eligibility limits applicable to Roth contributions to an IRA.

One of the advantages of Roth contributions is that the earnings can be withdrawn tax-free if a Participant’s Roth account within the plan has been in existence for at least 5 years. The ability to make Roth contributions is generally attractive to participants in lower tax brackets currently as well as higher tax-bracket participants who want tax diversification in their investment portfolio.

Catch-Up Contributions Another feature included in most 401(k) plans (82.4% according to PSCA data) is the ability of certain participants to make “catch-up” contributions. “Catch-up” contributions are effectively an increase in the statutory or plan limits for employees who are 50 and older by the end of the plan year. The theory is that those who are at least age 50 may need to increase contributions to the plan as they near retirement. Being able to defer amounts in excess of otherwise applicable limits is an attractive feature for this segment of the workforce, particularly for individuals who might not have been able to save earlier in their working life. These catch-up contributions are not counted for purposes of many of the required compliance tests, which we will cover in another module. However, they are deferrals and can therefore be pre-tax and/or Roth, as permitted by the plan. The annual catch-up limit for 2021 is $6,500. Just like the 402(g) deferral limit, this amount may increase for future cost-of-living adjustments.

Example: Assume Caroline is age 50 and participates in her employer’s 401(k) plan. For 2021 she has deferred the maximum 402(g) amount of $19,500. If the plan permits catch-up contributions – and the plan is not required to do so - she may defer an additional $6,500 for 2021. Or, rather than being limited by the 402(g) limit, suppose her employer’s plan limits salary deferrals to a percentage of compensation and she has deferred that maximum percentage. If the plan permits catch-up contributions, she would be able to make deferrals in excess of the plan’s imposed limit that applies to those who are under age 50.

Voluntary after-tax employee contributions In addition to Roth after-tax contributions, a 401(k) plan may allow employees to make voluntary after-tax contributions. One way to view these contributions is that they are not salary deferrals, even though these amounts are typically contributed through the employer’s payroll system – and even though the contributions are made on an after-tax basis, the earnings on these contributions will be taxed when withdrawn, though there is no five-year requirement.

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Employers may choose to permit these contributions because they are not salary deferrals and therefore are not subject to the 402(g) salary deferral limit. They are, however, subject to an annual – and very comparable nondiscrimination test, as well as an overall limit on how much can be allocated to a participant’s account. We’ll cover this in more detail in a later module.

D. Employer Contributions As indicated earlier, a 401(k) plan is actually a profit sharing or stock bonus plan with a salary deferral feature. Nevertheless, a 401(k) plan is not required to provide for any contributions other than salary deferrals. However, many 401(k) plans do provide for additional employer contributions and these contributions, if any, must be set forth in the plan document.

There are two primary types of employer contributions. As we’ve already discussed, profit sharing contributions let employees share in the profits of the employer. These contributions are usually discretionary. Matching contributions match all or a portion of a participant’s salary deferrals in order to encourage participating in the plan. These are very general categories and other more specific terms are used in plan documents and recordkeeping systems to identify the variations.

Example: Most profit-sharing contributions are considered non-elective contributions, but some may also be qualified non-elective contributions.

Employer contributions are not subject to the 402(g) limit (which only applies to salary deferrals). There is, however, a limit on how much can be deducted and there is an overall limit on how much can be allocated to a participant’s account for a particular year. This is referred to as the 415 annual addition limit. In addition, employer contributions must be nondiscriminatory. These issues are addressed later in the course.

Employer Matching Contributions Matching contributions are employer contributions that are based on employee contributions to the plan. Matching contributions are the most common type of employer contribution to a 401(k) plan, in no small part because they provide an incentive for employees to contribute to the plan. Recall that a plan could permit pre-tax deferrals, Roth deferrals, catch-up contributions, and voluntary after-tax contributions. A matching formula could be based on any combination of these amounts. Most plans also limit the amount of employee contributions that are matched to a certain percentage of pay. For example, the employer matching contribution might be 50% of an employee’s pre-tax and Roth salary deferrals that do not exceed 5% of the participant’s compensation.

The determination of the matching formula is based on the goals of the program, keeping in mind it is a variable cost. If an eligible employee does not make a

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contribution, then he or she won’t receive an employer matching contribution. On the other hand, if all participants contribute at the full matched rate, the matching contribution could be a significant amount. Match Formulas The allocation of the match to participant accounts is usually based on the amount or percentage of compensation the participant defers into the plan. Common matching formulas are either fixed or discretionary, or a combination of the two. The formula must be set forth in the plan document.

1. Fixed match formula Under a fixed match formula, the plan promises a matching contribution according to a specific formula detailed in the plan document. For example, a common fixed matching formula would provide “a dollar for dollar” match of the employee’s pre-tax salary deferrals up to 6% of a participant’s pay. Under this example, an employee who defers 6% of his pay into the 401(k) plan would receive a total contribution of 12% - 6% from his own contributions, and 6% as a match from the employer. The advantage of using a fixed matching contribution is employees know what the contribution will be and this encourages participation in the plan.

2. Discretionary match formula

It is common for plan sponsors to reserve the right to decide if they want to provide a match in any given year. This is called a discretionary match formula. Employers with uncertain business results may prefer the flexibility of a discretionary formula. If the terms of the plan document indicate the match will be at the plan sponsor’s discretion, then each year the plan sponsor must decide whether a match will be made and what formula it will use to allocate the match. However, uncertainty as to whether a match will be made or the level of the match may weaken its impact as an incentive for employees to contribute.

3. Designing Matching Formulas Once it’s been determined to use a fixed or discretionary matching contribution, you must then determine the actual matching contribution formula. The matching contribution should adhere to the overall goals of the plan outlined in our first module, including workforce strategy and budget. Key considerations include whether the goal is to increase participation, increase the level of participation (i.e., encouraging employees to increase their deferral rates), and/or reward certain employees, such as those with longer tenure.

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4. Tiered Match Formula This type of match is known as a tiered match because the employer match changes (usually decreasing as deferrals increase) at various levels of participant salary deferrals. For example, a common tiered match formula would be 100% match on the first 3% of pay and 50% on the next 2% of pay for a total matching contribution of 4% on a total salary deferral of 5%. The higher matching rate for the first tier is a powerful incentive to encourage employees to begin saving. The lower matching rate at higher contribution levels – the second tier in our example - also encourages participation, but those who can afford to defer at the higher rates typically don’t need as much incentive to do so.

5. Stretch Match Formula To encourage eligible participants to increase their salary deferrals while managing the cost of matching contributions, plans may use a “stretch” match formula. For example, rather than offering a 50-cent match on every dollar contributed to a 401(k) plan up to 5% of a participant’s salary, you might offer 25 cents on every dollar up to 10% of salary. The cost to the employer is theoretically the same, but the idea is that participants will be inclined to save up to whatever level to get the full match. Stretching the formula incents employees to save more, and there is no additional cost to the company. In designing a stretch match you must keep in mind that higher wage earners may utilize the match at greater levels triggering a potential problem with the nondiscrimination tests.

6. Length of Service Match Formula A less common approach is to provide matching contributions equal to a uniform percentage of each participant’s salary deferrals based on the participant’s years of service (or periods of service if the elapsed time method is selected). Separate tiers could be established based on years of service, with each tier receiving a different matching amount. For example, an employer may decide to provide 50% match on deferrals for those participants with 3 years of service or less and 100% match on deferrals for those participants with more than 3 years of service. Like a tiered match, passing the ACP test may be a problem when longer tenure employees (who are usually higher paid) receive a disproportionate amount of the match.

7. Match Frequency In addition to the formula and amount of employer contributions, employers have discretion on when to allocate employer contributions to participant accounts, including matching contributions. Overall, employer contributions, including matching contributions, must be deposited to the plan no later than

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the due date of the employer’s tax return including extensions. The determination of the amount of the contribution, however, requires careful plan design because it’s possible to have a different determination period of the match.

Most plans determine and allocate the match on a pay-period basis. In these plans the matching is also contributed to the plan at the same time as the employee deferral. When the plan has a stated match (as distinguished from a discretionary match) this approach not only mirrors typical participant expectations, it also helps the e employer manage cash flows because a large contribution is due at the end of the year. With a discretionary matching contribution, the match is usually determined at the end of the plan year when the employer has a better sense of profitability and cash flow. In any event the plan document must be specific on when matching contributions will be allocated to participants’ accounts.

E. Profit-Sharing Contributions As noted earlier, profit-sharing contributions are usually discretionary, meaning they are not required for any given year; employers may choose to reduce contributions, or forego making contributions altogether in years when profits are down or nonexistent. The contribution formula is not required to be discretionary. Some plans choose to state the contribution so that there is no employer discretion as to the amount of the contribution.

In addition to the contribution formula, contributions must be allocated to participant accounts according to a nondiscriminatory allocation formula specified in the plan document. Common formulas for allocating profit sharing contributions to participants include:

1. Pro Rata Under this formula each eligible participant receives a profit-sharing allocation equal to the same percentage of pay. With this allocation method, the higher paid employees receive a larger share of the employer contribution.

2. Flat Dollar Under a flat dollar contribution formula, the same dollar amount is allocated to each eligible participant.

3. Permitted Disparity Permitted disparity formulas, also known as integrated formulas, provide larger allocations to those participants who earn more than the Social Security Taxable Wage

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Base ($142,800 for 2021). This “disparity” helps compensate for the replacement ratio gap from Social Security of participants impacted by the wage base limitation.

4. Groupings Grouping formulas divide participants into groups and permit different allocations for different groups of participants. This method is also referred to as a “cross-tested” method because of the way the allocations are tested for nondiscrimination. We’ll have more information on how this testing is performed in another module.

F. Vesting Vesting refers to the ownership that a participant has in his or her account balance or accrued benefit – and it can have an impact both on the cost of the contribution design, as well as the effectiveness of the plan as a retention tool. The minimum vesting standards for plans are designed to ensure that participants will own their benefit within a certain time period. Generally, the plan’s vesting schedule must satisfy the requirements under one of two minimum schedules: “cliff” vesting (100% vesting at a point in time, and 0% up to that point) or “graded” vesting (gradual vesting over a period of time). Plans may also call for immediate (100%) vesting which means the participant has full ownership in his or her account or accrued benefit without regard to length of service. The portion of a participant’s account balance or accrued benefit that is not vested is forfeitable to the plan and can be used for a variety of purposes including reducing employer contributions.

Immediate Vesting Employee salary deferrals are always 100% vested. Additionally, Qualified Nonelective contributions (QNECs) and qualified matching contributions (QMACs) (those used to correct certain plan testing errors) also must be 100% vested when made. These are addressed in other modules. In addition, a plan must provide that a participant is 100% vested at normal retirement age and if the plan requires more than 1 year of service as an eligibility condition (which is allowed for matching and profit-sharing contributions). .

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Graded vesting Under the six-year graded vesting schedule, employees must be 100 percent vested once they have completed six years of service. Prior to completing six years of service, participants must vest according to a minimum vesting percentage as outlined below.

Years of Service % Vested 2 years At least 20%

3 years At least 40%




Cliff vesting Under the three-year cliff vesting schedule, employees must be 100 percent vested once they complete three years of service. Prior to completing the third year of service, the vested percentage is zero percent.

Years of Service % Vested 1 years 0%

2 years 0%

3 years 100%

A plan may design a customized cliff or graded vesting schedule provided that participants are no less vested at any point in time than they would be under the statutory cliff or graded vesting schedules noted above.

G. Distributions

Loans Many plans allow participants access to their retirement account prior to one of the common distributable events noted above. Allowing a plan participant to take a nontaxable distribution from the plan in the form of a loan is an appealing feature to workers, but one that increases the complexity of plan administration and can carry a significant amount of risk to the plan and participant. Lax compliance with the loan provisions in the IRC, plan documents, and loan policies adopted by the employer can result in taxes and penalties to the participant and disqualification of the plan.

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That said, loan provisions are common in 401(k) plans – according to PSCA data the majority of plans (84.4 percent) continue to permit participants to borrow against their plan accounts. This is at least partly due to the reality that because the ability to temporarily borrow from their savings provides employees with a sense that, in the event of a financial emergency, they can access those funds. This type provision likely encourages many to save, and others to save more, than if they were told they had to wait for a final distribution event.

We’ll cover loan program rules, limits and processing considerations in another module. In-service distributions As noted earlier, you can design a 401(k) and profit-sharing plans to allow participants to withdraw all or a portion of their account balances while they are still employed via an “in-service” distribution provision. These events generally include reaching age 59 ½ , becoming disabled, birth or adoption of a child, or death. Distributions made prior to age 59½ are generally subject to federal and state (if applicable) income tax, plus an additional 10% early distribution penalty tax unless an exception applies. One advantage of an in-service distribution option is that it can provide participants access to a broader array of investment options than provided by the plan.

Different types of contributions are often subject to different in-service distribution rules. For example, employee salary deferrals are subject to the most restrictive in-service distributions rules (i.e., generally limited to situations of hardship or attainment of age 59 ½). The rules related to in-service distributions of employer-provided contributions and rollover contributions are usually more liberal (e.g., rollovers can be made available immediately and most employer contributions can be distributed after a specified period of time). In-service distributions, other than those taken as a result of hardship, are generally eligible for rollover. According to a survey by the Plan Sponsor Council of America, more than 70% of 401(k) plans allow in-service withdrawals.

As with loans, the ability to access funds prior to retirement is a feature that tends to be reassuring to workers in making contribution decisions. However, these provisions do add administrative complexity and costs – and, if overused, can undermine the purpose of the program and worker retirement security. Consequently, you’ll want to take care in designing these options to balance those sometimes competing interests. Hardship distributions Another plan design option that has pros and cons is a provision for withdrawal on account of a financial hardship. Hardship distributions must meet a two-prong test: 1) the participant is experiencing an immediate and heavy financial need, and 2) the distribution is necessary to satisfy that immediate and heavy financial need. As a plan sponsor, you are responsible for the proper administration of hardship distributions,

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including the responsibility to maintain records of such distributions, and documentation that confirms 1) the employee requesting the hardship had exhausted other permitted plan distributions; and 2) the hardship distribution didn’t exceed the amount necessary to satisfy the participant’s immediate and heavy financial need.

According to PSCA data, the most common reasons for permitting these withdrawals include:

• 91.5% - medical expenses • 82.0% - post-secondary education expenses • 77.3% - purchase of a primary residence or to prevent eviction or foreclosure

While participant self-certification is permitted to show that a distribution is the sole way to alleviate a hardship, self-certification is not allowed to show the nature of a hardship. The IRS does, however, have safe harbor rules, which if followed, help ensure hardships distributions comply with the rules. The safe harbor rules contain a list of expenses can qualify for a hardship, such as medical expenses, certain tuition payments, funeral expenses, casualty loss expenses, and certain expenses due to a federally declared disaster. They also provide rules on how participants can demonstrate that they have no other resources available to satisfy the needs. Most plans use the safe harbor hardship rules because it provides some certainty that the plan will not be disqualified on account of making an impermissible distribution.

Hardship withdrawals were taken by an average of 2.3% of participants, when available, according to PSCA data. Final Distributions A key consideration – both from the standpoint of cost and administrative efficiency, as well as employee retention and workforce management – is how, when, and in what form participants are able to access the funds accumulated in the retirement plan.

First and foremost, a participant’s distribution is function of their vested account balance – as noted earlier, the proportion of the account to which they have accrued a vested interest. Beyond that, a participant’s access to his or her account balance or accrued benefit is defined in the plan document and must comply with IRS and Department of Labor rules. Generally, the payment methods must be either mandatory or subject to the participant’s (or beneficiary’s) election. With very limited exceptions, the employer or other plan fiduciary does not have the discretion to choose the form and timing of the payment that conflicts with the terms of the plan document.

The most common final distributable events for a qualified retirement plan distribution include, but are not limited to,

• Attainment of a normal retirement age, or early retirement age, • Severance of employment,

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• Plan termination (if the employer does not maintain an alternative plan), • Disability, • Divorce, or • Death

It is possible for a plan to allow participants access to their account balances while still working through loans and certain in-service distributions, such as hardships or attainment of a specified age, such as attainment of age 59 ½. These are addressed in a later section. Plans can also have different distribution rules for different sources of contributions.

Example: salary deferrals might be distributable at severance of employment but employer profit sharing and/or matching contributions might not be distributable until attainment of normal retirement age.

As plan sponsor, you’ll bear the responsibility for determining the eligibility of participants for each of those the participant for each of these events. Forms of distribution The forms of benefit payment for qualified retirement plan participants are, in some cases, set by the IRC and must be defined in the plan document. Retirement plan sponsor have some latitude in selecting optional plan distribution options. Plans can offer payments in the following forms: Lump sum (optional form of payment common to most qualified plans), Annuitized payments (required for money purchase and defined benefit plans but not for most 401(k) plans), and Periodic payments (optional form of payment that is common in defined contribution plans)

Lump sum A lump sum payment represents a one-time payment of a plan participant’s entire account balance or accrued benefit. If the vested balance is more than $5,000, then a lump-sum distribution can generally only be made with the participant’s consent. Most 401(k) plans do not require spousal consent to receive the distribution, but can vary depending on whether the plan permits annuity forms of distribution.

Small sums Plans may contain a provision that allows certain accounts to be distributed without the consent of the plan participant. The provision that allows for these distributions is found under IRC Sec. 411(a)(11) and allows the plan to distribute accrued benefits to certain separated participants without their consent as long as the participant’s accrued benefit does not exceed $5,000. These forced payments are referred to as “cash outs” or “mandatory distributions.”

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The law requires plans to automatically roll over to IRAs cash outs valued at more than $1,000 if the participant does not direct otherwise. The Department of Labor (DOL) has issued “safe harbors” under which a plan administrator’s designation of an institution to receive the automatic rollover, and the initial investment choice for the rolled over funds would be deemed to satisfy the employer’s fiduciary responsibility. The safe harbor rules specify that for any mandatory distribution greater than $1,000, the plan must notify the participant that the failure to elect to receive a cash-out distribution directly, or to provide the plan administrator with information as to where to directly roll over the mandatory distribution, will result in the mandatory distribution being directly rolled over to an IRA. The safe harbor rules also provide that it is possible for an employer to establish IRAs to receive automatic rollovers for any participants who do not elect to receive the distribution directly or have the distribution rolled over to an eligible retirement plan of his or her choice. In short, plan fiduciaries must follow a number of rules and procedures to properly process a small sum automatic IRA rollover. Recordkeepers and TPAs often provide automatic rollover services to plan sponsors.

Installments Plans can offer installment type payments. It is common for defined contribution plans to offer a payment option of the participant’s vested account balance over regular intervals, for a definite period (such as five or 10 years) or in a specified amount (for example, $2,000 a month) to continue until the account is depleted. A very common form of installment payment from a defined contribution plan is a payment that is scheduled over the participant’s expected life expectancy—often called a systematic withdrawal payment” or SWP. A SWP ends when the account balance is depleted. In other words, there is generally no guaranteed payment.

Annuity Annuity forms of payment are required (unless waived by the participant and spouse if applicable) by defined benefit and money purchase pension plans. It is rare to find an annuity form of payment under a 401(k) plan unless the plan was merged into a prior plan that included an annuity form of benefit. A 401(k) is not required to follow the annuity rules that apply to defined benefit and money purchase pension plans as long as 2 conditions are met: (1) the participant doesn’t actually elect an annuity form of payment, and (2) upon death, the participant’s spouse is the beneficiary of the participant’s entire account (unless

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the spouse consents to the alternative beneficiary). If an annuity form of payment is not permitted, then the first condition will always be satisfied. If an annuity form of payment is permitted in a 401(k) plan, then typically the plan purchases an annuity in the market with the participant’s vested account balance. Payments are then made to the participant from the annuity contract.

H. Rollovers

Rollovers into a 401(k) plan When designing a plan, a sponsor can decide whether it will allow rollovers from other eligible plans or IRAs to its retirement plan. Rollovers into a plan are gaining popularity with plan sponsors. This is because having the ability to roll over plan assets from their old employers’ plans into their new employers’ plans has great appeal to job changers. Many employees want to consolidate their retirement assets into one vehicle, and PSCA data indicates that not only do more than 95% of 401(k) plans permit rollovers, just under 4 in 10 (39.4%) of responding plans say they actively encourage participants to roll assets into their plan. While this can add a modest amount of administrative complexity, it’s generally thought that adding assets to the plan helps reduce overall expense.

If the plan accepts rollover contributions, then the incoming funds must:

a) be permissible rollovers allowed by the plan document, b) come from a qualified plan, 403(b) plan, governmental 457(b) plan or IRA, c) be the type of funds eligible to be rolled over, and d) generally be paid into the new plan no later than 60 days after the employee

receives the funds from the old plan or IRA.

The plan administrator must take reasonable steps to evaluate whether these conditions are met. The IRS has issued guidance that helps plan administrators more easily accept their employees’ rollover contributions. The guidance describes simplified due diligence procedures for a plan administrator to confirm the sending plan or IRA’s tax-qualified status and conclude that a rollover contribution is valid. This is helpful because plan administrators do not want to accept tainted funds (i.e., amounts that may be received from a plan that doesn’t meet the qualification requirements).

Rollover contributions must be separately accounted for by the plan and must be 100% vested. Beyond that, they are generally treated like any other account in the plan. Most plans permit rollover accounts to be used for participant loans and permit a distribution of the rollover account at any time. These are design features you would need to consider prior to accepting rollovers.

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In-Plan Roth Rollovers An increasingly common provision in 401(k) plans is a provision allowing “in-plan Roth rollovers.” Only plans that permit Roth deferrals are allowed to include this provision. The name is somewhat misleading because a distribution/rollover is actually being made in the same context as a traditional rollover. Rather, an in-plan Roth rollover simply allows a participant to change the tax character of all or a portion of his or her account (including employer contributions) from pre-tax to Roth. The amounts recharacterized are treated the same as Roth deferrals – the earnings on the account can be distributed income tax free provided the distribution is a qualified distribution. The participant, however, must pay current income taxes on the amounts that are recharacterized.

You must coordinate with your outside providers before including in-plan Roth rollover provisions in the plan. Some providers are not able to recordkeeper the recharacterization of all amounts in the plan. For example, many providers do not allow loans (the note) to be recharacterized as a Roth contribution. Similarly, some providers only allow the recharacterization of amounts a participant could otherwise have elected to receive as a distribution.

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