Elective Deferrals (401(k) Plans)

Your qualified plan can include a cash or deferred arrangement (401(k) plan) under which participants can choose to have you contribute part of their before-tax compensation to the plan rather than receive the compensation in cash. (As a participant in the plan, you can contribute part of your before-tax net earnings from the business.) This contribution is called an "elective deferral" because participants choose (elect) to set aside the money, and they defer the tax on the money until it is distributed to them.

In general, a qualified plan can include a 401(k) plan only if the qualified plan is one of the following plans.

• A profit-sharing plan.
• A money purchase pension plan in existence on June 27, 1974, that included a salary reduction arrangement on that date.

Automatic enrollment in a 401(k) plan. Your 401(k) plan can have an automatic enrollment feature. Under this feature, you can automatically reduce an employee's pay by a fixed percentage and contribute that amount to the 401(k) plan on his or her behalf unless the employee affirmatively chooses not to have his or her pay reduced or chooses to have it reduced by a different percentage. These contributions qualify as elective deferrals. For more information about 401(k) plans with an automatic enrollment feature, see Revenue Ruling 2000-8 in Internal Revenue Bulletin 2000-7.

Partnership. A partnership can have a 401(k) plan.

Restriction on conditions of participation. The plan cannot require, as a condition of participation, that an employee complete more than 1 year of service.

Matching contributions. If your plan permits, you can make matching contributions for an employee who makes an elective deferral to your 401(k) plan. For example, the plan might provide that you will contribute 50 cents for each dollar your participating employees choose to defer under your 401(k) plan.

Nonelective contributions. You can, under a qualified 401(k) plan, also make contributions (other than matching contributions) for your participating employees without giving them the choice to take cash instead.

Employee compensation limit. No more than $170,000 ($200,000 for 2002) of the employee's compensation can be taken into account when figuring contributions.

SIMPLE 401(k) plan. If you had 100 or fewer employees who earned $5,000 or more in compensation during the preceding year, you may be able to set up a SIMPLE 401(k) plan. A SIMPLE 401(k) plan is not subject to the nondiscrimination and top-heavy plan requirements discussed later under Qualification Rules. For details about SIMPLE 401(k) plans, see SIMPLE 401(k) Plan in chapter 3.

Limit on Elective Deferrals

There is a limit on the amount an employee can defer each year under these plans. This limit applies without regard to community property laws. Your plan must provide that your employees cannot defer more than the limit that applies for a particular year. For 2001, the basic limit on elective deferrals is $10,500. (For 2002, this limit increases to $11,000 and participants who are age 50 or over can make a catch-up contribution of up to $1,000.) If, in conjunction with other plans, the deferral limit is exceeded, the difference is included in the employee's gross income.

Self-employed individual's matching contributions. Matching contributions to a 401(k) plan on behalf of a self-employed individual are not subject to the limit on elective deferrals. These matching contributions receive the same treatment as the matching contributions for other employees.

Treatment of contributions. Your contributions to a 401(k) plan are generally deductible by you and tax free to participating employees until distributed from the plan. Participating employees have a nonforfeitable right to the accrued benefit resulting from these contributions. Deferrals are included in wages for social security, Medicare, and federal unemployment (FUTA) tax.

Reporting on Form W-2. You must report the total deferred in boxes 3, 5, and 12 of your employee's Form W-2. See the Form W-2 instructions.

Treatment of Excess Deferrals

If the total of an employee's deferrals is more than the limit for 2001, the employee can have the difference (called an excess deferral) paid out of any of the plans that permit these distributions. He or she must notify the plan by March 1, 2002, of the amount to be paid from each plan. The plan must then pay the employee that amount by April 15, 2002.

Excess withdrawn by April 15. If the employee takes out the excess deferral by April 15, 2002, it is not reported again by including it in the employee's gross income for 2002. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10% tax on early distributions.

If the employee takes out part of the excess deferral and the income on it, the distribution is treated as made proportionately from the excess deferral and the income.

Even if the employee takes out the excess deferral by April 15, the amount is considered contributed for satisfying (or not satisfying) the nondiscrimination requirements of the plan. See Contributions or benefits must not discriminate, later, under Qualification Rules.

Excess not withdrawn by April 15. If the employee does not take out the excess deferral by April 15, 2002, the excess, though taxable in 2001, is not included in the employee's cost basis in figuring the taxable amount of any eventual benefits or distributions under the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.

Reporting corrective distributions on Form 1099-R. Report corrective distributions of excess deferrals (including any earnings) on Form 1099-R. For specific information about reporting corrective distributions, see the 2001 Instructions for Forms 1099, 1098, 5498, and W-2G.

Tax on excess contributions of highly compensated employees. The law provides tests to detect discrimination in a plan. If tests, such as the actual deferral percentage test (ADP test) (see section 401(k)(3)) and the actual contribution percentage test (ACP test) (see section 401(m)(2)), show that contributions for highly compensated employees are more than the test limits for these contributions, the employer may have to pay a 10% excise tax. Report the tax on Form 5330.

The tax for the year is 10% of the excess contributions for the plan year ending in your tax year. Excess contributions are elective deferrals, employee contributions, or employer matching or nonelective contributions that are more than the amount permitted under the ADP test or the ACP test.

See Notice 98-1 for further guidance and transition relief relating to recent statutory amendments to the nondiscrimination rules under sections 401(k) and 401(m). Notice 98-1 is in Cumulative Bulletin 1998-1.

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