Defined Contribution (401K or 403B) Retirement Plans
Section 401K or 403B of the Internal Revenue Code (IRC) allows for pre-tax dollars to be used for qualified retirement plans. Section 403B Plans were initially the only plan available to certain employers (mostly 503c3 not-for-profits) but now 401K Plans are available. Sections ??? discuss the discrimination testing and definitions for highly compensated employees.
These pre-tax dollars lower Federal, State and Local income taxes when contributed. Thus amounts contributed as well as investment earnings are tax deferred; subsequently, taxes are paid when distributions are made to participants. The allowed contributions for 403B Plans are slightly higher than those for 401K Plans. 401K Plans can be terminated more easily than 403B Plans, so for newly formed retirement plans, 401K Plans are recommended
For 2003 the annual contribution for a 401K plan is the lesser of 15% of annual compensation or $12,000. (There are special additional catch-up contributions allowed for participants over age 50, for example $1,000 extra is allowed in 2002 and $2,000 extra is allowed in 2003).
Getting Started
The 401K or 403B Plan requires: a Plan Document, a Summary Plan Description (SPD), discrimination testing, and a Form 5500 filing. Employee communications need to be carefully considered as education and counseling is important. Employers do not need to make matching contributions. However, the ”Highly Compensated Employees” (usually management and key executives) annual contributions may be limited based on the overall contributions. A financial institution should be used to manage the separate participant accounts thereby allowing employees to individually direct their fund investments. Usually there are setup fees for implementing the plan, but the annual fees for the separate employee accounts are charged to the investment funds and paid by the employees from investment earnings. Once the plan design is finalized, the enrollment process can be completed in two to three weeks depending on the communications approach.
Basic Pricing
Setup costs are usually paid by the employer and will vary depending on the number of employees. Plan Documents usually cost $500 or less.
Administrative fees are between $20-$40 and are usually deducted from participants’ accounts (reducing net earnings). In addition, there can be fund management fees taken from the fund earnings and broker commissions if stock is traded in the investment accounts.
| ADVANTAGES |
DISADVANTAGES |
| + Employees are encouraged to save for retirement and save on payroll taxes (federal, state, and local income taxes). |
- Elections for highly compensated employees may be limited as determined by discrimination testing.
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| + Earnings and capital gains are tax deferred until distribution.
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- If an employer match is made there are significant costs. |
| + Employees can individually direct their investments subject to limitations set by the investment funds. |
- Employers should avoid fiduciary responsibility (by allowing self-directed funds outsourced to investment managers |
| + Administrative costs for investment management are usually paid from participant accounts |
- Investment funds usually have management fees, which reduce the net earnings to participants. |
| + Loans in specific circumstances hardships withdrawals can be allowed |
- Amounts withdrawn prior to age 591/2 are subject to income taxes and a 10% penalty tax when taken. |
| + Investment fund managers now offer a range of diversified investments.
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- Employee education is important in understanding the investment options.
- The employer usually pays startup costs including discrimination testing and Plan Documents. |
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