Aaron's Frequently Asked Questions
1: When must employers deposit withheld employee contributions into a 401(k) plan or other pension plan?
The DOL states that employers must transmit employee contributions to pension plans as soon as they can be reasonably segregated from the employer's general assets, but not later than the 15th business day of the month immediately after the month in which the contributions either were withheld or received by the employer.
Employee contributions include 401(k) deferrals, loan payments and employee after-tax contributions. An example provided by the DOL includes a small company needing only two business days following the date of withholding to make the deposit. Based on this, and the fact that the DOL is making an effort to identify employers making late deposits, the best practice is to submit any employee contributions as soon as possible.
2: When can a participant take a distribution from a 401(k) plan?
The following distribution events are permitted under a 401(k) plan:
- The employee's severance from employment
- The employee's death
- The employee's disability
- The employee's attainment of age 59 ½(or later age as specified by plan)
- The termination of the plan
- The employee's financial hardship (see below)
3: What is a hardship distribution?
The 401(k) regulations allow an in-service distribution (hardship distribution) on account of an immediate and heavy financial hardship. A hardship distribution is not a loan, and therefore, does not need to be paid back. The safe harbor definition of hardship lists four circumstances that represent an immediate and heavy financial hardship. These are:
- Expenses for medical care for the employee, the employee's spouse, or the employee's dependents.
- Costs directly related to the purchase of a principal residence (not mortgage payments)
- Payments necessary to prevent eviction from the employee's principal residence.
- Payment of educational expenses for employee, the employee's spouse, or the employee's dependents.
The need must be documented and the distribution amount should match the need. Before a distribution can be taken on account of hardship, all other available distributions and loans from the plan must be taken. Only employee deferrals, without adjustment for investment gain/loss, can be distributed under a hardship. Once a hardship distribution is taken, the employee cannot defer to the 401(k) plan for a period of six months.
4: What are the relevant rules relating to participant loans?
A participant loan program is an additional feature that may be incorporated into a plan. A plan does not have to allow loans. With the limited distribution options of many plans, a loan program allows participants to access a portion of their money while still employed. Generally, participant loan programs set up and administered by Fox & Fox have the following ERISA compliant features:
- Maximum loan amount is 50% of vested account balance.
- Maximum loan amount = $50,000, minimum loan amount = $1,000.
- Interest rate is set at the Prime Rate + 1%.
- Maximum loan payback is 5 years.
- Loan repayment is done through payroll deduction.
5: What are the tax and penalty consequences of a lump sum distribution to the participant versus a rollover distribution?
Participants who choose to have their benefit paid directly to them in a single payment will have 20% of the amount withheld for Federal income taxes. State taxes will be withheld, or may be elected out of, based on the state. State withholding rates, like the rules, vary from state to state. Participants under age 59 ½ will also be subject to a 10% early withdrawal penalty. This amount will not be withheld from the payment, but will be disclosed and accounted for through income tax filing.
Participants who choose to have their benefit rolled over to an eligible tax deferred vehicle will not have 20% withheld and will not be subject to the 10% early withdrawal penalty. The full value of their account will be transferred and they will continue to receive tax-deferred growth of their funds.
6: What are Catch-Up Contributions?
Catch-up contributions allow a plan participant, age 50 or older, to make elective deferrals for a year that exceed an otherwise applicable limit (i.e., statutory limits, employer-provided limits and the actual deferral percentage limit). Catch-up contributions were introduced by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The IRS has issued proposed regulations on catch-up contributions impacting 401(k) plans, SIMPLE IRA plans, simplified employee pensions, 403(b) tax-sheltered annuity plans, and 457 governmental plans.
The catch-up contribution limit for a tax year is the lesser of: (a) the applicable dollar catch-up contribution for the tax year or (b) the participant's compensation for the year, reduced by any other elective deferrals made by the participant for the year. The applicable dollar catch-up limits for plans other than SIMPLE 401(k) and SIMPLE IRA plans, are: $1,000 for the 2002 tax year, $2,000 for the 2003 tax year, $3,000 for the 2004 tax year, $4,000 for the 2005 tax year, and $5,000 for the 2006 tax year and thereafter. The dollar limits applicable in 2006 and thereafter will be adjusted annually for inflation in $500 increments beginning in 2007.
7: What does GUST stand for?
GUST is an acronym for a series of laws passed since 1994 affecting qualified retirement plans. GUST stands for GATT (General Agreement on Tariffs and Trade-generally referred to as the Retirement Protection Act of 1994), USERRA (Uniformed Services Employment and Reemployment Rights Act of 1994), SBJPA (the Small Business Job Protection Act of 1996), TRA '97 (Taxpayer Relief Act of 1997), and the IRS Restructuring and Reform Act of 1998.
8: What changes to the law were made by GUST?
GATT - GATT sets interest and mortality tables for purposes of determining lump sum distributions and the 415 limits for defined benefit plans. For defined contribution plans, GATT sets increments in cost of living increases in the $30,000 415 limit (i.e., the limit rises in $5,000 increments).
USERRA - sets forth how contributions and service credit is handled when a participant is called up for military service. Loan payments may also be suspended during military service.
SBJPA - made many changes including:
- New definition of Highly Compensated Employee - HCEs are now either more than 5% owners in the current or prior plan year or employees in the prior plan year who earned more than $80,000 (as adjusted for COLA increases; for 2000 and 2001 the threshold is $85,000) and, if elected, were in the top 20%.
- Current or Prior Year testing - sponsors may make a choice as to using the current year's ADP/ACP average when testing or base the test on the prior year NHCE averages.
- Corrective distributions of failed ADP/ACP tests are now made to the HCEs with the highest dollar amount of deferrals.
- Minimum distributions - participants other than 5% owners who remain employed past 70 ½ may elect to postpone receiving distributions until they actually retire.
- 415 compensation for testing and compensation limitation purposes includes deferrals made to a 401(k), 403(b), 457 or cafeteria plan.
- 415(e) limits for Defined Benefit and Defined Contribution plans are repealed.
- Establishment of Safe Harbor 401(k) plans.
- Establishment of Simple IRAs and 401(k) Plans.
- Family aggregation rules repealed for purposes of determining HCEs and compensation limits.
- Special aggregation rules for plans of owner-employees repealed.
- Minimum participation rules of Section 401(a)26 restricted to DB plans only.
- Definition of "leased employee" changed to mean only if services are performed under the primary direction or control of the service recipient.
- "Social Security Retirement Age" can be used for nondiscrimination testing.
- Matching contributions made for the self-employed are no longer treated as elective deferrals.
- 15% deduction limit increased to the greater of 15% of plan compensation or amount required to be contributed to a SIMPLE 401(k).
- Governmental employees permitted to purchase additional service credits under Section 415(n).
- New ESOP rules for S Corporations including exemption from stock distribution requirements (conformity with prohibited transaction exemption and exemption from UBTI).
- 403(b) plan exclusion allowance to include 403(b), 401(k) or cafeteria plan salary reduction contributions in includible compensation.
- 401(k) plans that allow early participation may test using permissive aggregation.
- Full funding limit for DB plans increased from 150% to 170% by 2005 (with phase in).
- Limits on investments by 401(k) plans in employer securities (limit is 10% of elected deferrals).
- Repeal of five-year forward averaging for lump sum distributions.
- Tax exempts can have 401(k) plans.
- Indian tribes can have 401(k) and 403(b) plans.
- No new SARSEPs after December 31, 1996.
- 15% excess distribution tax repealed.
- Repeal of 50% income exclusion for certain ESOP loans.
- Waiver of the thirty-day period for election of an annuity (to seven days).
- 457 plans required to have a trust.
- Multi-employer plans can no longer have ten year cliff vesting.
- Repeal the $5000 death benefit exclusion.
- New rules on how basis recovered for annuity payments.
- Raises 3,500 involuntary cash out limit to $5,000.
- Allows a plan to debit the account of a fiduciary if there is a judgment of wrongdoing against the plan.
IRS Restructuring Act
- A hardship distribution of elective deferrals is no longer an "eligible rollover" and is therefore not subject to mandatory 20% withholding.
- No early withdrawal penalty for IRS levy on a qualified plan.