Elective deferrals are made at the election of the Participant pursuant to a salary reduction. There are several key points the Plan Sponsor should be familiar with in the management of their retirement plan.
Your Adoption Agreement will state if there is a limit on the dollar amount or percentage that Participants can contribute on a calendar year basis to their 401(k) account. The annual limit for 2012, based on Internal Revenue Code Section 402(g) and adjusted annually for cost of living increases, is $17,000. Participants age 50 or older may have the ability to increase their elective deferral by $5,500, for a total annual maximum contribution of $22,500.
Despite these deferral limits, your Adoption Agreement may impose different restrictions by limiting the amount each Participant can defer based on a percentage or dollar amount of compensation. For example, the Participant may be allowed to defer from 1% to 75% of compensation.
A participant should never be allowed to contribute to the plan at a higher percentage or dollar amount than specified in the Adoption Agreement.
In addition, the plan may need to further limit elective deferrals for Participants in order to meet nondiscrimination requirements.
Types of Elective Deferrals
Your Plan may make one or all three elective deferral types available:
- Pre-tax. This deferral lowers the Participant’s taxable income in the year deferred. The Participant pays income taxes at the time of distribution.
- Roth. These contributions are contributed on a post-income-tax basis. When the distribution is made, the Participant doesn’t pay any income taxes on the contributions and the related earnings.
- Catch-up. Only available for Participants who are age 50 or older. Participants can defer an additional $5,500 annually.
Automatic enrollment allows the Employer to automatically deduct elective deferrals from an employee’s wages unless the employee makes an election not to contribute (opt out) or to contribute a different amount. Deferrals can be designated as pre-tax or Roth contributions. There are three types of automatic enrollment arrangements:
- Automatic Contribution Arrangements (ACA). This is what automatic enrollment is known as. The ACA can also be set up to automatically increase a Participant’s deferral election at a designated time each year.
- Eligible Automatic Contribution Arrangements (EACA). This has the features of an ACA. If certain requirements are met, the Plan can allow Participants to request a permissible withdrawal (a time period, between 30-90 days, where contributions made through auto enrollment can be returned). The Plan also is granted an extended deadline to make distributions to Participants so that the Plan can pass ADP and ACP tests without being subject to a 10% penalty.
- Qualified Automatic Contribution Arrangements (QACA). This option includes the ACA features and requires a mandatory contribution to be made by the Employer (either as a matching or nonelective contribution). Advantages to this option are that the plan does not have to undergo ADP and ACP testing and a vesting schedule can be set for the Employer contributions.
Separate Deferral Election for Bonuses
If bonuses are considered compensation for elective deferral purposes, your Adoption Agreement may have a separate section that defines whether Participants can contribute at a rate that is different from their current deferral rate.
Frequency of Changes (Deferral Modifications)
Some Adoption Agreements state the specific frequency and timing for participants to change their deferral elections (i.e., cease deferrals, modify the rate of deferrals, or resume deferrals). Other Agreements allow for the Plan Administrator to determine how changes can be made.
If the Adoption Agreement doesn’t provide specific guidelines, the Employer must create and follow a uniform and nondiscriminatory administrative policy for how Participants can change their deferral elections. Each type of participant change (cease, modify, and resume) can have different rules.
The most common mistake with elective deferrals is allowing Participants to contribute more than what is allowable under the plan (either exceeding the IRS-approved annual limit or Plan-allowable limit, whichever is applicable).
The only solution here is to distribute the excess deferrals to the affected Participant(s). The timeliness of the distribution determines how the Participant is affected.
Excess withdrawn by April 15. If the excess deferral is distributed by April 15, the excess distribution is included in the Participant’s gross income for the tax year in which the contribution was made. However, any income earned on the excess deferral taken out is taxable in the tax year in which the excess deferral withdrawal is completed. Key point: if the distribution is made on or before April 15th, it is not subject to the additional 10% tax on early withdrawals.
Excess not withdrawn by April 15. If the excess deferral is not distributed by April 15, the excess is taxed twice, once when contributed and again when distributed. The distribution is also subject to the additional 10% tax on early withdrawals.
If the excess deferral is never removed from the plan, the plan may become disqualified.