What are the Types of 401(k) Plans?
With a 401(k) plan, employees can choose to defer some of their salary. Instead of receiving that amount in their paycheck, the employee defers, or delays, getting that money. In this case, their deferred money is going into a 401(k) plan sponsored by their employer. This deferred money generally is not taxed until it is distributed. There are a number of different types of 401(k) plans.
In general, a 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts. A 401(k) plan that is pre-approved by the IRS might be just the thing to cut down on administrative headaches and expenses.
Most Common Types of 401(k) Plans
Traditional 401(k) plan
A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested.
Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.
Solo 401(k) Plan
The Solo 401(k) plan, also known as an individual 401(k) or self-employed 401(k) plan, is an IRS approved retirement plan which is suited for business owners who do not have any full-time employees, other than themselves and perhaps their spouse. The Solo 401(k) plan is not a new type of plan; It is a traditional 401(k) plan covering only one employee. A Solo 401(k) plan is not subject to ERISA as there are no non-owner employees. For 2020, a solo 401(k) plan participant can contribute up to $57,000 or $63,500 if over the age of 50.
Profit Sharing Plan
A type of defined contribution plan under which the employer agrees to make discretionary contributions (usually out of profits). Retirement benefits are based on the amount in the participant’s individual account balance at retirement. The account balance depends on contributions made and earnings credited through the years. The maximum employer profit sharing contribution is 25% of compensation or 20% if self-employed or single member LLC.
Money Purchase Pension Plan
A type of defined contribution plan under which the employer contribution is mandatory, defined by the plan document, and is usually based on participant compensation. Retirement benefits under the plan are based on the amount in the participant’s individual account balance at retirement. The account balance depends on contributions made and earnings credited through the years.
Target Benefit Plan
A cross between a defined benefit plan and a money purchase plan. Similar to a defined benefit plan, the annual contribution is determined by calculating an amount to accumulate a fund sufficient to pay a targeted retirement benefit to each participant on reaching retirement. Similar to a money purchase plan, though, contributions are allocated to separate accounts maintained for each participant and are subject to limitations specific to defined contribution plans. The account balance depends on contributions made and earnings credited through the years. Actual retirement benefits will differ from the “target” and are based on the amount in the participant’s individual account balance at retirement.
Cross-Test & Age-Weight Plans
These plans generally have complex formulas for allocating contributions under a profit sharing arrangement. Depending on the actual plan’s formula, the allocation may be based on age, compensation, employee classification, service, or a combination of these factors. The account balance depends on contributions made and earnings credited through the years.
Cash or Deferred Section 401(k) Plans
An arrangement (defined by Internal Revenue Code Section 401(k)) under which a covered employee can elect to defer income by making pre-tax contributions to a profit sharing or stock bonus plan. A 401(k) plan may also provide for matching contributions and/or profit sharing contributions.
Safe harbor 401(k) plans
A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals.