401(k) and Qualified Plans: Contributions

A qualified plan may be funded by both employer and employee contributions. However, the type of contribution that can be made to a particular plan, and the contribution limit depend on the type of plan.

Contributions are mandatory for some plans and discretionary for others. An employer should take this into consideration when choosing a qualified plan. For example, an employer who is not certain about whether it can meet contribution obligations every year, might not want to choose a defined benefit plan as contributions to defined benefit plans are mandatory. Instead, such an employer might want to choose a profit-sharing plan for which contributions are discretionary.

Defined Benefit Pension Plan

Contributions to a defined benefit plan are actuarially determined, and are mandatory. As a result, if the plan’s actuary determines that a contribution is required to be made to the plan for a year, then the employer is generally required to make that contribution.

Defined benefit plans are typically funded with employer contributions, and are subject to an annual benefit limit. For 2019, the annual benefit limit is $225,000, which is a $5,000 increase over 2018.

Contributions for an employee’s benefit for the year is usually limited to the lesser of (a) 100% of the employee’s compensation for his or her highest three consecutive calendar years and (b)the annual benefit limit.

The amount that must actually be contributed to a defined benefit plan for year, is usually dependent on whether or not contributions are required to ensure that the plan meets its funding obligations. The funding obligation is usually based on a predetermined pension benefit promised to employees.

Generally, an actuary would need to determine how much must be contributed to the plan for a year, and how much must be allocated to an employee.

The details of the funding rules for a defined benefit plan are highly complex and beyond the scope of this tutorial.

Defined Contribution Plans

Whether contributions to a defined contribution plan are mandatory generally depends on the type of plan.

However, regardless of the type of plan the annual addition limit on contributions are the same.

A defined contribution plan is generally funded only with employer contributions. An exception applies if the plan has a 401(k) feature, allowing employees to make salary deferral contributions.

The following is an overview of the contribution rules that apply to the more popular types of defined contribution plans:

Profit-Sharing and Stock-Bonus Plans
Contributions to profit-sharing and stock-bonus plans are typically made on a discretionary basis. This means that the employer decides each year whether to contribute to the plan. An employer may choose to contribute to the plan without regard to profits.

Money-Purchase Pension Plans (MPPP)
Contributions to a money-purchase pension plan are fixed and are mandatory. For instance, if the plan stipulates that each eligible employee receive a contribution in the amount of 10% of eligible compensation, each eligible employee must receive the contribution regardless of whether the employer made profits for the year.

An employer who adopts a money-purchase pension plan must take care not to over- or under-contribute to the plan. The funding limit is stated in the plan and must not be exceeded. For instance, an employer that elects to make a 10% contribution to the plan may not exceed this amount for the year. On the other hand, employers who under-fund a money purchase plan could owe penalties up to 100% of the shortfall. In addition to paying this penalty, the employer must meet the funding requirement. Employers that fund the plan in excess of the plan limit will owe a 10% penalty on the excess amount.

Target benefit plan

A target benefit plan is a money purchase pension plan that shares some of the features of a defined benefit plan, because contributions are usually based on similar formulas. However, unlike a defined benefit plan where employees are intended to receive a promised pension benefit, the amount an employee receives from a target benefit plan is based on contributions and performance of the assets in which contributions are invested.

401(k) Profit-Sharing Plan
A 401(k) plan is a qualified plan that allows employees to defer receiving compensation in order to have the amount contributed to the plan. This arrangement is commonly referred to as a cash or deferred arrangement (CODA). Contributions deferred by employees are referred to as elective deferrals, which are typically made to the 401(k) plan on a pretax basis. An employer may choose to have a stand-alone 401(k) plan or a profit-sharing plan with a 401(k) feature.

A 401(k) plan can include a designated Roth account (DRA) feature, which is commonly referred to as a Roth 401(k). Roth 401(k) accounts are funded with amounts that have already been taxed.

The employer may also choose to make matching, nonelective or profit-sharing contributions to the plan. These contributions cannot be made to Roth 401(k) accounts, and must instead be made to traditional 401(k) accounts.

A 401(k) plan is suited for an employer who wants employees to assist with funding the plan.

Contribution Limits to Defined-Contribution Plans

The aggregate employee and employer contributions made to an employee's account under a defined contribution plan must not exceed $56,000 in 2019 (up from $55,000 in 2018). An employee's compensation in excess of the compensation cap is not considered when computing plan contributions. The compensation cap is $280,000 for 2019, which is up by $5,000 over 2018. These limits are indexed for inflation and the IRS sends a notice in the last quarter of every year indicating whether the limits will increase for the next year.

401(k) Elective Deferral Contribution Limits

• An employee may elect to defer 100% of compensation up to $19,000 in 2019, up from $18,500 in 2018.
• Deferral contributions in excess of these limits are excess deferrals, which must be removed from the employee's 401(k) plan account within certain time frames. Excess contributions require special administrative handling and will be assessed penalties if not removed within a specific time frame.
• A plan may implement additional contribution limits; it may, for instance, limit each employee's elective-deferral contribution to a certain percent of compensation.
• Eligible employees who are at least age 50 by the end of the year may make additional contributions, which are referred to as "catch-up contributions." The catch-up contribution limit is $6,000.
• If the 401(k) plan includes a Roth feature, aggregate salary deferral contributions to both the traditional and Roth components cannot exceed this limit.

Other 401(k) Contributions

Matching: An employer may choose to make matching contributions on salary-reduction contributions that the employee makes. For instance, an employer may choose to make dollar-for-dollar matching contributions, up to 6% of compensation.

The plan document should be consulted to determine the matching contribution formula that is available under the 401(k)-plan document.

QNEC and QMAC: Salary-reduction contributions are subject to nondiscrimination testing. If the plan fails nondiscrimination tests, the employer might be required to make additional contributions to bring the plan into compliance. These contributions are called qualified nonelective contributions (QNEC)s and qualified matching contributions (QMAC)s

Within IRS-established limits, the employer is eligible to receive a tax deduction for contributions made to the plan. The following example illustrates how the contribution limits apply.

Example 1: IRS-Established Contribution Limits
XYZ Corporation has decided to make a 25% contribution for each eligible employee for the 2018 tax year. Employees received W-2 wages in the following amounts:

Mark – $300,000
Jane – $160,000
Mary – $80,000
Jim – $40,000

Each employee's contribution is allocated as follows:

Contribution Formulas

An employer may choose among several formulas to calculate contribution allocations. These include the following:

• Flat dollar – Under this formula, each eligible employee receives the same dollar amount as a contribution.
• Pro-rata – This formula results in each eligible employee receiving the same percentage of his or her eligible compensation. The pro-rata formula is demonstrated in the example above, with XYZ Corporation.
• Age-weighted – Here, an employee’s age is taken into consideration when calculating contributions. Older employees end up receiving a larger percentage of the total contribution amount that is made to the plan.
• Social Security integration – This formula awards higher-paid employees a larger percentage of their compensation because Social Security payments will represent a smaller percentage of their total retirement benefit. The employer assigns to the qualified plan an amount that is a percentage of the accumulated total of all eligible employees' compensation. Using a special formula, the employer then allocates a contribution percentage to each eligible employee. The allocation must be done according to specific IRS-provided requirements; otherwise, the plan may be disqualified.

Example 2: XYZ Corp. Allocates $110,000 to the Plan
For the employees and the figures in Example 1, XYZ determines that the total contribution to the plan will be $127,000. Instead of allocating 25% to each employee, XYZ decides to allocate the $127,000 among the employees using the Social Security integration formula. As a result, higher-paid employees will receive a higher percent (based on eligible compensation) than lower-paid employees.

As employer is allowed to use a contribution formula, only if it is available under the governing qualified plan document. As such, employers should check the plan document to determine the contribution formulas that are available. Choosing an allocation method that is not available under the plan document could result in disqualification of the plan.

Contribution Deadline

Employer contributions must be made to each employee's account by the employer's tax-filing deadline (including extensions).

An elective-deferral contribution must be transmitted to the employee's account as soon as the contribution can be reasonably segregated from the employer's general assets. The deadline, however, is the 15th business day of the month immediately after the month in which the contributions either were withheld or received by the employer (7 business days after the amount has been withheld, for small plans with fewer than 100 employees).

Employer Deductions to Defined-Contribution Plans

For their contributions made to a qualified plan, employers are allowed a tax deduction, which they claim on the business's income tax return. Employers, however, should not make contributions in excess of the deductible limit, as the excess amounts may not be tax deductible and could result in penalties being owed (to the IRS).

The deduction for contributions cannot be more than 25% of the total compensation paid (or accrued) during the year to eligible employees participating in the plan. When figuring the deduction limit, the following rules apply:

• Elective deferrals are not subject to the limit.
• Compensation includes elective deferrals.
• The maximum compensation that can be taken into account for each employee is $275,000.

Example 3: Deducting Money Purchase Plan Contributions
ABCD Inc. adopted a money-purchase pension plan and elected to make a 10% contribution to the plan each year. Eligible employees earn compensation as follows:

The total contribution that ABCD Inc. may make to the plan is $53,000 dollars ($530,000 x 0.1 = $53,000), to be allocated in accordance with the allocation formula chosen by the plan.

Example 4: Deducting 401(k) Plan Contributions
WXYZ Corporation adopted a 401(k) plan and will make a profit-sharing contribution of 10% of eligible compensation to the plan. Compensation and elective-deferral contributions are as follows:

Compensation, for purposes of determining deduction limits, includes elective deferrals. WXYZ's profit-sharing contribution will be $43,000 ($430,000 x 0.1 = $43,000) to be allocated among employees in accordance with the plan's chosen allocation formula.

Deduction Limit for Self-Employed Individuals
The examples used in this module use W-2 wages, which are paid to employees. Self-employed individuals – including partners in a partnership – must use a special formula to determine their compensation for plan purposes. For assistance, these individuals may consult with a tax professional and refer to IRS Publication 560, which can be found at the IRS website.

Excess Contributions
If plan contributions exceed the deductibility limit for the year, the employer may carry over and deduct the difference in later years and combine it with contributions for those years. The combined deduction in a later year is limited to 25% of the participating employees' compensation for that year.

Employee Deductions to Defined-Contribution Plans

Employees who contribute to a 401(k) can reduce their taxable income by the amount of their contribution, up to $19,000 for 2019 and $18,500 for 2018. Unless the rules change with the new tax legislation, those age 50 and over can also include a catchup contribution of $6,000 more per year.

Investing Plan Assets

A qualified plan may direct the investments of the plan assets for employees. Others may allow the employees to direct their own investments by selecting from a list of investments provided by the plan.

The U.S. Department of Labor provides that the party responsible for directing the investment of plan assets is responsible for the consequences of the investment decisions. If the employee is allowed to choose from a number of investments, the employee is also responsible for the consequences of investment decisions. If the plan makes the investment decisions, the plan has a fiduciary responsibility for investment decisions.

If allowed to make their own selections, employees are entitled to receive a broad range of information about the investment choices available. Thus, a plan that intends to relieve plan officials of fiduciary duties over investments must inform employees of that fact. According to the U.S. Department of Labor, the information that must be provided to employees includes the following:

• a description of each investment option, including the investment goals and the risk and return characteristics
• information about designated investment managers
• an explanation of when and how to make investment instructions and any restrictions on when the employee can change investments
• a statement of the fees that may be charged to the employee's account when he or she changes investment options or buys and sells investments
• information about the employee's shareholder voting rights and the manner in which confidentiality will be provided on how the employee votes his or her shares of stock
• the name, address and phone number of the plan fiduciary or other person designated to provide certain additional information on request

Investment Options

Permissible investments for qualified plans include publicly traded securities, real estate and money market funds. Some plans even allow investing in options. The plan document is required to state the investment choices for plan assets.