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401(K) FAQs

I own my own business. What type of retirement plan can I sponsor?

There are various types of plans that break down into two general categories, pension or profit-sharing. Additional features can be added in the plan design to increase deductible contributions or add other benefits, like employee 401(k) contributions.

Does it matter that I am a sole proprietor or a Subchapter S Corporation owner?

All types of retirement plans may be sponsored by any employer.

Do I have to cover all of my employees?

Reasonable eligibility requirements for any retirement plan may be designed into the plan. The law permits the exclusion of certain employees. Employees may be generally excluded if they have not attained age 21 or have been with you for 12 consecutive months as a full-time employee (1000 hours of service). After excluding employees who don’t meet those requirements, reasonable eligibility requirements may be added to the plan as long as the plan continues to meet minimum coverage requirements.

If I establish a plan, do I have to fund it each year?

That depends on the type of plan. Pension plans have minimum funding standards and have a required contribution each year, depending on the plan contribution formula. Contributions to profit-sharing plans are discretionary and are not required each year.

Can I terminate a plan after it has been established?

Yes. A retirement plan can be amended or terminated at any time, as long as the termination is for valid business reasons. At the time a plan is established, the employer must intend to make it permanent; however, if business circumstances change, the plan may be altered or terminated.

How much can I contribute?

That depends on the type of plan. Pension plan contributions must meet a minimum funding standard. Defined benefit pension plans have contributions that are actuarially determined each year. Profit-sharing contributions are not required each year and may be funded up to 25% of the total amount of compensation of the employees who are eligible to participate in the profit-sharing plan. The Internal Revenue Code sets a limit on how much compensation is to be used in this test. In combinations of pension and profit-sharing plans, the employer may deduct up to 25% of the compensation of the employees who are eligible to participate in both plans. A plan sponsor may require employees to gain ownership of their benefits over time. This is known as a vesting schedule.

How does vesting work?

Employees are required to receive a year of vesting credit for each plan year in which they complete 1,000 hours of service for the employer.

Can I establish a plan for just one business?

Yes, but if you own or have a controlling interest in more than one business, the employees of all of the controlled businesses may need to be considered for the minimum coverage requirements.

Why not just pay my profits as a bonus?

Bonuses are taxable income to the employees who receive them. Contributions to a tax-qualified retirement plan are deductible by the employer but are not taxable to the employees at the time that they are contributed into the plan. Employer contributions to a retirement plan are not subject to payroll taxes and may be subject to a vesting schedule that may reduce the ultimate distribution to shorter-term employees.

What are my investment options?

That depends on the plan design. Many plans permit participant-directed accounts where each individual participant can choose among available investment options. Other plans use trustee-directed pooled accounts.

Can I borrow from my plan?

That also depends on whether or not the plan has loan provisions and whether or not the employer has adopted a loan policy. If the plan does permit loans, the Internal Revenue Code limits the total amount of loans to an individual participant from all plans of an employer to the lesser of 50% of the participant’s vested interest or $50,000. Further, any participant loan must be fully repaid over no more than five years, and principal and interest payments must be made at least quarterly.

I sponsor a retirement plan and all of the funds are maintained in a pooled fund trust. Am I responsible for investing the contributions?

That is typically the case, but your plan’s trust document should confirm whether or not you are considered to be the fiduciary responsible for trust investments. The plan may also permit you to engage the services of an investment advisor who would accept fiduciary responsibility for directing the investments. In many cases, participants are now being given the opportunity to invest their own benefits, provided the plan provisions meet extensive Department of Labor requirements as participant-directed accounts. If those requirements are met, some fiduciary responsibility for trust investments may be transferred to the participants.

When do I have to withdraw my benefit?

At age 70½, if you are a 5% owner of the business, minimum distributions from the plan must begin. If you are not a 5% owner, distributions can be deferred until you actually retire from your employer.

When may I take my benefit?

That depends on the plan design. Benefits are generally eligible for distribution only after a participant’s death, total disability, attainment of normal retirement age or separation from service. Some plans permit early retirement benefits, but some plans do not permit any benefit distribution until normal retirement age, regardless of when a participant separates from service. You should confirm your plan’s distribution options with your Summary Plan Description.

How may I receive my benefit?

This also depends on the particular plan design. Some plans permit only lump-sum distributions and some plans permit distributions in the form of an annuity, or in installments. The Summary Plan Description should provide that information.

I have read about early distribution penalties. What are they?

The Internal Revenue Code specifies a 10% tax penalty on distributions before age 59½ unless the reason for the distribution meets a specific exception. In California, an additional state tax penalty of 2½% may also apply. The IRS has published rules about how to start distributions in a manner that will avoid these penalties. If you wish to start benefits before age 59½, it is important to review whether the plan design permits such distributions and what the income taxes, including penalties, may be.

If I think my benefit has been calculated incorrectly, or if I have asked for a benefit that has been denied, how should I proceed?

Your Summary Plan Description is required to include a claims procedure and notification of the persons responsible for plan administration. You should request an explanation of how your benefit was determined under that claims procedure.

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