By: Tahir M. Jaffri, ChFC®, CPFA®, LUTFC®, Financial Advisor

The Basics

Any profit-sharing or stock bonus plan that meets certain participation requirements of IDC Sec. 401(k) can be a cash or deferred plan. An employee can agree to a salary reduction or to defer a bonus that he or she has coming. Tax-exempt entities may also adopt a 401(k) plan.

How It Works

The employee has the option of taking cash or having it paid to the trust for retirement. This is equivalent to a tax-deductible employee contribution. However, employee deferrals are subject to FICA, Medicare, and FUTA payroll taxes, with applicable payments from both the employer and employee.

• Any additional employer contributions are tax deductible.
• Employer contributions, if any, are not taxed currently to the employee.
• Earnings accumulate income tax-deferred.
• Distributions are generally taxed as ordinary income; at retirement from the current employer, rolled over to a traditional or a Roth IRA, or to another employer plan if that plan accepts rollovers.

Two Types of Plans

• Salary reduction: An employee can agree to a salary reduction, e.g., 10% of compensation, which the employer then pays to the retirement plan trust. It is deductible to the employer but is not included in the employee’s gross income.
• Cash or deferred: The employer can decide to pay a bonus and give the employees the following choices: Take it as cash, defer it to the trust, or take part and defer the rest.             

How Much Will There Be at Retirement?

The risk of good or bad investment returns rests upon the employee. The amount available at retirement will depend upon three factors: The frequency and amount of contributions, the number of years until retirement, and the investment return.

Additional Considerations

• Maximum annual allocations: Employers may deduct contributions of up to 25% of covered payroll.
• Individual limits: For 2022, the allocations total of employer contributions and employee deferrals to a participant’s account may not exceed the lesser of 100% of compensation or $66,000 per year. An employee’s annual elective contributions to the plan are limited to $22,500. For those age 50 and older, additional “catch-up” contributions of $7,500  may be made.
• Investment of plan assets: Plan investments must be diversified and prudent. Subject to plan provisions, plan assets may be invested in equity products such as mutual funds, stocks, or debt-free real estate, or in debt investments such as T-bills or CDs. Life insurance and annuity policies may also be used.
• Automatic enrollment arrangement: An employer may adopt an arrangement under which a specified percentage of salary will automatically be contributed to the 401(k) plan for each employee unless an employee chooses to “opt out” of the system.
• Discretionary contributions: In addition to any matching and/or top-heavy contributions, an employer may make discretionary contributions from year to year so long as the allocation among the participants is on a non-discriminatory basis. These contributions may be allocated in several different ways. These contributions can be made to the plan up to the due date of the return plus any extension granted to the employer. Any employer contributions made on a discretionary basis that are not required to maintain the plan qualification may have gradual vesting.

Overall, it is important to have the proper plan in place when planning for retirement. It is never too soon to start saving from both your employer and your personal funds. Use the above feedback to configure the best way to save for your post-career lifestyle. How you spend and save now will certainly have an effect on your future. Save well, and save much.