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Establishing a 401k Plan

Money Manager | Monday, September 15th, 2008

When you establish a 401k plan you must take certain basic actions. For instance, one of your decisions will be whether to set up the plan yourself or consult a professional or financial institution – such as a bank, mutual fund provider, or insurance company – to help you establish and maintain the plan.

Initial Actions

Here are four basic actions necessary to have a tax-advantaged 401k plan:

  • Adopt a written plan,
  • Arrange a trust fund for the plan’s assets,
  • Develop a recordkeeping system, and
  • Provide plan information to participants.

Adopt a written plan – Plans begin with a written document that serves as the foundation for day-to-day plan operations. If you have hired someone to help with your plan, that person likely will provide it. If not, consider obtaining assistance from a financial institution or retirement plan professional. In either case, you are bound by the terms of the plan document.

Before beginning a plan document, however, you will need to decide on the type of 401k plan that is best for you – a traditional 401k , a safe harbor 401k , or a SIMPLE 401k plan.

A traditional 401k plan offers the maximum flexibility of the three types of plans. Employers have discretion as to make contributions on behalf of all participants, to match employees’ deferrals, or do both. These 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 . In addition, a traditional 401k allows participants to make pre-tax contributions through payroll deductions. Annual testing ensures that benefits for rank-and-file employees are proportional to benefits for owners/managers.

A safe harbor 401k plan is similar to a traditional 401k plan, but, among other things, must provide for employer contributions that are fully vested when made. However, the safe harbor 401k is not subject to many of the complex tax rules that are associated with a traditional 401k plan, including annual nondiscrimination testing.

Both the traditional and safe harbor plans are for employers of any size and can be combined with other retirement plans.

A SIMPLE 401k plan was created so that small businesses could have an effective cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401k plan is not subject to the annual nondiscrimination tests that apply to the traditional plans. Similar to a safe harbor 401k plan, however, the employer is required to make employer contributions that are fully vested. This type of 401k plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. In addition, employees that are covered by a SIMPLE 401k plan may not receive any contributions or benefit accruals under any other plans of the employer.

Once your have decided on the type of plan for your company, you will have flexibility in choosing some of the plan’s features — such as which employees can contribute to the plan and how much. Other features written into the plan are required by law. For instance, the plan document must describe how certain key functions are carried out, such as how contributions are deposited in the plan.

Arrange a trust fund for the plan’s assets – A plan’s assets must be held in trust to assure that assets are used solely to benefit the participants and their beneficiaries. The trust must have at least one trustee to handle contributions, plan investments, and distributions to and from the 401k plan. Since the financial integrity of the plan depends on the trustee, this is one of the most important decisions you will make in establishing a 401k plan. If you set up your plan through insurance contracts, the contracts do not need to be held in trust.

Develop a recordkeeping system – An accurate recordkeeping system helps track and properly attribute contributions, earnings and losses, plan investments, expense and benefit distributions in participants’ accounts. If you have a contract administrator or financial institution assist in managing the plan, that entity typically will help in keeping the required records. In addition, a recordkeeping system will help you, your plan administrator, or financial provider prepare the plan’s annual return/report that must be filed with the Federal government.

Provide plan information to employees – As you put your 401k plan in place, you must notify employees who are eligible to participate in the plan about your plan’s benefits and requirements. A summary plan description, or SPD, is the primary vehicle to inform participants and beneficiaries about the plan and how it operates. The SPD typically is created with the plan document. You will need to send it to all plan participants. In addition you may want to provide your employees with information that emphasizes the advantages of joining your 401k plan. Employee perks – such as pre-tax contributions to a 401k plan or tax-free distributions in the case of Roth 401k s , employer contributions if you choose to make them , and compounded tax-deferred earnings – help highlight the advantages of participating in the plan.

This content provided by the Internal Revenue Service: www.irs.gov

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