A 401(k) salary reduction plan is a defined contribution plan; a type of profit sharing plan that allows employees to fund a deductible contribution for themselves. It provides a means for employers and employees to share plan contributions. Because of the curtailment of individual retirement plans(IRAs) under the Tax Reform Act of 1986, 401(k) plans may provide a better vehicle for employees to save for retirement.

Under a traditional savings and thrift plan, company matching contributions were deductible by the company, but employee contributions were not deductible. By converting a savings and thrift plan into a 401(k) plan, employee contributions that were previously not deductible can now be deductible.

Recently the 401(k) concept has spread to smaller companies, as employers and employees have begun to realize that the tax advantages of a 401(k) plan are far more generous than an IRA plan.

These plans got their name when Section 401(k) was added to the Internal Revenue Code in 1978. Proposed regulations relating to 401(k) plans were issued in 1981 and final regulations were issued in 1991. Beginning in 1997 Tax-exempt organizations may again adopt 401(k) plans.

401(k) Plans are especially popular with employees because they enable employees to defer taxation of money that otherwise would be taxed as ordinary income. Further, a 401(k) plan allows an employee to defer far more income (currently annually) than can be deferred under an individual retirement account(IRA), (currently $2,000 annually). Most 401(k) Plans provide for a matching Employer contribution.

Under a typical 401(k) plan, the employees are allowed to defer a percentage of their annual salary. The percentage is adjusted downward from 15% to account for Employer matching contributions and Employer discretionary contributions. In the usual arrangement, the employee elects the contribution rate and the amount is contributed to the plan by means of payroll deductions, subject to the limitation of the maximum amount of deferral ( annually per individual). The Employer makes a matching contribution in an amount specified in the plan document. A typical matching Employer contribution is $.25 or $.50 for each dollar contributed by the employee. However, some plans provide for 100% matching Employer contributions. Other plans provide for a variable matching Employer contribution which is announced each year. In addition, all plans provide for discretionary Employer contributions over and above the amount that the Employer is provides as matching Employer contributions.

Although the Employer is not required to provide any matching contributions, as a practical matter matching contributions will be necessary in most cases in order to encourage sufficient employee participation to meet the coverage requirements for a qualified plan. The plan must allow each employee the option of changing his or her rate of contribution to the plan at least annually but may allow for more frequent contribution changes.

A 401(k) plan is typically designed as a separate plan. If the company already has an existing profit sharing plan or thrift plan, the profit sharing plan or thrift plan can be restated as a 401(k) plan. It should be noted that the conversion of a profit sharing plan or a thrift plan into a 401(k) plan does not result in the termination of the prior plan for purposes of vesting.

If the company already maintains a defined benefit pension plan or a Money Purchase Pension Plan, the 401(k) plan will typically be adopted as an additional plan. In this case, care must be taken to ensure that the total contribution for all plans combined does not exceed 25% of eligible payroll. In this regard, it should be noted that, for purposes of determining the maximum annual contribution, any employee deferrals or contributions are deemed to be Employer contributions.

One of the characteristics of a 401(k) plan is that, like an IRA, each participant may be allowed to direct his own investments. This aspect may give employees a feeling of participation in the management and control of the plan. It may, however, result in a much lower rate of investment return than if the investments are controlled by the Plan Trustees and managed by professional managers.

In the typical 401(k) plan, the employee will have three investment options: an equity fund, a bond fund, and a money market fund. In the typical plan, an employee would be limited to changing his investment options once during each three-month interval in order to simplify the administration of the plan.

A 401(k) plan can also offer the option of investing in Employer securities. As a practical matter, the option is never offered in privately owned companies, since the option to invest in Employer securities constitutes an "offering" for securities law purposes. Such an offering would require that the company be registered with the SEC, if the company has employees in more than one state, or that the offering be registered with the state securities department, if all the employees are residents of a single state.

A 401(k) Plan will always be more advantageous to an employee than an IRA plan. This results from the fact that a 401(k) plan allows an employee to defer as much as 15% annually, whereas an IRA is limited to $2,000 annually. Obviously, this results in much greater current tax savings to the employee, and enables the employee to compound a far larger retirement benefit than would be possible under an IRA.

It should be specifically noted, however, that under the 1986 Tax Act, an employee is permitted to make contributions both to a 401(k) and to an IRA. If, however, the employee's adjusted gross income is more than $50,000 in the case of a married taxpayer, or $35,000 in the case of a single taxpayer, any contributions to the IRA plan will not be deductible. At lower levels of adjusted gross income, all or a portion of the IRA contribution may be deductible.

The following chart illustrates the annual federal and California income taxes that could be saved under a 401(k) plan, assuming the employee makes contributions of 6% of annual pay. In most states, including California, state income taxes are also reduced by salary deferrals.

The amount of the salary reduction will, however, still remain subject to Social Security taxation if the participant earns an amount in excess of the Social Security base. On the other hand, contributions to a salary reduction plan will not reduce Social Security benefits, and need not reduce the amount considered as covered compensation under a pension or profit sharing plan, if the plan so provides.

Contributions accumulate without tax until a payout is made from the plan. Shown below is an illustration of the account build up for each $1,000.00 of annual contributions:

The 401(k) plan is considerably more flexible than the IRA plan in that withdrawals of employee contributions and loans are permitted under 401(k) plans. These provisions are prohibited under IRA plans. The following chart illustrates the advantages of the 401(k) in comparison to an IRA plan.

401(k) plans are highly popular with employees. A company that maintains a 401(k) plan has a definite edge in hiring and retaining qualified employees.

Under a 401(k) plan, all employees must be eligible to participate after completing one year of service and attaining age 21. More liberal eligibility provisions may be specified in the Plan.

In general, the ratio of the percentage of non-highly compensated employees in the plan must be at least 70% of the percentage of highly compensated employees in the plan. An employee is counted if the employee is eligible to make deductible elective contributions regardless of whether the employee actually makes an elective contribution.

Employees must positively elect to defer a portion of their pay to be deposited into the Plan Trust. Elective deferrals must be deposited in the Trust within 15 days after the month the deferral is deducted from a participant's pay.

All employee deferrals are fully vested. Company matching contributions and discretionary contributions are subject to IRS-approved vesting schedules. Under the Tax Reform Act of 1986, Employer contributions must vest under one or the other of the following vesting schedules:

More liberal Employer contribution account vesting may be provided in the Plan.

Employer matching contributions and Employer discretionary contributions are not counted in determining the non-discrimination ratio, unless the contributions are fully vested and not subject to early withdrawal. Accordingly, Employer matching contributions and Employer discretionary contributions are typically fully vested in order to minimize non-discrimination problems. Top-heavy plans must provide somewhat more generous vesting.

The Tax Reform Act of 1986 provides a special non-discrimination test for 401(k) plans that is designed to prevent disproportionate deferrals by employees who are "highly compensated". A 401(k) plan will meet this special non-discrimination test for a plan year if it meets one of the following "Actual Deferral Percentage" tests:

1. The average deferral percentage for the highly compensated employees is not more than 125% of the average deferral percentage for all other eligible employees; or,

2. The average deferral percentage for the highly compensated employees does not exceed the lesser of:

a. The average deferral percentage for other eligible employees, plus two percentage points; or,

b. Two times the average deferral percentage for other employees.

The following chart illustrates the actual deferral percentage that can be made for highly compensated employees in relation to the other employees under the above described tests.

If the special non-discrimination rule for a 401(k) plan is not satisfied for any plan, the plan will not be disqualified if the excess contributions (plus allocable income) are distributed before the close of the following plan year.

An employee who changes jobs or who works for more than one employer may participate in more than one 401(k) plan. However, the code limits elected deferrals under all 401(k) plans to per year.

If am employee contributes more than to a 401(k) plan or to a group of 401(k) plans, then the Employer will incur a 10% excise tax on excess contributions. This excise tax can be avoided if the excess contribution, together with any income earned on the excess, is distributed to the employee no later than 2 1/2 months after the close of the plan year in which the excess contribution was made.

If an excess contribution, together with the income attributable to the excess, is returned to the employee no later than 2 1/2 months after the close of the employee's taxable year, then the excess amount, plus the income, will be taxable as part of the employee's W-2 wages for the calendar year ending with or within the plan year.

However, if such excess contribution, together with the income on the excess is not distributed within 2 1/2 months of the plan year, then the amount will be taxed in the year in which it is received.

Under the Tax Reform Act of 1986, withdrawals can be made under a 401(k) plan only for hardship and only in the amount of the employee's elective deferrals. Hardship withdrawal of Employer matching contributions or of Employer discretionary contributions are not permitted. To qualify as a hardship distribution, the distribution must be necessary in light of immediate and heavy financial needs of the employee, which needs cannot be reasonably satisfied from other resources of the employee. In addition, the distribution cannot exceed the amount required to meet the immediate financial needs.

The distribution will be taxable as ordinary income. In addition, if the distribution is paid prior to attainment of age 59 1/2, the distribution will be subject to a 10% excise tax.

The restrictive aspects of the early withdrawal provisions can be avoided by including a loan provision in the plan. A loan provision need not be restricted to immediate financial need. The Code allows a plan participant to borrow up to $50,000 or 50% of his vested account balance, whichever is less. All loans must be paid, together with interest, within five years, unless the loan is used to acquire the principal residence of a participant, in which case it is to be paid within a reasonable period of time.

A plan loan must be amortized in level payments, made not less frequently than quarterly, over the term of the loan.

Under a special provision of the Tax Reform Act of 1986, no interest deduction is allowed with respect to interest paid on loans secured with elective deferrals under a 401(k) plan. No interest deduction is allowed for interest paid on any loan to a "key" employee.

Except for hardship distributions, funds accumulated under a 401(k) plan may not be distributed earlier than:

1. Death, disability, separation from service, or attainment of age 59 1/2, whichever event is earlier.

2. Termination of the plan without establishment of a successor plan.

3. The date of sale by a corporation of substantially all of the assets of the business.

4. In the event that the corporation is a subsidiary of another corporation, the date of the sale of the subsidiary by the parent corporation

If the distribution is in a lump sum and is made on account of death, disability or attainment of age 59 1/2, then the distribution will be eligible for taxation under the five-year forward averaging provisions. In the alternative, the distribution may be rolled over into an Individual Retirement Account.

If the distribution is not on account of death or disability and is made prior to age 59 1/2, then the amount will be subject to ordinary income tax and to the 10% excise tax on early distributions, unless the amount is rolled over into an Individual Retirement Account.

The amount of an employee's elective deferrals must be reported to the employee on his or her W-2 statement. In addition, he or she is entitled to receive an annual report of his or her accrued benefit, and a summary annual report of the assets and liabilities of the plan. In addition, an annual information return, Form 5500, must be filed with the Internal Revenue Service.