401k Plan FAQ's

What are the different types of 401k plans available?

There are several types of 401k plans available to employers - traditional 401k plans, safe harbor 401k plans and SIMPLE 401k plans. Different rules apply to each. For tax-favored status, a plan must be operated in accordance with the applicable rules. Therefore, it is important that the employer be familiar with the special rules that apply to its plan so the plan is administered in accordance with those rules. To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan’s provisions. The following is a brief overview of important qualification rules. It is not intended to be all-inclusive.

Traditional 401k plans -A traditional 401k plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401k plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both. These employer 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, or be immediately vested. Rules relating to traditional 401k plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.

Safe harbor 401k plans - A safe harbor 401k plan is similar to a traditional 401k plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401k plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401k plans.

SIMPLE 401k plans -  The 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 traditional 401k plans. As with a safe harbor 401(k) plan, 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. Employees who are eligible to participate in a SIMPLE 401k plan may not receive any contributions or benefit accruals under any other plans of the employer.

What is the maximum amount that I can contribute to my 401(k) plan?

The maximum amount an employee can contribute to a 401k plan is determined annually. You may be allowed catch up contributions in addition to annual limit, if you are age 50 or older. Refer to "Elective Deferrals" in Publication 525, Taxable and Nontaxable Income. The maximum amount applies to an employee's aggregate pre-tax contributions to a 401k plan and 403b plan. There are several different limits that apply to a 401k plan in addition to the overall contribution limit. These limits, your salary, and the type of 401k plan to which you are contributing may limit your 401k contributions to a lesser amount.

The rules for retirement plans are complex. Your plan administrator should have written information about your particular plan that explains these limitations as well as other regulations that apply.

Can I withdraw funds penalty free from my 401k plan to purchase my first home?

If you are under the age of 59 1/2, you cannot withdraw funds from your 401k plan to purchase your first home without being subject to a 10 percent additional tax on early distributions from qualified retirement plans. However, depending on the rules for your 401k plan, you may be able to borrow money from your 401k plan to purchase your first home. Your plan administrator should have written information about your particular plan that explains when you can borrow funds from your 401k plan as well as other plan rules.

If taxes are withheld from my 401k distribution, do I have to include that money as income and do I pay the 10% early withdrawal fee as well?

Yes, you need to include in income the total amount of your 401k distribution reported on Form 1099-R (PDF), Distributions From Pensions, Annuities, Retirement on Profit-Sharing Plans, IRAs Insurance Contracts, etc. In addition, if the distribution occurs before you are age 59 1/2, you may need to pay a 10 percent additional tax on early distributions from qualified retirement plans unless you meet one of the exceptions in Publication 575, Pension and Annuity Income. You will include the federal income tax withheld on the appropriate line of your federal tax return along with any other federal income tax.

If I can't withdraw funds penalty free from my 401k plan to purchase my first home, can I roll it over into an IRA and then withdraw that money to use as my down payment?

Yes, if you are receiving a distribution from a 401k that is eligible to roll over into a IRA and you meet all of the qualifications for an IRA distribution for a first-time home buyer. Your plan administrator is required to notify you before making a distribution from your 401k plan whether that distribution is eligible to be rolled over into an IRA. To see if you qualify for a distribution to be used as a first-time home buyer, refer to Chapter 1 of Publication 590, Individual Retirement Arrangements (IRAs).