How Contributions
to a Qualified 401k & Other Retirement Plans Work
(January 23rd, 2010)
 As
you read from the introductory article on 401k
plans, you know that contributions to a qualified plan can be made
by both employers on behalf of their employees and from bi-weekly
payroll deductions from the employees (known as elective
deferrals). The aggregate totals for both employer and employee
contributions to a qualified 401k plan must not exceed $46,000 for
2008 and $49,000 for 2009. Also, the maximum compensation cap for
eligibility to contribute to 401k plans is $230,000 for 2008 and
$245,000 in 2009. You might wonder, if there is a stated compensation
limit of $245,000 for 2009, then why does the IRS impose a $49,000
contribution limit for contributions to a 401k plan? Well first
point is, this $49,000 maximum 401k contribution limit for 2009
applies to BOTH employee & employer matched contributions.
Second is, the compensation cap limits the amount
of money that highly compensated employees can receive from their
employers in the form of matched contributions. As an example, say
there is the CEO of a corporation that gets paid $500,000 annual
compensation a year. If there was no compensation cap of $245,000
then that employee could have gotten a huge employer matched contribution
of say, 15% x $500,000 = $75,000 which would be unfair to all the
lower level line employees, managers & directors in the company
that get paid 1/5th of the salary of the CEO. Let’s compare
2 scenarios as examples:
i) Annual Contributions to 401k WITH Compensation
Cap
| Employee
maximum contribution for 2009 = $16,500
Employer matched contribution for 2009
= 13% x $245,000 = $31,850
Total contributions to 401k Plan = $31,850
+ $16,500
Total contributions
to 401k Plan = $48,350
|
i) Annual Contributions to 401k WITHOUT Compensation
Cap
Employee maximum contribution for 2009
= $16,500
Employer matched contribution for 2009
= 13% x $500,000 = $65,000
Total contributions to 401k Plan = $16,500
+ $65,000
Total contributions
to 401k Plan = $81,500
|
From the 2 examples above, we used a compensation
cap of $245k in example i) and the total 401k contribution resulted
in $48,350 for 2009 which is below the cap of $49,000 thus it becomes
qualified.
However in example ii) we used $500,000 for the
employer matched contribution and the total contribution came out
to $81,500 which is well ABOVE the defined limit of $49,000. So
now you should get an understanding of why the IRS has set both
401k maximum limits as well as compensation limits for qualified
contributions.
The benefit to employers of matching their employees’
contributions is that they get a tax deduction. Let’s consider
an example where there are 2 highly compensated employees and 2
normal paid employees of a corporation.
Example 1
ABC Corp. has decided to make a 25% contribution
for each of its 4 below employees for the 2009 tax year. The names
of the 4 employees and their W-2 compensation are as follows:
Adnan - $300,000
Johnson - $180,000
Fergie - $85,000
Norman - $45,000
|
The employer contribution for each employee is
calculated as follows:
Employee
Name
|
W-2
Compensation |
Employer
Contribution (25% of Compensation) |
Reasoning |
| Adnan |
$300,000 |
$49,000 (maximum
limit) |
- Only
up to a limit of $245,000 compensation can be considered when
determining Adnan’s total contributions.
- Since 25% of $300,000 is $75,000 which is over the contribution
limit of $49,000, we only select this $49,000 as his 2009
contribution. |
| Johnson |
$180,000 |
$45,000 |
- Johnson
received 25% of his $180,000 compensation totalling $45,000
which is below the annual $49,000 limit and thus permitted. |
| Fergie |
$85,000 |
$21,250 |
- Maximum
annual contribution is 25% of compensation which is 25% x $85,000
= $21,250 or $49,000 whichever is lesser. Thus, we select the
$21,250 answer. |
| Norman |
$45,000 |
$11,250 |
- Maximum
annual contribution is 25% of compensation which is 25% x $45,000
= $11,250 or $49,000 whichever is lesser. Thus, we select the
$11,250 answer. |
401k Contribution Formulas
i) Pro-rata based on Compensation
– An example of this formula is presented in the table above
where each eligible employee is to receive the same percentage of
his eligible compensation, which in this case is 25%
ii) Social Security Integration
– This formula allows highly compensated employees to have
a larger percentage of their compensation matched by their employers.
The employer with the help of an actuary must assign a percent that
is fair to all employees of that organization and this should be
a percentage of the accumulated total of all eligible employees'
compensation. The allocation of the percentages must be done in
compliance with IRS requirements otherwise the 401k plan might be
disqualified. It is best advised for companies to consult a 401k
tax attorney regarding this matter.
|
