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To adopt a tax advantaged 401(k) plan, you can use an
IRS-approved master or prototype plan offered by a sponsoring organization
or an individually designed plan.
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Written Plan Requirement
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To qualify, the plan you
set up must be in writing and must be communicated to your employees. The
plan's provisions must be stated in the plan. It is not sufficient for the
plan to merely refer to a requirement of the Internal Revenue Code.
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Master Or Prototype Plans. Most qualified plans
follow a standard form of plan (a master or prototype plan) approved by the
IRS. Master and prototype plans are plans made available by plan providers
for adoption by employers (including self-employed individuals). Under a
master plan, a single trust or custodial account is established, as part of
the plan, for the joint use of all adopting employers. Under a prototype
plan, a separate trust or custodial account is established for each
employer.
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Plan Providers. The following organizations
generally can provide IRS-approved master or prototype plans.
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Individually Designed Plan. If you prefer, you can
set up an individually designed plan to meet specific needs. Although
advance IRS approval is not required, you can apply for approval by paying a
fee and requesting a determination letter. You may need professional help
for this. Revenue Procedure 2003-6 in Internal Revenue Bulletin 2003-1 may
help you decide whether to apply for approval. Internal Revenue
Bulletins are available on the IRS website at www.irs.gov. They are also
available at most IRS offices and at certain libraries.
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User Fee. The fee mentioned earlier for requesting
a determination letter does not apply to certain requests made in 2003 and
later years, by employers who have 100 or fewer employees who received at
least $5,000 of compensation from the employer for the preceding year. At
least one of them must be a non-highly compensated employee participating in
the plan. The fee does not apply to requests made by the later of the
following dates.
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The request cannot be made by the sponsor of a prototype
or similar plan the sponsor intends to market to participating employers.
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More information about whether the user fee applies is in
Revenue Procedure 2003-8 and
Notice 2003-49.
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Participants can choose (elect) to have you contribute
part of their before-tax compensation to the plan rather than receive the
compensation in cash. This contribution is called an “elective deferral”
because participants choose (elect) to set aside the money, and they defer
the tax on the money until it is distributed to them.
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Alternatively, your 401(k) plan can have an automatic
enrollment feature. Under this feature, you can automatically reduce an
employee's pay by a fixed percentage and contribute that amount to the
401(k) plan on his or her behalf unless the employee affirmatively chooses
not to have his or her pay reduced or chooses to have it reduced by a
different percentage. These contributions qualify as elective deferrals.
More information about 401(k) plans with an automatic enrollment feature is
in Revenue Ruling 2000-8.
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Limit On Elective Deferrals
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There is a limit on the amount an employee can defer each
year under these plans. This limit applies without regard to community
property laws. Your plan must provide that your employees cannot defer more
than the limit that applies for a particular year. For 2003, the basic limit
on elective deferrals is $12,000. (For 2004, this limit increases to
$13,000.) If, in conjunction with other plans, the deferral limit is
exceeded, the difference is included in the employee's gross income.
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Catch-Up Contributions. A 401(k) plan can permit
participants who are age 50 or over at the end of the calendar year to also
make catch-up contributions. The catch-up contribution limit for 2003 is
$2,000 ($3,000 for 2004). Elective deferrals are not treated as catch-up
contributions for 2003 until they exceed the $12,000 limit, the ADP test
limit of Internal Revenue Code section 401(k)(3), or the plan limit (if
any). However, the catch-up contribution a participant can make for a year
cannot exceed the lesser of the following amounts.
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Treatment Of Contributions. Your contributions to a
401(k) plan are generally deductible by you and tax free to participating
employees until distributed from the plan.
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Participating employees have a nonforfeitable right to
the accrued benefit resulting from these contributions. Deferrals are
included in wages for social security, Medicare, and federal unemployment (FUTA)
tax.
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Reporting On Form W-2. You must report the total amount
deferred in boxes 3, 5, and 12 of your employee's Form W-2. See the Form W-2
instructions.
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Treatment Of Excess Deferrals
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If the total of an employee's deferrals is more than the
limit for 2003, the employee can have the difference (called an excess
deferral) paid out of any of the plans that permit these distributions. He
or she must notify the plan by April 15, 2004 (or an earlier date specified
in the plan), of the amount to be paid from each plan. The plan must then
pay the employee that amount by April 15, 2004.
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Excess Withdrawn By April 15. If the employee takes out
the excess deferral by April 15, 2004, it is not reported again by including
it in the employee's gross income for 2004. However, any income earned on
the excess deferral taken out is taxable in the tax year in which it is
taken out. The distribution is not subject to the additional 10% tax on
early distributions.
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If the employee takes out part of the excess deferral and
the income on it, the distribution is treated as made proportionately from
the excess deferral and the incomeEven if the employee takes out the excess
deferral by April 15, the amount is considered contributed for satisfying
(or not satisfying) the nondiscrimination requirements of the plan, unless
the distributed amount is for a non-highly compensated employee who
participates in only one employer's 401(k) plan or plans.
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Excess Not Withdrawn By April 15. If the employee does
not take out the excess deferral by April 15, 2004, the excess, though
taxable in 2003, is not included in the employee's cost basis in figuring
the taxable amount of any eventual benefits or distributions under the plan.
In effect, an excess deferral left in the plan is taxed twice, once when
contributed and again when distributed. Also, if the entire deferral is
allowed to stay in the plan, the plan may not be a qualified plan.
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Reporting Corrective Distributions On Form 1099-R. Report
corrective distributions of excess deferrals (including any earnings) on
Form 1099-R. For specific information about reporting corrective
distributions, see the Instructions for Forms 1099, 1098, 5498, and W-2G.
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Tax On Excess Contributions Of Highly Compensated
Employees. The law provides tests to detect discrimination in a plan. If
tests, such as the actual deferral percentage test (ADP test) (see section
401(k)(3)) and the actual contribution percentage test (ACP test) (see
section 401(m)(2)), show that contributions for highly compensated employees
are more than the test limits for these contributions, the employer may have
to pay a 10% excise tax. Report the tax on Form 5330. The ADP and ACP tests
do not apply to safe harbor 401(k) plans.
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The tax for the year is 10% of the excess contributions
for the plan year ending in your tax year. Excess contributions are elective
deferrals, employee contributions, or employer matching or nonelective
contributions that are more than the amount permitted under the ADP test or
the ACP test.
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Notice 98-1 provides further guidance and transition
relief relating to the nondiscrimination rules under sections 401(k) and
401(m).
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Amounts paid to plan participants from a qualified plan
are called distributions. Distributions may be nonperiodic, such as lump-sum
distributions, or periodic, such as annuity payments.
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Distributions From 401(k) Plans
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Generally, distributions cannot be made until one of the
following occurs.
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The employee retires, dies, becomes
disabled, or otherwise severs employment.
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The plan ends and no other defined
contribution plan is established or continued.
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In the case of a 401(k) plan that is
part of a profit-sharing plan, the employee reaches age 59½ or suffers
financial hardship. For the rules on hardship distributions, including
the limits on them, see section 1.401(k) - 1(d)(2) of the regulations.
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Caution. Certain distributions listed above may be
subject to the tax on early distributions discussed later.
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Qualified
Domestic Relations Order (QDRO). These distribution restrictions do
not apply if the distribution is to an alternate payee under the terms of a
QDRO.
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Tax Treatment Of Distributions
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Distributions from a qualified plan minus a prorated part
of any cost basis are subject to income tax in the year they are
distributed. Since most recipients have no cost basis, a distribution is
generally fully taxable. An exception is a distribution that is properly
rolled over as discussed next under Rollover.
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The tax treatment of distributions depends on whether
they are made periodically over several years or life (periodic
distributions) or are nonperiodic distributions.
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Rollover. The recipient of an eligible rollover
distribution from a qualified plan can defer the tax on it by rolling it
over into a traditional IRA or another eligible retirement plan. However, it
may be subject to withholding as discussed under Withholding requirement,
later.
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Eligible rollover distribution. This is a distribution of
all or any part of an employee's balance in a qualified retirement plan that
is not any of the following.
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A required minimum distribution. See
Required Distributions, below.
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Any of a series of substantially equal
payments made at least once a year over any of the following periods.
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The employee's life or life
expectancy.
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The joint lives or life
expectancies of the employee and beneficiary.
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A period of 10 years or longer.
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A hardship distribution.
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The portion of a distribution that
represents the return of an employee's nondeductible contributions to
the plan. See Tip, below.
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A corrective distribution of excess
contributions or deferrals under a 401(k) plan and any income allocable
to the excess, or of excess annual additions and any allocable gains.
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Loans treated as distributions.
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Dividends on employer securities.
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The cost of life insurance coverage.
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Tip. A distribution of the employee's
nondeductible contributions may qualify as a rollover distribution. The
transfer must be made either (1) through a direct rollover to a defined
contribution plan that separately accounts for the taxable and nontaxable
parts of the rollover or (2) through a rollover to a traditional IRA.
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Withholding Requirement. If, during a year, a
qualified plan pays to a participant one or more eligible rollover
distributions (defined earlier) that are reasonably expected to total $200
or more, the payor must withhold 20% of each distribution for federal income
tax.
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Exceptions. If, instead of having the distribution
paid to him or her, the participant chooses to have the plan pay it directly
to an IRA or another eligible retirement plan (a direct rollover), no
withholding is required.
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If the distribution is not an eligible rollover
distribution, defined earlier, the 20% withholding requirement does not
apply. Other withholding rules apply to distributions such as long-term
periodic distributions and required distributions (periodic or
non-periodic). However, the participant can still choose not to have tax
withheld from these distributions. If the participant does not make this
choice, the following withholding rules apply.
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For periodic distributions,
withholding is based on their treatment as wages.
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For non-periodic distributions, 10% of
the taxable part is withheld.
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Estimated Tax Payments. If no income tax is
withheld or not enough tax is withheld, the recipient of a distribution may
have to make estimated tax payments.
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Tax On Early Distributions
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If a distribution is made to an employee under the plan
before he or she reaches age 59½, the employee may have to pay a 10%
additional tax on the distribution. This tax applies to the amount received
that the employee must include in income.
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Exceptions. The 10% tax will not apply if
distributions before age 59½ are made in any of the following
circumstances.
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Made to a beneficiary (or to the
estate of the employee) on or after the death of the employee.
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Made due to the employee having a
qualifying disability.
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Made as part of a series of
substantially equal periodic payments beginning after separation from
service and made at least annually for the life or life expectancy of
the employee or the joint lives or life expectancies of the employee and
his or her designated beneficiary. (The payments under this exception,
except in the case of death or disability, must continue for at least 5
years or until the employee reaches age 59½, whichever is the longer
period.)
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Made to an employee after separation
from service if the separation occurred during or after the calendar
year in which the employee reached age 55.
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Made to an alternate payee under a
qualified domestic relations order (QDRO).
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Made to an employee for medical care
up to the amount allowable as a medical expense deduction (determined
without regard to whether the employee itemizes deductions).
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Timely made to reduce excess
contributions under a 401(k) plan.
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Timely made to reduce excess employee
or matching employer contributions (excess aggregate contributions).
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Timely made to reduce excess elective
deferrals.
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Made because of an IRS levy on the
plan.
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Reporting The Tax. To report the tax on early
distributions, file Form 5329, Additional Taxes on Qualified Plans
(Including IRAs) and Other Tax-Favored Accounts. See the form instructions
for additional information about this tax.
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Required Distributions
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A qualified plan must provide that each participant will
either:
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Receive his or her entire interest
(benefits) in the plan by the required beginning date (defined later),
or
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Begin receiving regular periodic
distributions by the required beginning date in annual amounts
calculated to distribute the participant's entire interest (benefits)
over his or her life expectancy or over the joint life expectancy of the
participant and the designated beneficiary (or over a shorter period).
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These distribution rules apply individually to each
qualified plan. You cannot satisfy the requirement for one plan by taking a
distribution from another. The plan must provide that these rules override
any inconsistent distribution options previously offered.
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Minimum Distribution. If the account balance of a
qualified plan participant is to be distributed (other than as an annuity),
the plan administrator must figure the minimum amount required to be
distributed each distribution calendar year. This minimum is figured by
dividing the account balance by the applicable life expectancy.
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Minimum Distribution Incidental Benefit Requirement.
Minimum distributions must also meet the minimum distribution incidental
benefit requirement. This requirement ensures the plan is used primarily to
provide retirement benefits to the employee. After the employee's death,
only “incidental” benefits are expected to remain for distribution to
the employee's beneficiary (or beneficiaries).
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Required Beginning Date. Generally, each
participant must receive his or her entire benefits in the plan or begin to
receive periodic distributions of benefits from the plan by the required
beginning date.
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A participant must begin to receive distributions from
his or her qualified retirement plan by April 1 of the first year after the
later of the following years.
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However, the plan may require the participant to begin
receiving distributions by April 1 of the year after the participant reaches
age 70½ even if the participant has not retired.
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If the participant is a 5% owner of the employer
maintaining the plan or if the distribution is from a traditional or SIMPLE
IRA, the participant must begin receiving distributions by April 1 of the
first year after the calendar year in which the participant reached age
70½.
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Distributions After The Starting Year. The
distribution required to be made by April 1 is treated as a distribution for
the starting year. (The starting year is the year in which the participant
meets (1) or (2) above, whichever applies.) After the starting year, the
participant must receive the required distribution for each year by December
31 of that year. If no distribution is made in the starting year, required
distributions for 2 years must be made in the next year (one by April 1 and
one by December 31).
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Distributions After Participant's Death. Special
rules cover distributions made after the death of a participant.
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More information on distributions is available in
Publication 575. More information on rollovers is also available in
Publication 590.
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Information on the benefit claims procedure governing
participants’ claims for their retirement benefits is available in How To
File A Claim for Your Pension and Health Benefits.
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