401(k) Plan Design Guide

Proper design is crucial for a successful 401(k) plan. It is the building block on which the plan is constructed. The design will affect the other 401(k) plan functions of investment, administration, recordkeeping and communication with employees. It will determine how the plan is installed and maintained and who will provide services for the plan. A 401(k) plan should be designed before the service providers are selected. The use of a 401(k) design consultant is extremely important in the design process; if cost is a concern, time and charges can be limited, but the presence of a specialist should be considered essential.

Before the design process begins, it must be determined that a retirement plan is needed for the organization. Alternatives to a 401(k) should be explored before the 401(k) is selected. It is conceivable that a retirement plan is not essential and that employees can be rewarded by some other mechanism; or, even if a plan is needed, a SEP, SIMPLE or other type of retirement plan may be more appropriate for the organization than a 401(k).

If a decision is made to establish a 401(k), a basic plan design should be developed. Once this has been done, the employer should proceed as follows, prior to the selection of 401(k) service providers:

1. An investment policy should be outlined and investment options selected. A decision is needed whether investments will be employer or participant-directed; if participant-directed investments are chosen, the number and types of investments to offer must be selected.

2. Decisions are needed regarding whether an individually-designed plan document or a prototype should be used and whether the document should be submitted to the IRS for approval.

Once the above decisions have been made, 401(k) service providers can be selected. In this regard, the following must be considered:

1. Plan selection and installation The selection of the 401(k) plan document will affect the choice of service providers, since many providers offer a complete or "bundled" approach that requires the use of their prototype (which can be fairly simplified and restricted) rather than the use of an individually-designed document. In addition, such providers may not facilitate submission to the IRS for plan approval.

2. Investment of assets The investment of plan assets may be significantly limited by 401(k) providers offering a bundled approach; in many cases, investments outside the provider's family of funds are prohibited. The use of a Third-Party Service Provider (TPA) can overcome this problem; however, additional investment options may increase the difficulty of the recordkeeping function.

3. Determination of how the 401(k) plan will be administered and how the records will be kept. The plan can be administered by a TPA, mutual fund or other investment firm that also provides investment alternatives (frequently, a bundled-service provider) or in-house (rarely do the capabilities exist to do so, except in larger organizations) or by a combination of the above. Transactions in each employee's account must be diligently recorded. The recordkeeping function will likely be managed by the organization that provides the administrative services.

4. Communication With Employees The 401(k) plan must be efficiently communicated to employees for it to be effective. The employer should supplement the services of any provider with additional in-house communication with employees.

5. Cost Limitation 401(k) costs exist in each of the functions described above. It is important to control these expenses and indirect ones, such as the cost of employees' time spent in plan-related activities.


Design of a 401(k) should satisfy the goals of the employer while concurring with existing pension laws. These goals may include obtaining and securing valuable employees, rewarding good service, assisting in providing for the employees' financial security at retirement and encouraging employees to provide their own financial security through the tax and other advantages that a 401(k) plan can provide.

The design of a 401(k) plan can be divided into 3 stages:

I. Design Aspects Relating to Funds Entering the 401(k) Plan

II. Design Aspects Relating to Funds Within the 401(k) Plan

III. Design Aspects Relating to Funds Exiting the 401(k) Plan

I. Design Aspects Relating to Funds Entering the 401(k) Plan

1. Coverage

2. Eligibility

3. Contributions

A. Restrictions from the Internal Revenue Code

B. Compensation Used to Determine Contributions

C. Employee Contributions

a. Elective Deferrals

b. Rollovers

c. After-tax voluntary contributions

D. Employer Contributions

a. Matching

b. Profit Sharing

c. Allocation of Contributions

E. Forfeitures

1. Coverage

The first question that must be answered when designing a 401(k) plan is determining which employees the employer wants to cover. Frequently, all employees are covered. However, coverage can be limited, provided the coverage requirements of the Internal Revenue Code are satisfied. Coverage can be limited to salaried or hourly employees, an employee unit within the organization or any other arrangement that is "nondiscriminatory." When deciding which employees should be covered, the employer must consider:

a. Which employees does the employer want to cover and to what extent does the employer want the 401(k) Plan to benefit them? Is it preferable to provide additional benefits to some employees by other means?

b. What are the cost considerations of providing coverage to all employees versus one particular group or groups?

c. Will exclusion of certain employees from coverage lead to legal or morale problems?

2. Eligibility

All covered employees must satisfy the plan's eligibility requirements before becoming participants. The law permits establishing a maximum age of 21 and a service limitation of one year. When considering eligibility requirements, the employer should consider that although a delay in participation may reduce short-term costs, it will make the 401(k) plan less attractive to prospective employees. Also, recent favorable changes in the laws may encourage more employers to seek immediate eligibility. Frequently, there are dual eligibility requirements for the 401(k) plan; for example, all employees who are present on the day the plan is adopted are immediately eligible, while a waiting period is required for employees hired after that date.

3. Contributions.

A. Restrictions from the Internal Revenue Code

The plan must not only be carefully designed within the needs of the employer, but also within legal limits imposed on plan contributions. In summary, annual 401(k) contributions are limited by the Code as follows:

a. The deductible limit on total employee and employer contributions to the plan is 15% of the total compensation of plan participants.

b. The limit on total employee and employer contributions for any participant is 25% of the total compensation of that participant. If contributions exceed that amount, an "annual additions" violation occurs, which can be corrected by either allocating the excess to the other 401(k) participants or refunding it.

c. The dollar limit on employee deferral contributions is currently $10,000 but adjusts annually for cost-of-living increases.

d. Minimum top heavy contributions, no more than three percent of compensation, may be required when more than 60% of the retirement plan account balances are concentrated in the accounts of "key employees."

e. Nondiscrimination requirements regarding employer contributions according to Section 401(a) of the Code must be met.

B. Compensation Used To Determine Contributions

Many plans use W-2 compensation (frequently including elective deferrals) to determine contributions, but numerous other choices for compensation are possible. Some factors which should be considered are:

a. Simplicity. The use of W-2 compensation throughout the 401(k) plan will simplify 401(k) testing and administration.

b. Legal Constraints. Excluding some compensation, such as overtime, may lead to discrimination problems between the "highly and non-highly compensated employees" or endanger the qualification of the plan rendering it more difficult to administer.

C. Employee Contributions

a. Elective deferral contributions. These deferrals are limited to $10,000. They are also restricted in that total employer and employee contributions must not exceed 15% of the total participants' compensation (for deductibility purposes) and by the limit on employer and employee contributions for any one participant of 25% of compensation. Thus, when selecting the maximum percentage of compensation that each employee is allowed to contribute towards elective deferrals, the total amount of anticipated employee and employer contributions (made through a match or as profit sharing contributions) must be considered. Employee contributions should be encouraged so employees can increase their savings for retirement. In addition, increased employee 401(k) contributions may lower required employer contributions needed to pass the "ADP/ACP" tests. The IRS has recently approved "mandatory" employee deferral contributions, frequently referred to as "negative elections." In these situations, salary reduction contributions are made for employees who do not affirmatively select to receive cash or have a specified amount of deferrals contributed to the plan. Care should be taken before requiring these contributions since the employer may be viewed by employees as requiring them to contribute.

b. Rollover contributions from other plans

These contributions are frequently accepted by 401(k) plans. Prior to recent changes in the law, improper rollovers threatened plan qualification.

c. After-tax voluntary employee contributions

These contributions were frequently used in the past but are no longer as common today.

D. Employer contributions

a. Matching Contributions. Choosing an appropriate matching contribution is an intricate process. Many experts advise starting with no match or a low one, since it can always be increased but once established may be difficult to reduce. However, since a match can be used to motivate employees, increase employee participation and help reduce any 401(k) employer contributions that may be needed to pass the ADP/ACP tests, provisions for a match may be advisable when establishing the plan.

b. Employer Profit Sharing Contributions. These contributions are subject to the aforementioned limitations. They can be discretionary. The profit sharing plan contribution can be allocated on a uniform basis to eligible participants or weighted by compensation, age, length of service or other criteria.

i. Uniform Allocation. Usually, the profit sharing contribution under this approach is allocated in proportion to the compensation of the plan's participants.

ii. Non-uniform Allocation. Under an "integrated" approach, a higher percentage of compensation is allocated to higher-compensated employees by giving them an additional contribution on compensation in excess of a stated amount (frequently the Social Security wage base). Under an age-weighted approach, a higher percentage of compensation is allocated to older employees by using defined benefit plan techniques. Under a "points" approach, a weighted average of service and compensation is frequently used to allocate the contribution.

c. Allocations of Contributions

Employer contributions may be restricted and not allocated to participants who do not complete 1000 hours of service in a year or are no longer employed by the company at the end of the year. However, this may result in the plan failing to satisfy the coverage requirements regarding "non-highly compensated employees." A safeguard provision must be included in the plan document to add a contribution for enough of these otherwise ineligible participants to satisfy these requirements.

E. Forfeitures Employer contributions which are not fully "vested" in the employee (please see the discussion below) are frequently forfeited upon termination of service and allocated to the remaining participants. They can also be used to reduce employer contributions or pay 401(k) plan expenses.

II. Design Aspects Relating to Funds Within the 401(k) Plan

1. Vesting

2. Investment of Funds

1. Vesting requirements

Although participants are always "vested in" (entitled to) 100% of their contributions, the employee is not always entitled to the accumulated value of the employer's contributions. A vesting schedule must be adopted indicating the vesting percentage of each 401(k) participant concerning the value of the accumulated employer contributions. Some basic vesting choices are:

a. For "top-heavy plans" (those in which the value of the accounts of the "key employees" are greater than 60% of the value of the accounts of all employees), a vesting schedule that is at least as liberal as one that provides for 100% after 3 years of service or a 6-year graded vesting schedule (increasing 20% a year and starting in the second year) must be chosen.

b. For plans that are not top-heavy, a vesting schedule at least as liberal as one that provides 100% after 5 years of service or a 7- year graded vesting schedule (increasing 20% a year beginning in the third year) must be chosen.

Frequently, full and immediate (100%) vesting is selected by the employer. This creates employee appreciation of the plan and prevents resentment arising from employees not being entitled to accumulated employer contributions already made on their behalf. If there is high turnover, the use of a vesting schedule may substantially lessen employer costs, since non-vested amounts are forfeited after employees terminate service.

2. Investment requirements and allocation of earnings

It is important to establish the way plan investments should be managed. There are three basic considerations when making these decisions. A more detailed analysis is presented in our 401(k) Investment Guide:

A. Employer-directed pooled investments versus participant-directed investments Factors to consider when making this decision may include:

i. Fiduciary and recordkeeping concerns of the employer. By satisfying the requirements of Section 404(c) of the Internal Revenue Code and offering participant-directed accounts, the employer can reduce exposure for investment losses by the participants. A pooled approach will require less sophisticated recordkeeping. If investments are in one family of funds, the requirements of the service provider frequently dictate the use of a pooled or participant-directed approach.

ii. Needs of the participants. If a considerable portion of the plan contributions are employee money, the 401(k) participants may want to control their funds.

B. Investment selections Investments may be limited to a single fund, a family of funds or almost any investment allowed by law.

Fiduciary and recordkeeping concerns will affect the scope of 401(k) investments. In addition, investments will be limited by plan service providers. Mutual funds which are chosen to provide services for the plan may frequently limit investments to their family of funds. In addition, the ability of participants to change their investments at least four times a year under a participant-directed approach must be addressed.

C. Frequency of valuation of investments Investments can be valued using a daily or periodic approach. Daily valuations require a more sophisticated recordkeeping system and are not offered by all 401(k) service providers.

III. Design Aspects Relating to Funds Exiting the 401(k) Plan- Distributions

1. Payment Upon Separation From Service

A. Time of Payment

B. Form of Payment

2. Payments while in Service

A. Hardship Distributions

B. Loans

1. Payment Upon Separation From Service. On separation from service such as retirement, termination of employment, death or disability, participants usually prefer to receive the vested account balance from a 401(k) plan in a lump sum and transfer this amount to an IRA to avoid immediate taxation.

A. Time of payment Though some former participants may prefer to leave their funds in the 401(k) plan until retirement, most desire to receive a distribution upon separation from service. However, an employer may consider the ability of the participant to obtain funds prior to an actual retirement date as a temptation to use them prematurely. In these situations, the employer may require that distributions be deferred to the date of the participant's normal retirement age (or age 65, if earlier) or completion of 10 years of participation in the plan, whichever is later.

B. Form of payment Benefit payments can be payable as a lump sum, annuity or in installment distributions. An employer's adopting a lump sum option allows the employee to control the plan proceeds, which can be transferred directly into an IRA where the participant can control the investments and avoid immediate taxation. In most small plans and many larger ones, employers also prefer this option, which eliminates future recordkeeping and administration and may limit resentment from employees who may argue that the account belongs to them and should be under their control.

2. Payments While in Service. Participants may obtain in-service distributions through loan or hardship provisions only if the plan document provides these features. Spouses of participants in a divorce may be awarded a portion of the participants' account through a Qualified Domestic Relations Order (QDRO). In-service distributions represent additional paperwork and recordkeeping but may be justified if they meet the needs of employees.

A. Hardship distributions Since the laws governing these distributions are complex and violations can result in plan disqualification, an employer may not wish to adopt hardship provisions in the 401(k) plan despite employee pressure. However, hardship provisions are widespread and can contribute substantially to the plan's appeal.

B. Loans Loan provisions are offered by most 401(k) plans and may lead to fewer difficulties than hardship provisions. Despite recordkeeping and other administrative requirements, loans frequently encourage additional employee participation and appreciation by meeting financial needs that may occur prior to retirement. If they are offered, a loan policy must be established, loans must be available to all participants on a reasonably equivalent basis and meet strict constraints and requirements.

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