Is a Traditional 401k Plan Right For You?
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. ADP Testing - Any eligible employee can contribute up to the maximum amount allowable by law per year, but how much each actually contributes is the thing that interests the IRS. Specifically, the agency does not want to see highly compensated employees contributing substantially higher portions of their income than do lower compensated employees. The contributions used for ADP testing include 100% vested contributions. The ACP is performed in the same way as the ADP test, and the parameters for passing are the same. The ACP for each group of employees (highly compensated/non-highly compensated) is the average of the actual contribution ratios (ACRs) for the employees in that group. The ACR for each employee is the ratio of his or her employer match to their compensation for the year, expressed as a percentage. As with the ADP test, an employee who is eligible but receives no match is included in the calculation with an ACR of zero. Information provided by Internal Revenue Service - Department of the Treasury
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