Ch. 3
Module 3 Profit-Sharing and Other Defined Contribution Plans
TOPIC 3.1: TRADITIONAL PROFIT-SHARING PLANS
Reading: Traditional Profit-Sharing Plans
LO 3.1.1: Describe the characteristics and benefits of traditional profit-sharing plans.
A traditional profit-sharing plan is a qualified defined contribution plan featuring a flexible, discretionary employer contribution provision. Accordingly, the employer’s contribution to the plan each year may be purely discretionary or based on some kind of formula related to the employer’s profits. Discretionary contributions are not strictly tied to profits. The employer can choose to make profit-sharing contributions even if there were no profits that year. In this case, the contributions would come from retained earnings or current cash flow. Also, the employer is not required by law to make profit-sharing contributions for any individual profitable year. Regardless, as a qualified plan, contributions must still be made in a nondiscriminatory manner so as not to violate the coverage rules discussed in Module 1. In addition, for a profit-sharing plan to remain qualified, Treasury Regulations require that contributions be made on a substantial and recurring basis. This is usually interpreted to mean that a contribution must be made in three of every five years. Annual contributions to a participant’s account are limited to the lesser of 100% of employee compensation or $72,000 (2026) with only the first $360,000 (2026) of employee compensation taken into account. The most common formula for profit-sharing contributions provides for contributions to be allocated to individual participant accounts on a pro rata basis determined by a given participant’s includible compensation in relation to the aggregate includible compensation of all participants. The deduction for employer contributions is limited to 25% of aggregate includible compensation.
Similar to individual retirement accounts, a nonrefundable income tax credit is available for worker elective contributions made to a 401(k) plan, 403(b) plan, 457 plan, SIMPLE, or SARSEP. It is called the retirement savings contribution credit (saver’s credit). The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution. The credit is available to individuals who are age 18 or over, other than full-time students and individuals claimed as dependents by another taxpayer. The maximum annual contribution eligible for the credit is up to $2,000, depending on the taxpayer’s adjusted gross income and filing status for the tax year. The amount of the contribution eligible for the credit is reduced by taxable distributions from 401(k) plans, 403(b) plans, 457 plans, SIMPLEs, SARSEPs, traditional IRAs, or Roth IRAs.
A major advantage of any profit-sharing plan (including one with a Section 401(k) feature) is the option of in-service distributions, or the ability of the participant to access the individual account balance prior to retirement. This option for certain in-service distributions is not a federal mandate. The employer makes the decision whether or not to include in-service withdrawals when the plan document is accepted. Most profit-sharing plans only allow in-service withdrawals for hardship withdrawals or after age 591⁄2. Also, hardship withdrawals can always be permitted
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for employee elective deferrals. Since 2019, QNEC, QMAC, and safe harbor employer contributions can also be made available for hardship withdrawals if the plan document allows. QNECs and QMACs were briefly discussed in Module 1. Another major change that started in 2019 is that the earnings on these sources (including elective deferrals) are also allowed for hardship withdrawals. What about employer contributions? The IRS maintains that an employer may allow workers to have access to their vested balances from employer contributions and the earnings on the employer contributions. This would be included in the plan document. Next, prior to 2020, a retirement plan that allowed hardship withdrawals could force the participant to take a retirement plan loan before allowing a hardship withdrawal. Under the TCJA, this restriction is no longer required. Also, the plan could prevent the worker from contributing for the next six months. This is no longer allowed. Now, a worker who receives a hardship withdrawal can continue contributing into the retirement plan.
A hardship withdrawal must meet the following tests: „ Financial needs test: the hardship must be due to an immediate and heavy financial need of the participant-employee.
„ Resources test: the participant must not have other financial sources sufficient to satisfy the need.
In addition to meeting these tests, the money may only be withdrawn for the following reasons: „ Payment of unreimbursed medical expenses or funeral costs (not just those above 7.5% of AGI limit that are deductible)
„ Disasters that have been declared by the federal government „ Purchase of a primary residence „ Payment of higher education expenses for the participant, the participant’s spouse, dependent children, or beneficiaries
„ Payment necessary to prevent foreclosure on the participant’s primary residence The definition of need includes any federal and state income taxes and penalties.
PROFESSOR’S NOTE You can remember the potentially eligible hardship withdrawal expenses by the saying, “My disastrously faulty emergency
fund.” “My” is for medical and funeral expenses (unreimbursed). “Disastrously” is for federally declared disasters. “Faulty” is for buying a “first home” in the sense of a primary residence. This is NOT the same definition as a first-time homebuyer for exceptions to the 10% early withdrawal penalty for IRAs. Also, hardship withdrawals
can only be used for a primary residence—never a second home. “Emergency” is for education (higher education) expenses. “Fund” is for foreclosure of the primary home.
Hardship withdrawals can be thought of as “my disastrously faulty emergency fund” because they should not be thought of as the emergency fund at all. However, hardship withdrawals are often used when a true emergency fund has not been established. Hardship
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withdrawals are not a proper emergency fund because they are taxed and penalized. Worse still, the principal and the forgone earnings will not be available for retirement. Next, unreimbursed medical expenses are not exactly the same as deductible medical expenses. Hardship withdrawals are available for unreimbursed medical expenses whether or not they rise to the amount relative to AGI that allows some of the expenses to be deducted. On the other hand, the requirement that a financial need be “immediate and heavy” means low-level, routine unreimbursed medical expenses do not qualify. Hardship withdrawals are actually a plan document issue. Retirement plans are not required by law to offer hardship withdrawals. In fact, if hardship withdrawals are allowed, the plan has the ability to include or exclude any of the five reasons. These five reasons are simply withdrawal methods the IRS or a court have permitted in the past and therefore should be thought as similar to a safe harbor provision for hardship withdrawals.
Finally, if a hardship withdrawal is approved and made, the distribution is taxable and a 10% early withdrawal penalty will apply for all distributions except for deductible unreimbursed medical expenses—those medical expenses exceeding 7.5% of the person’s AGI, and qualified disaster withdrawals. Also, hardship withdrawals attributed to Roth contributions are neither taxed nor penalized. Note that SECURE 2.0 has some provisions for getting emergency money without using hardship withdrawals. Hopefully, they will lessen the need for hardship withdrawals.
PROFESSOR’S NOTE Notice that hardship withdrawals for higher education expenses are
subject to the 10% early distribution penalty. This is different from IRA withdrawals for qualified higher education expenses. Traditional and Roth IRA withdrawals used for qualified higher education expenses are exempt from the 10% early distribution penalty. The exception to the 10% early withdrawal penalty for unreimbursed medical expenses only applies to amounts over 7.5% of AGI. For example, Sally, age 45, has an AGI of $100,000. She took a hardship withdrawal distribution from her employer retirement account of $17,500 for unreimbursed medical expenses. She is income taxed on the entire $17,500. She owes the 10% penalty on $7,500, but not on the $10,000 that is above 7.5% of her AGI. These results would also apply if she would have taken the $17,500 from her traditional IRA. In 2020, Congress made 7.5% of AGI the permanent percentage for the exception to the 10% penalty for medical expenses.
Profit-sharing plans have no legal limit on the percentage of contributions that can be invested in the employer’s securities. In this sense, they are not subject to the ERISA diversification requirements relative to employer securities that apply to pension plans—nor are profit-sharing plans subject to the minimum funding requirements. Finally, since they are not a defined benefit plan, they are not covered by the PBGC.
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When to Use a Profit-Sharing Plan A traditional profit-sharing plan may be appropriate when „ an employer’s profits, or cash flow, fluctuate from year to year. In the CFP world, cash flows fluctuating means sometimes there are annual losses and sometimes gains. Requiring retirement plan contributions in the face of a large loss would be very difficult on the enterprise;
„ an employer wishes to implement a qualified plan with an incentive feature by which an employee’s account balance increases with employer profits;
„ the majority of employees are young (under age 50) and have substantial time to accumulate retirement savings; or
„ the employees are willing to accept a degree of investment risk in their individual accounts.
EXAMPLE: Profit-sharing plan Joe, age 40, owns a business with sporadic income. Sometimes he does well, but in other years the company loses money. Joe knows he needs to be saving for his own retirement and he would like to help his employees with their retirements if possible. Should Joe implement a pension plan or a profit-sharing plan? Pension plans and profit-sharing plans have several industry definitions. In this case the question is asking if the retirement plan should have a mandatory annual contribution or flexible annual contributions. With sporadic earnings, Joe’s best choice would be some retirement plan from the profit-sharing category. While there are several types of plans in this category, clearly the entire pension plan category is inappropriate. Thus, all the “Be my cash target plans” (benefit in defined benefit, money purchase, cash balance, and target benefit plans) should be eliminated.
PRACTICE QUESTIONS
Choose the best answer for the following questions. The answers can be found at the end of this module. 1. Which statement about a traditional profit-sharing plan is FALSE? A. Profit-sharing plans are qualified defined contribution plans. B. Profit-sharing plans are suitable for companies that have unstable cash flows.
C. A company that adopts a profit-sharing plan is required to make contributions each year.
D. Company profits are not a prerequisite for employer contributions. 62
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TOPIC 3.2: OTHER TYPES OF PROFIT-SHARING PLANS AND EMPLOYEE STOCK OWNERSHIP PLANS (ESOPs)
Reading: Age-Based Profit-Sharing Plans and New Comparability Plans
LO 3.2.1: Distinguish the advantages and disadvantages of age-based profit-sharing plans and new comparability plans.
Age-Based Profit-Sharing Plan An age-based profit-sharing plan is a profit-sharing plan in which allocations to participants are made in proportion to the participant’s age-adjusted compensation. It is an example of a cross-tested plan where compliance with the nondiscrimination rules is tested in accordance with benefits rather than contributions. In other words, cross-tested plans start out like a defined benefit plan and then finish as a defined contribution plan. Under such a plan, each participant’s compensation is weighted by an age factor. The employer contribution is then allocated to create an actuarially equivalent benefit at the normal retirement age under the plan for each participant (typically, when the participant reaches age 65). A participant’s compensation is age-adjusted by multiplying the participant’s actual compensation by a discount factor based on the participant’s age and the interest rate elected by the plan sponsor. As a result, older employees (the business owner is usually among them) receive the greatest allocation.
An age-based profit-sharing plan is most appropriate when the business owner is significantly older than most of the employees and wishes to skew the annual contribution on his behalf without violating the nondiscrimination rules. When a profit-sharing plan is age-weighted, however, the business owner is still limited to a dollar contribution of the lesser of $72,000 (2026) or 100% of compensation with no more than $360,000 (2026) of annual compensation taken into account for plan contribution purposes.
New Comparability Plan A new comparability plan is a flexible, tailored type of cross-tested profit-sharing retirement plan in which the employee-participants are divided into nondiscriminatory groups or classes. Common group classifications used include owners and executives, highly compensated and non-highly-compensated employees; job titles/categories; age; or years of service. Each group or class typically receives a different level of employer contribution as a percentage of compensation. The plan works particularly well when there is more than one owner of a business, with the owners having substantially different ages, thus precluding the age-based profit-sharing approach. However, a new comparability plan can also work when there is not a wide disparity of ages among the owners. Still, for test purposes. a big difference in ages for the owners or decision makers can differentiate a new comparability plan from an age-based profit-sharing plan.
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Because the new comparability plan is a form of a cross-tested plan, it may also be tested for nondiscrimination on the basis of benefits rather than contributions, thus permitting considerable flexibility in plan design. The goal of a new comparability plan is often to skew plan contributions in favor of highly compensated, key employees, management, and owners. Nondiscrimination is partly achieved by ensuring the different categories have acceptably “equivalent benefit accrual rates” (EBARs). The details of EBARs are beyond the scope of the CFP® education program.
In addition to acceptable EBARs, a new comparability plan will only satisfy the nondiscrimination rules if the plan design satisfies one of two minimum gateways: 1. Each eligible non-HCE must receive an allocation of at least 5% of compensation.
2. If the plan provides an allocation rate of less than 5%, the minimum allocation rate for non-HCEs is one-third of the highest allocation rate under the plan. For instance, if the top allocation rate is 12%, the minimum allocation rate for non-HCEs would be 4% (12% divided by 3).
EXAMPLE: New comparability plan Peter is a 27-year-old technical genius who produces top video games. However, he is consumed with his technical work and would be terrible as the CEO of his company. Beth is 50 and an incredible business person. She knows how to run a business, but she does not know how to invent the products. These two owners need each other, but their different ages are a challenge for traditional retirement plans. An age-weighted profit-sharing plan would contribute far more to Beth’s retirement each year than Peter’s. A normal profit-sharing plan would not contribute enough for Beth. A deferred compensation plan would work for Peter and Beth, but the company needs a retirement plan to attract quality workers. This is the classic scenario for a new comparability plan. Peter and Beth can both receive large contributions to their retirement accounts as long as the total plan meets one of the gateway tests. The rank-and-file workers win with a 5% contribution or at least a third of the plan’s largest contribution percentage. These contributions are better for the workers than the owners having a deferred compensation plan and the workers not having any retirement plan or a very low match in a 401(k) plan.
This example combines a large difference in the ages of the power players. However, new comparability plans can also be used when the power players have similar ages, especially if they are young. The major point is that new comparability plans allow the firm to give some categories of employees more than other categories. However, the government allows a certain amount of differentiation as long as the plan follows the rules concerning EBARs (the Equivalent Benefit Accrual Rates) and it passes one of the gateway tests. The details around EBARs are beyond the scope of the CFP® program. Essentially, new comparability plans focus on ensuring the rank-and-file workers get a certain level of benefits and then allow certain, higher limits for the for the power players.
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PROFESSOR’S NOTE Essentially, the new comparability plan is a trade-off. The nondiscriminatory rules are relaxed in exchange for a presumably higher contribution rate for the rank-and-file workers.
Cross testing means using defined benefit mechanisms for determining the contributions to a defined contribution plan. The hope is that the higher contributions for older workers will be offset by the younger workers having more time for their benefits to accrue to roughly the same level.
Reading: Stock Bonus Plans and Employee Stock Ownership Plans (ESOPs)
LO 3.2.2: Analyze the benefits of employee stock ownership plans (ESOPs) as they relate to profit-sharing plans.
Stock Bonus Plan A stock bonus plan is a type of profit-sharing plan with one major difference from a traditional profit-sharing plan: the employer contributions and benefits distributed from the plan are generally made in the form of employer stock, not in cash. In a stock bonus plan, the employer contributes either cash or employer securities to the individual participants’ accounts in accordance with normal defined contribution rules and limitations. A stock bonus plan is appropriate for an employer with unstable cash flow who does not wish to deplete needed cash and, instead, wishes to make contributions in the form of listed or closely held stock.
A major employee tax advantage of participating in a stock bonus plan is the ability to defer net unrealized appreciation (NUA) on employer securities if the distribution of the stock is in a lump sum. To receive NUA treatment, the departing worker must elect to receive the stock in shares instead of cash. This election is made by the worker with the plan administrator in the distribution paperwork. The shares received cannot be rolled over while cash received from the stock bonus plan can be rolled over to allow continued deferral of income tax. Under the NUA tax benefit, participant retirees are not taxed on the full FMV of employer stock when it is distributed. Instead, the NUA is always and without fail taxed as long-term capital gain when the participant or beneficiary subsequently sells the stock. At the time of distribution, the participant recognizes as ordinary income an amount equal to the cumulative value of the stock at the times of contribution. This ordinary income recognition when the stock is irrevocably distributed outside of any possible retirement account establishes a tax basis in the employer stock for the employee-participant that is recovered tax free as a return of basis upon sale of the stock from the person’s normal brokerage account (as opposed to an IRA or other type of retirement account). Any further appreciation of the stock subsequent to the time of the lump-sum distribution is then subject to short-term or long-term capital gain tax treatment, depending on the holding period after the lump-sum distribution. If the stock is held longer than a year, then the gain since the distribution is treated as a long-term capital gain. If the person sells the stock within a year or less from the date of distribution from the plan, any gain since the distribution will be treated as a
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short-term capital gain. The NUA portion of the lump-sum distribution will always be treated as long-term capital gain, regardless of the holding period after the lump-sum distribution. Next, any losses after the date of distribution will be be taken out of the NUA amount (reduce the NUA amount) and the person will not have as large a long-term capital gain when the shares are sold. Finally, the NUA amount is not stepped-up at death. Thus, the heir’s basis after death is the FMV on the date of death minus the NUA amount.
There are disadvantages associated with investing so much of a retirement plan’s assets in employer stock. The existing owner experiences the dilution of their shares. However, the primary risk/disadvantage for the plan participant is holding a concentrated (largely undiversified) portfolio. This risk is especially important if the company goes bankrupt or performs poorly (like Enron or Worldcom).
There are several strategies to address an excess amount of risk due to being invested too heavily in the ex-employer’s stock in an NUA situation. First, the risk can be partially mitigated after the stock is distributed using covered calls. A covered call would provide some income if the stock does not appreciate. This can also cushion a small fall in the stock price (a fall equal to the premium received). If the stock does appreciate, the NUA holder is paid something extra (the premium) above the exercise price when the stock is sold. Thus, a covered call can help a client decide to sell a stock they need to sell because they are looking to diversify.
A second strategy would be to sell the shares over time. Essentially, a large position in the single stock could be sold according to a predetermined plan. For example, Maya has $1 million of her former employer’s stock. It has $900,000 of NUA. She could sell the shares at a rate of 25% per quarter over the next year. That would give her some time diversification. If the stock appreciated during the year, she would benefit from some of the appreciation. If the stock dropped over the year, at least she would have sold some of the shares at the higher earlier prices. Also, selling the concentrated position over more than one tax year could lower her capital gains taxes over time. Still, the main point of having a predetermined strategy to sell the stock over time is to lower the undue risk from having too much money in a single stock. Any side benefits or losses are secondary.
A third strategy for dealing with an excessive concentration like an NUA situation involves setting prices below the current FMV at which to sell or at least attempt to sell the stock using stop-loss and sell stop-limit orders. These orders involve selling some or all of the position whenever the current FMV drops to a specified price. A stop-loss order instructs the broker to sell the stock if it falls to the set price. When the stock price falls to the stop-loss price, the order becomes a market order. That means the stock will be sold at whatever the market price is when the market order is executed. In a severe bear market, the final price at which the stock is sold may be well below the stop-loss price.
Continuing with Maya’s situation, if she set the stop-loss at $50/share when the stock was selling for $60/share, nothing would happen as long as the shares were worth more than $50/share. However, if the price fell to $50, the stop-loss order would become a market order. If the price fell further down to $44 before her market order was executed, she would end up selling those shares for $44/share.
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A second type of stop order is a sell stop-limit order. A sell stop-limit order is also set below the current FMV of the stock. Again, nothing happens until the stock falls to the stop-limit price. If that happens, the order is switched to a limit order instead of a market order like a stop loss order. A sell limit order would sell the stock for the stop price or higher. If the stop-limit order could not sell the stock at a price at or higher than the stop price, then the shares would not be sold. For example, in Maya’s situation above, her stop-loss order would have ended up selling her stock for $44/share, but a sell stop-limit order would not sell the shares unless the price rose back to $50 or more. Usually a stop-loss order will end up selling the shares somewhere close to the stop price; however, in an extremely volatile market, a stop-loss could sell the position well below the stop price. That would be bad for Maya if the market immediately turned around, but it would be great if the market dropped substantially below $44/share. For example, if her stock dropped to $10, Maya would be thrilled she got out at $44. If she had placed a sell stop-limit order at $50/ share, she would still have the shares when they were worth only $10/share. That could be life-changing for her.
Employers that sponsor qualified plans in which a portion of the plan accounts are invested in the employer’s publicly traded stock must permit participants to immediately divest themselves of the stock and diversify the proceeds into other plan investments. This diversification rule is not applicable to employee stock ownership plans that do not hold employee contributions. However, if the employer’s securities are not readily tradable on an established market, a participant who separates from service must be provided a put option that will be available for at least 60 days after distribution of the stock. The option must be redeemed by the employer (not the retirement plan) and the value of the stock must be determined fairly.
EXAMPLE: Stock bonus plan
When he retired, Kurt had $1.5 million in his company retirement account. $1 million was from his 10,000 shares in company stock and $500,000 was in various mutual funds inside the company retirement plan. He had made elections as allowed over the years to diversify his retirement account. He completed the paperwork to transfer the $500,000 of mutual funds directly into an IRA. He also made the NUA election on the plan’s paperwork to distribute the 10,000 shares of company stock worth $1 million directly into his non-retirement brokerage account with his Series 7 financial planner. The fair market value of the stock contributed over the years was $250,000. This was tracked by the retirement plan and reported to Kurt when the shares were distributed.
In this example, $750,000 is treated as NUA and is not taxed upon distribution. In the year of the lump-sum distribution, $250,000 will be taxable as ordinary income.
Because $250,000 was treated as ordinary income at the time of distribution, Kurt’s adjusted taxable basis in the 10,000 shares equals $250,000. If Kurt sells shares of stock, his adjusted basis for tax purposes will equal $25 per share and any gain over the $75 per share that is NUA will be subject to capital gains tax, short or long term, depending on Kurt’s holding period since the distribution to his brokerage account. On the other hand, if Kurt eventually sells the stock for less than $100 per share, his NUA amount would be decreased by the loss.
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For example, Kurt immediately sells some of his shares for $101 per share soon after the shares arrived in his brokerage account. He will not be taxed on $25 per share from the sale of the shares because he was already income taxed as ordinary income on $25 per share on all 10,000 of his shares when the shares were originally distributed. He has a long-term capital gain on $75 per share due to this being the NUA amount/share. He also has a short-term capital gain on $1 per share.
More than a year after the shares were distributed, Kurt sold some of his shares for $110. He is not taxed on $25 per share because that became his basis when he was taxed as ordinary income on the $25/share when the shares were distributed. The NUA of $75 per share is always considered long-term gain by definition. His final $10 per share is also considered a long-term capital gain because he waited a year and a day or longer to sell these shares.
If Kurt sold shares at any time for less than $100 per share, it would reduce his NUA amount. For example, Kurt sold shares at $90 per share. His basis was $25 per share, so his long-term capital gain from NUA is $65 per share.
Since NUA amounts are already tax advantaged, they do not receive a stepped-up basis if he dies holding the shares. For example, if Kurt never sold any of the shares and he died when they were worth $3 million, his heir would receive the shares with a stepped-up basis of $2,250,000 ($3,000,000 - the $750,000 NUA amount). Finally, if Kurt separated from service after attaining age 55, he would not be subject to the 10% EWP on NUA distributions. For example, if Kurt was 52 when he separated from service and made the NUA election, he would not only owe ordinary income tax on the $250,000, he would would also owe $25,000 due to the 10% EWP. If he had attained age 55 (meaning he would be 55 on December 31st of the year he separated from service), he would not owe the 10% EWP.
TEST TIP
A test question can signal the NUA election either by stating that the person made the NUA election or by the fact that shares were distributed out of the company retirement account. The only way shares (instead of cash) can be distributed is by the former plan participant making the NUA election at the initial withdrawal.
Employee Stock Ownership Plan (ESOP) An employee stock ownership plan (ESOP) is a type of stock bonus plan in which individual participant accounts are invested primarily in employer stock. It has a unique advantage over every other type of qualified plan in that the ESOP may borrow money in the name of the plan without violating the prohibited transaction rules against a retirement plan borrowing money. If the ESOP does borrow money in the plan’s name, it is commonly referred to as a leveraged ESOP (LESOP) and engages in a series of transactions, shown in the following diagram.
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Figure 3.1: Leveraged ESOP Transactions 1. Cash $ 6. Stock
Guarantee of loan or direct loan to corp.
Corporation 1. The plan trustee secures a bank loan.
2. The plan trustee purchases employer stock with loan proceeds. 3. The stock is pledged as loan collateral.
4. With the cash from the stock sale, the employer makes a contribution to the ESOP. 5. The employer’s cash contribution is used to pay off the loan. 6. The bank releases the stock to the ESOP.
Important observations regarding the previous diagram include the following: „ The employer stock is pledged as collateral for the loan secured in the name of the ESOP; thus, an ESOP is only appropriate for an incorporated business (a C or S corporation).
„ With the cash from the sale of the stock, the employer makes a cash contribution to the ESOP; thus, in selling the stock to the employees of the business, the employer is now making them owners of the business.
„ A market is created for employer stock that helps improve the marketability of the stock for existing shareholders; thus, an ESOP is appropriate for creating a market for stock (particularly for closely held stock). A normal ESOP can also increase the marketability of the employer stock. However, a LESOP can be used to sell a larger quantity of the employer stock upfront. Thus, a LESOP can be especially helpful if owners are nearing retirement and want to sell a major portion of their stock quickly.
When plan participants take distributions from the ESOP, participants have the right to demand that the distribution be in the form of the employer stock. If the stock is not publicly tradable, participants may require the employer to repurchase the employer stock using an actuarially determined formula to determine the fair market value. The forced sale is referred to as a put option or a repurchase option in the ESOP. The repurchase or put option must be available for the 60-day period immediately following the stock distribution and for 60 days in the following plan year.
Like the stock bonus plan, an ESOP provides the tax advantages of NUA for employer stock distributed in a lump sum to employee shareholders.
A LESOP is the only qualified defined contribution plan that can fund more than 25% of the employees’ includible compensation. The normal contributions to a LESOP have the 25% limitation. However, interest on the plan loan can mean the total contribution to the LESOP is more than 25% of employee compensation.
Module 3 Profit-Sharing and Other Defined Contribution Plans
A shareholder can obtain tax benefits by selling stock to an ESOP plan. „ The shareholder who reinvests the proceeds received from the ESOP sale in domestic securities pays no current capital gains. This allows the shareholder to create a diversified retirement portfolio from a previously nondiversified investment without tax consequences.
„ Nonrecognition of capital gains on the sale of stock by a shareholder to an ESOP occurs if all of the following three requirements are met. a. The ESOP must own at least 30% of the stock (either of each class or of the total value).
b. The owner must have held the stock for at least three years before the sale. c. Qualified replacement property must be purchased within one year after the sale (or three months before the sale).
These conditions pertain to publicly traded domestic stock as well as privately owned stock.
An ESOP is a rather costly and complex retirement plan and is most appropriate when
„ the employer wishes to make the employees owners of the business through a tax-advantaged means and at a relatively low cost. While an ESOP has the advantage of using stock instead of cash as the contribution to the ESOP, other features like the put option and valuing the stock can be costly and administratively complex;
„ the employer wishes to provide an advantageous vehicle for the company to borrow money for business needs such as an expansion, etc.; and
„ the owner of the business wants to engage in estate and financial planning that creates a market for the stock (at the expense of having additional shareholders).
A disadvantage of an ESOP is that the employer stock may be a very speculative investment. The inherent risk can create employee ill-will because either the plan is not considered valuable by employees or employees expect too much from the plan.
As mentioned in Module 1, an ESOP may not be integrated with Social Security. That is because Congress determined that ESOPs already had enough advantages for the owners.
PROFESSOR’S NOTE A LESOP works especially well for a closely held company where the major owner needs cash out of the company for their impending retirement because the closely held company owner can sell a lot of shares all at once to the ESOP. These shares are collateral for the original loan. Over time, the company contributes cash to the LESOP to fund the workers’ retirement. The LESOP uses the cash to repay the loan. The loan payments gradually free the individual retirement accounts of this lien.
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Module 3 Profit-Sharing and Other Defined Contribution Plans TOPIC 3.3: SECTION 401(K) PLANS
Reading: Traditional 401(k) Plans LO 3.3.1: Recognize the characteristics and tax benefits of traditional 401(k) plans.
The plural of the Section 401(k) heading is used here because there are actually five types of Section 401(k) plans. They are the „ traditional Section 401(k); „ safe harbor Section 401(k); „ SIMPLE 401(k); „ Roth 401(k); and „ starter 401(k).
Traditional Section 401(k) Plan
A traditional Section 401(k) plan is also known as a qualified cash or deferred arrangement (CODA). It is a qualified profit-sharing or stock bonus plan under which plan participants have an option to contribute money to the plan on a pretax basis, known as an elective deferral, or receive taxable cash compensation. Although elective deferrals are not subject to current income taxation, they are subject to FICA and FUTA taxes. FICA is how Social Security benefits are funded. FICA is paid by the worker and by the employer. FUTA funds federal contributions to unemployment benefits. FUTA is only paid by the employer. 401(k) plans are allowed for all types of employers except for state and local governments. Since 1986, state and local governments have not been allowed to establish a 401(k). However, plans established before 1986 were grandfathered and thus allowed to continue. The federal government defined contribution plan is called the “Thrift Savings Plan” or “TSP.” It is like a 401(k) on the worker side without the same employer obligations as a 401(k).
As in all qualified plans, the employee is immediately 100% vested in all elective deferrals and the earnings on the worker’s deferrals. On the other hand, the employer’s contributions can be subject to the normal defined contribution vesting schedules (three-year cliff vesting and two-to-six-year graded vesting). Because the participant has the right to receive cash compensation, a Section 401(k) plan is an exception to the constructive receipt rules of income taxation. Amounts contributed to the Section 401(k) plan are not taxable until withdrawn by the participant. However, the worker must elect to contribute the money into the plan before it is earned. In other words, the election only applies to future earnings. This allows employees a degree of choice in the amount they wish to save.
Employers can deduct 401(k) profit-sharing plan contributions of up to 25% of the participating employees’ payroll. “Payroll” includes the elective deferrals and catch-up contributions of those employees. For purposes of calculating the 25% deduction limit, employer contributions are defined as nonelective contributions, matching contributions, and discretionary profit sharing contributions only. Employee elective
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deferrals and catch-up contributions are not considered to be employer contributions for this purpose. This is an advantage for an employer that wants to maximize deductible contributions to a 401(k) plan. Plus, it works in favor of employee-participants who want to maximize their plan contributions.
Employer contributions are limited by the maximum annual addition rules covered in Module 1. Thus, the total contribution for an individual employee is usually limited to the lesser of 100% of compensation or $72,000 in 2026 according to Section 415 of the Tax Code. The maximum annual addition is made up of employer contributions, employee contributions, and reallocated forfeitures. Age-related catch-ups are not included in the $72,000 (2026) annual limit. The age 50+ catch-up for 2026 is $8,000. The catch-up for ages 60-63 in 2026 is $11,250. Thus, the maximum that can be contributed to a 401(k) in 2026 is $80,000 for those 50 and older and $83,250 for those 60-63. However, if asked about the limit on a test, the answer is $72,000 for 2026 unless the question specifically addresses the catch-up amount because Section 415 does not include the age 50 catch-up or the age 60-63 catch-up.
As of 2026, the retirement plan catch-up for those 60-63 for most types of plans will increase to the greater of $10,000 or 150% more than the 2024 catch-up amount. 150% of the 2024 catch-up is also “50% more than the 2024 catch-up.” The $10,000 started being indexed in 2026. The number for 2026 is $11,250.
SECURE 2.0 was partially funded by the age related catch-ups for employees making more than $145,000 (indexed) subject to FICA (W-2 wages) in the previous year from the current employer only being allowed to be Roth contributions. This includes SIMPLE 401(k)s, SIMPLE IRAs, 403(b)s, and 457 plans. This was originally supposed to take effect in 2024, but the IRS delayed implementation until 2026. The indexed number for workers in 2026 is $150,000 earned in 2025. In other words, 2026 age-related catch-up contributions are limited to Roth elective deferrals for people who had W-2 earnings of $150,000 or more in 2025. One benefit to this rule is that most of the remaining 401(k)s that did not offer Roth elective contributions are being amended to allow them. Without this amendment, higher earners would not be allowed to make age-related catch-up contributions at all starting January 1, 2026. Government and union plans have until January 1, 2027. Also, note that the $145,000 (indexed) is $150,000 in 2025 for contributions for 2026. This threshold amount or more must have been earned from the employer with the retirement plan. Thus, the rule does not apply to people in their first year with a new employer as long as the new employer is not related to their former employer. Also, the restriction might not apply to a higher earner who was hired late in the previous year. The final regulations for this issue were published in September 2025. Finally, this provision does not apply to the self-employed, only to workers with wages subject to FICA. That means they received W-2 income.
The maximum amount that may be contributed to the Section 401(k) plan by the participant is specified by law and is indexed for inflation. The maximum elective deferral is $24,500 (2026). Participants at least age 50 by the end of the year can make additional catch-up contributions of $8,000, and $11,250 for those 60-63 in 2026. As discussed earlier, an employer can make additional contributions to the participant’s account in the form of matching contributions or profit-sharing contributions. An employer can also commit itself to contribute a set amount even if the worker does not contribute to the 401(k). For example, an employer can
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contribute 3% to all eligible worker’s 401(k) amount regardless of whether or not the worker defers money into the plan or not. This is called a nonelective contribution. The firm can raise, lower, or even eliminate this commitment each year.
Employer-matching contributions are typically a dollar-for-dollar match or $0.50 match for each dollar the participant defers, up to a specified limit.
As a type of profit-sharing plan, a 401(k) can offer in-service and hardship withdrawals as described in LO 3.1.1. Plan loans are also available with 401(k) and 403(b) plans if the plan document chooses to allow loans. Retirement plan loan information is found in LO 6.3.2. 401(k) plans can integrate nonelective contributions with Social Security as described in LO 1.3.3. However, a 401(k) match cannot be integrated with Social Security, and neither can salary deferrals.
A traditional Section 401(k) plan is appropriate when „ an employer wants to provide a qualified retirement plan for employees but can afford only minimal expense beyond existing salary costs [such a plan can be funded entirely from employee salary reductions, except for installation and administration (testing) costs];
„ employees are relatively young and have substantial time to accumulate retirement savings; and
„ employers want to encourage employees to save for their own retirement. Some of this is the company being socially responsible, but it also helps the employer guard against older employees who stay too long because they cannot afford to retire. Retirement plan contributions are also an important recruitment and retention tool.
Pension Protection Act of 2006 (PPA) Automatic Enrollment in Traditional Section 401(k) Plans The PPA provides several incentives for sponsoring employers to adopt automatic enrollment in their Section 401(k) plans. Automatic enrollment, also known as a negative election, allows an employer to enroll employees in the Section 401(k) plan without the employees’ consent, as long as the employees have the right to opt out of contributing. The PPA includes safe harbor rules that would relieve a qualified automatic contribution arrangement (QACA) from special nondiscrimination testing, with lower required employer contributions than under the current safe harbor Section 401(k) plan rules. Such an arrangement will automatically qualify with Section 401(k) nondiscrimination testing if it „ provides for an automatic deferral percentage between 3% and 15% of employee compensation (if the automatic deferral percentage under the plan is less than 6%, a participant’s automatic deferral percentage must be increased each year by 1% until reaching at least 6% of compensation);
„ provides an employer contribution to non-HCEs of either an employer match of 100% of the first 1% deferred plus 50% of the next 5% or a 3% profit-sharing contribution in lieu of the matching contribution;
„ provides that the employer contributions become 100% vested after the employee has completed no more than two years of service; and
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„ requires that, within 30 days before enrollment (and annually thereafter), eligible employees must be given a written automatic enrollment notice and a qualified default investment notice and allow the employees not to make any contributions, if they so choose.
In addition, under the PPA, non-safe harbor automatic enrollment arrangements will have additional time to test for discrimination testing (under the ADP or ACP tests) and, if needed, make corrective distributions (six months after the end of the plan year rather than the normal 2.5 months).
Auto-enrollment becomes mandatory for most new employer plans when the employer has 11+ workers, and the business is at least three years old. Existing retirement plans (those in effect on December 29, 2022) are grandfathered under the old rules. Auto-enrollment for the new plans must start at 3-10% and auto-escalate at least 1%/year to 10-15%. The following types of plans are exempt from this requirement: SIMPLE plans, plans established before SECURE 2.0 was passed on December 29, 2022, employers with 10 or fewer employees; the retirement plans for any firm less than three years old (including any predecessor employers); governmental plans; and church plans. There is a $500/year credit for the first three years for employers who add auto-enrollment to their retirement plan.
PROFESSOR’S NOTE Automatic enrollment is an important topic in the real world because it is very successful in getting workers enrolled in the firm’s retirement plan.
Safe Harbor Section 401(k) Plan
Employers can avoid having to comply with special nondiscrimination testing (ADP and ACP tests) that apply to traditional Section 401(k) plans if the plan meets one of the safe harbor provisions under IRC Section 401(k)(12) and the Treasury Regulations. The safe harbor Section 401(k) plan permits a high level of elective deferrals by all employees without annual nondiscrimination testing. In addition, the safe harbor alternative is not subject to the top-heavy plan provisions. Being exempt from the ADP and ACP tests (which will be covered in the next learning objective), is highly beneficial in lowering nondiscrimination testing costs and allowing HCEs to contribute the normal amounts without restriction. This is why about 75% of 401(k)s are safe harbor 401(k)s. Safe harbor 401(k) plans are subject to the general nondiscrimination tests described in Module 1 (the percentage test, ratio test, and average benefit percentage test). Also, a mandatory minimum employer contribution is required in the safe harbor plan in which the employee must be 100% vested immediately. The two mandatory minimum employer contribution methods are
„ a nonelective contribution of 3% of compensation for all eligible employees (regardless of whether these employees are deferring salary into the Section 401(k) plan or not); or
„ an employer-matching contribution of 100% on the first 3% of non-HCE compensation plus a 50% match on the next 2% of non-HCE compensation (a total of 4%) for those non-HCEs who are actually deferring salary into the 401(k) plan. This is called the safe harbor 401(k) basic matching formula. The
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rate of matching for highly compensated employees must not exceed the rate of matching for nonhighly compensated employees. In tabular form, these matching contributions may be shown as follows.
Figure 3.2: Safe Harbor Basic Matching Formula
Employee Contribution as a % of Compensation
0% 1% 2% 3% 4%
5% or greater
Employer-Matching Contribution as a % of Compensation
0% 1% 2% 3%
3.5% 4%
Some safe harbor 401(k) plans use an enhanced matching formula. An enhanced matching formula must be at least as generous as the basic matching formula. The most common enhanced matching formula is a 100% match of the first 4% of compensation.
Notice which employer contribution plan is best for an employee’s retirement preparation. With a nonelective contribution, all eligible employees get a 3% contribution and many will not contribute to the plan. With the enhanced match, many will stop at 4%, so they will be saving 8%. With the basic match, the employee must save 5% to get the full match. Thus, a total of 9% will be saved for retirement. This is three times the nonelective contribution rate. In all, a matching formula is highly motivational for employees. Many people who think they “cannot afford to save for retirement” will save if there is a match.
Many small businesses that wish to adopt a Section 401(k) plan will opt for the safe harbor arrangement because it is less expensive to operate and does not need to be tested annually. The plan permits a high level of salary deferrals by employees without annual discrimination testing. In addition, similar to any profit-sharing plan, hardship withdrawals and loans are permitted in the safe harbor Section 401(k), a characteristic that is important to a small business owner and employee participants. Another aspect of safe harbor 401(k)s is that they must provide certain notices to eligible employees concerning their rights and obligations under the plan. The timing requirement is deemed to be satisfied if the notice is provided at least 30 days (and not more than 90 days) before the beginning of each plan year. Like all 401(k) plans, a safe harbor 401(k) only allows a maximum waiting period of one year to be eligible for the plan and only nongovernmental employers can offer a safe harbor 401(k). Finally, nongovernmental employers of any size may choose to offer a safe harbor 401(k). There is no limit on the number of employees.
PROFESSOR’S NOTE
Safe harbor 401(k)s reflect a change in the philosophy of regulation. Traditional 401(k) nondiscrimination tests were established first and are highly technical and bureaucratic. The goal of the tests is to force the company decision makers to increase plan contributions for non-HCE participants. However, an abundance of rules requires costly
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administration. The practical result can be that many employers, especially small and non-bureaucratic firms, skip having a retirement plan at all. Currently, over 40% of American workers do not have a retirement plan offered by their employer. Safe harbor regulations and other types of employer retirement accounts like SIMPLE plans, SEPs, and starter 401(k)s are an attempt to streamline employer retirement accounts by setting employer contributions at a reasonable level for workers and not fussing over the relative contributions of HCEs to non-HCEs.
EXAMPLE: Safe harbor
The DAL Corporation has a safe harbor 401(k). Steve makes $100,000 working for them and defers at least 5% in the plan. What are the minimum and maximum required contributions the DAL Corporation could make to Steve’s safe harbor 401(k)?
Minimum: The 3% nonelective contribution would be $3,000.
Maximum: The basic matching formula is 100% for the first 3% ($3,000) plus 50% of the next 2% ($1,000). The enhanced matching formula would also require a match of $4,000 when Steve contributes 4% or more.
Thus, either matching plan would cost the company $4,000 for Steve, but other workers might not contribute, so the normal matching plan would probably cost less than 4%.
Note that the basic matching plan would mean a worker contributing 5% would actually have a total savings of 9%. On the other hand, the minimum any eligible worker would have would be 3% if the employer chose the 3% nonelective formula.
PRACTICE QUESTIONS
Choose the best answer for the following questions. The answers can be found at the end of this module. 4. Elizabeth, age 54, has an annual salary of $120,000 and participates in a traditional Section 401(k) plan sponsored by her employer. The plan provides for a 50% company match on the first 6% of an employee’s salary deferred. If Elizabeth makes the maximum elective deferral for 2026 (including catch-up contributions), what additional amount can her employer contribute on her behalf without exceeding the annual additions limit? A. $24,500 B. $32,500 C. $35,900 D. $43,900
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5. Allen Equipment Co. has just implemented a safe harbor Section 401(k) plan. Which of the following can be avoided with the safe harbor arrangement? I. ADP test
II. ACP test III. Top-heavy rules IV. General nondiscrimination tests (coverage rules) A. I and II B. III and IV C. I, II, and III D. I, II, and IV
Reading: ADP and ACP Testing
LO 3.3.2: Calculate actual deferral percentages and/or actual contribution percentages to determine if a 401(k) plan meets ADP/ACP tests.
A Section 401(k) plan must not only satisfy one of the general nondiscrimination tests from Module 1 (percentage test, ratio test, or average benefits percentage test) but must also satisfy special nondiscrimination tests known as the actual deferral percentage (ADP) test and actual contribution percentage (ACP) test. Because of these tests, a traditional 401(k) plan can be relatively costly and complex to administer. In the ADP test, the employer must compare the average percentage of eligible HCEs’ pretax elective deferrals and Roth elective deferrals to the average percentage of the eligible non-HCEs’ pretax and Roth elective deferrals. (HCE means highly compensated employee as defined by more than 5% ownership or compensation above $160,000 in 2026 or $160,000 in 2025 as covered in Module 1.) In other words, the ADP test only counts what employees are actually deferring into the plan on their own. The ADP test does not count what the employer is putting into the plan directly or by matching. After-tax and catch-up elective deferrals are not considered in the ADP calculation. Using catch-up contributions would not be fair because employees cannot control when they were born. Also, not counting catch-up contributions is usually favorable to owners and upper management because they tend to be older and earn more. Thus, they are in a better position to make larger contributions. The point of the ADP test is to pressure the major decision makers to encourage the rank-and-file to save for their own futures as well. For example, the 45-year-old owner and only HCE of a small company wants to save 9% into his 401(k). Under the individual contribution test, he would be allowed to contribute up to $24,500 into the plan by salary deferral in 2026. That is his individual limit. However, 401(k) plans have more than one test, especially as regards to HCE contribution levels relative to non-HCE contribution levels. The ability for HCEs to contribute are also subject to the ADP and ACP nondiscrimination tests. In this circumstance, the HCE is not allowed to contribute 9% unless the rank-and-file workers are averaging 7% (according to the following ADP tests) or the plan will fail the ADP nondiscrimination test. Thus, the owner might establish a match of 50% for the first 8% to encourage the other workers to contribute to the plan because what the non-HCEs actually average deferring will limit the ability for the HCE to contribute the full amount they would like to save.
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counted as being worker contributions, they are immediately vested along with any earnings tied to the QMAC or QNEC contributions. As covered in LO 3.1.1, these two types of employer contributions and their earnings are now available for hardship withdrawals.
PROFESSOR’S NOTE
Emphasize the difference between QMAC and QNEC contributions versus employer-matching or voluntary employer contributions. For example, an employer puts 2% into all eligible worker’s 401(k) accounts and matches 3%. These contributions and their earnings can be subject to the vesting schedule. The feel for QMACs and QNECs is that the 401(k) is about to fail or has failed nondiscrimination testing and is being corrected. However, QMACs and QNECs are very deep for the CFP® Final and should not be overemphasized.
The ACP test applies to voluntary employer contributions, employer-matching, and employee after-tax contributions. Compliance with the ACP test is only a concern if the employer allows after-tax contributions, automatically contributes to all eligible plan participants, or matches the employee elective deferrals. If the employer does not do any of these things, only the ADP test must be satisfied. Because most employers do match employee elective deferrals, satisfaction of the ACP is also relevant for most employers sponsoring a traditional Section 401(k). The ACP test has the exact same percentage rules as the ADP test.
Figure 3.4: Summary of ACP Rules If ACP for non-HCE: Maximum ACP for HCE is: ≤ 2%
> 2%, but ≤ 8% > 8%
2 × ACP of non-HCE 2% + ACP of non-HCE 1.25 × ACP of non-HCE
403(b) plans that provide employer-matching contributions are also subject to the ACP test. In other words, if a 403(b) plan does not have an employer match, it is not subject to the ACP test. 403(b) plans usually are not required to pass the ADP test because they have a different requirement. A 403(b) must provide “universal availability,” which means they must allow any employee who will contribute at least $200/year to salary defer money into the 403(b).
PRACTICE QUESTIONS
Choose the best answer for the following questions. The answers can be found at the end of this module. 6. In a traditional Section 401(k) plan, which of the following must be considered in complying with the maximum annual additions limit? I. Employee elective deferrals
II. Catch-up contributions for an employee age 50 or older III. Qualified nonelective contributions IV. Qualified matching contributions A. I and II B. III and IV C. I, II, and IV D. I, III, and IV
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LO 3.3.3: Analyze the features, advantages, and disadvantages of SIMPLE 401(k), Roth 401(k), Solo 401(k) plans, and other types of 401(k)s.
SIMPLE 401(k)
There are two forms of the savings incentive match plan for employees (SIMPLE): a SIMPLE IRA and a SIMPLE 401(k). The more prevalent of the two is the SIMPLE IRA, which will be discussed in the next module. However, a Section 401(k) may also be structured as a SIMPLE for some employers. Employers with 100 or fewer employees earning $5,000 (or more) during the preceding year may adopt a SIMPLE 401(k). In fact, there is a two-year grace period for SIMPLEs when the employer grows beyond 100 workers. The employer usually may not maintain any other qualified or employer-sponsored retirement plan. There are two exceptions. First, if eligible, the employer can maintain a Section 457 plan (discussed in the next module) for the benefit of its employees. Second, the employer may maintain a union plan subject to good faith bargaining. However, these two exceptions should only be taken into account on a test if specifically mentioned. In general, it is true that an employer with a SIMPLE cannot also have another open retirement plan for its workers. The SIMPLE 401(k), like the safe harbor option, is exempt from the special nondiscrimination ACP/ADP tests that apply to the traditional Section 401(k) plan. Also, all SIMPLEs are exempt from top heavy testing and requirements.
Employees who participate in a SIMPLE 401(k) may make elective deferrals similar to the traditional Section 401(k) plan. However, the maximum deferral limits are less than those permitted under a traditional Section 401(k) plan. For example, in 2026, employee elective deferrals to the SIMPLE 401(k) are limited to $17,000 with a catch-up contribution for those employees age 50 or older of $4,000. Workers aged 60-63 get an enhanced catch-up. In 2026, it is $5,250. The employer-sponsor of the plan is generally limited to two choices for employer contributions. First, it can offer a 3% match. However, like all matches, if a worker contributed less than 3%, then the exact amount of the worker contribution would be matched. For example, if a worker making $100,000 defers $1,500 into the SIMPLE 401(k), then the company would also contribute $1,500. The second employer contribution option is to make a flat (nonelective) contribution of 2% of compensation for all eligible employees, even those who choose not to make elective deferrals. SECURE 2.0 added some additional employer contribution options. First, additional SIMPLE nonelective employer contributions may be made in a uniform manner to all employees up to 10% of compensation with a $5,000 maximum annual limit that is indexed. The 2026 number is $5,300. That means the up to 10% extra non-elective employer contribution covers pay up to $53,000. Second, the annual deferral limits for SIMPLE plans (both SIMPLE IRAs and SIMPLE 401(k)s) will be increased 10% from what it would normally be in 2026 for eligible firms with 25 or fewer employees. That makes the maximum under age 50 worker contribution for a firm with 1-25 workers $18,100 in 2026. An eligible firm has not had a qualified retirement plan in the last three tax years. Employers with 26 to 100 employees will qualify for the higher limit if they have a 4% match instead of the normal 3% match or if their nonelective contribution is 3% instead of the normal 2%. Workers 60-63 also get an enhanced age-related catch-up amount of $5,250 in 2026.Unlike traditional Section 401(k) employer contributions
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for which vesting schedules are permissible, a worker is always 100% vested in the contributions made to a SIMPLE 401(k) by the employer. One advantage of a SIMPLE 401(k) over a SIMPLE IRA is that a SIMPLE 401(k) can offer retirement plan loans. A SIMPLE 401(k) can also offer the normal 401(k) hardship withdrawals. A SIMPLE IRA never limits withdrawals at any time, so it does not need hardship withdrawal provisions. Finally, SIMPLE 401(k)s are subject to the mandatory 20% withholding for rollovers, like any qualified plan. As usual, a direct transfer escapes the 20% mandatory withholding rules. These rules will be covered in LO 6.1.2.
Roth 401(k) Plan
A Roth 401(k) plan is really a provision of or amendment to a traditional 401(k) that allows Roth contributions, in-plan Roth conversions, and also allows workers to elect to treat some or all of the employer’s contributions as Roth contributions. A Roth contribution does not get a current income tax deduction, so it is an after-tax contribution. A separate account is created for the Roth contributions and related earnings. The maximum contribution to such a plan is the same as in the traditional Section 401(k), $24,500 (2026). Participants age 50 or older may contribute an additional $8,000 (2026). There is also the adjustment for workers age 60-63. It is $11,250 in 2026.
If the employee also defers salary to a traditional Section 401(k) account, the total amount deferred under both the Roth and traditional Section 401(k) plans combined is limited to $24,500 plus the applicable catch-ups for 2026. Unlike the Roth IRA (to be discussed in Module 5), the ability to make contributions to a Roth 401(k) is not phased out based on the taxpayer’s AGI. Thus, high-income wage earners may find the Roth 401(k) option a very attractive retirement savings vehicle. Also, more than 40% of American workers do not owe income tax. That means a Roth elective deferral would be more appropriate than a tax sheltered deferral that did not actually reduce their current taxation. Employer Roth accounts would also be less heavily taxed if the worker is forced to take a hardship withdrawal. A hardship withdrawal from a Roth 401(k) would be income taxed and subject to the 10% EWP ratably. That means the withdrawn amount that comes from Roth contributions is not taxed or penalized. This is better than being income taxed and penalized on the entire amount. Also qualified distributions from Roth elective deferrals would be income tax free as described below. That might help lower the amount of Social Security retirement benefits that are subject to income taxes as described in Module 7.
The major difference between the traditional Section 401(k) plan and the Roth 401(k) plan is the tax treatment of the contributions and distributions. Only the employer-matching and nonelective contributions (if any) and the related earnings associated with any employer contributions with a Roth 401(k) are taxable when withdrawn. In other words, the employer contributions are made to the traditional Section 401(k) portion of the account on behalf of the employee. Worker contributions to the Roth 401(k), and earnings on such contributions, are tax free if made as a qualified distribution. The distribution of earnings from a Roth 401(k) are a qualified distribution and thus tax free if both of the following tests are met: „ The distribution is made after a five-year period beginning on the first day of the taxable year of the first regular contribution or in plan conversion to the Roth 401(k) plan. If money is moved into the plan from a former employer’s Roth 401(k), then the time frame from the first plan is attributed to the new employer
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Roth 401(k). On the other hand, note that employer Roth accounts have a separate five-year clock from Roth IRAs.
„ The distribution is made after the date on which the participant has attained age 591⁄2 or becomes disabled, or it is made to a beneficiary of a deceased participant. The three reasons for a qualified distribution from a Roth 401(k) can be remembered with the acronym “DAD” (Death, Age 591⁄2, and Disability).
Minimum distribution rules that apply to traditional Section 401(k) plans no longer apply to Roth 401(k) accounts. Since 2024, SECURE 2.0 exempts employer Roth money from RMDs while the original owner is still alive.
The following table is a comparison of the major characteristics of regular and Roth 401(k) plans.
Figure 3.5: Comparison of Traditional and Roth 401(k) Plans Attribute
Employee funding Employer-matching
Pretax Pretax
Traditional Section 401(k) Roth 401(k) After-tax
Pretax [identical to traditional Section 401(k) account] unless the worker elects to treat some or all of it as a Roth contribution
Allowable employee contributions
$24,500 plus $8,000 catch-up (2026)
The age 60-63 catch-up also applies to traditional and Roth 401(k)s
Qualified distributions subject to tax
Yes, all amounts, because qualified distributions are not a term that applies to a traditional 401(k)
Only employer-matching contributions and earnings are taxed unless the worker elected to treat the contributions as a Roth or made an in-plan Roth conversion. Qualified distributions from an employer Roth are tax-free.
Minimum distribution requirement
Rollover options
Yes, starting at age 73 or date of retirement (unless >5% owner)
Not for original owner while living. Yes for beneficiaries.
Tax free rollover to traditional IRA Tax free rollover to another Roth 401(k) or Roth IRA [but a Roth IRA can never be rolled into a Roth 401(k)]
Section 401(k) plans that permit Roth contributions may allow participants to convert pretax amounts into Roth accounts within the same plan. This is called an in-plan Roth conversion. The converted amount is subject to income tax, but not the 10% EWP. The mandatory 20% withholding from a qualified plan distribution does not apply to the conversion amount. The conversion amount is still taxable, but the taxpayer may pay the income tax from other funds. An in-plan Roth conversion can turn both employer and employee assets in the traditional portion of the 401(k) into Roth assets inside the plan.
$24,500 plus $8,000 catch-up (2026) [less any contributions to traditional Section 401(k) plan]
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Matching Qualified Student Loan Payments Since 2025, SECURE 2.0 allows employers to match workers making “qualified student loan payments.” In other words, a worker is paying a qualified student loan, but not contributing to the employer retirement plan. The firm is allowed to make matching contributions to its employer retirement account if the worker self-certifies that they are making student loan payments. This arrangement is effective for 401(k), 403(b), SIMPLE IRAs, and governmental 457(b) plans. A qualified student loan payment is defined as any indebtedness incurred by the employee solely to pay for qualified higher education costs for that employee alone.
Pension-Linked Emergency Savings Account (PLESA) Employers may automatically opt non-highly compensated employees into an
emergency savings account (ESA) linked to their retirement plan for up to 3% of salary with a $2,500 (indexed) cap. The 2026 limit is $2,600. The employer may choose a number less than $2,600, but why? Why set these “side car” emergency funds up and then set a lower cap? One answer is the worker contributions to these accounts must be matched, but still, even Scrooge McDuck should allow the full $2,600. Contributions over the $2,600 cap can be directed into a Roth account or stopped until the balance goes below the cap. Most plans will probably not choose to stop the contributions because this would be administratively difficult and it would change the work’s paycheck. Monitoring whether or not the balance is below the cap will be administratively burdensome. The contributions are treated like Roth deferrals and they must be matched by the employer as if they were going into the actual retirement plan. This is a combination emergency fund and Roth retirement plan. The PLESA portion must be invested in cash or similar investments. As an emergency fund, up to four withdrawals per year (also limited to one withdrawal per calendar month) can be taken without income tax or the 10% EWP. In other words, these PLESA withdrawals are automatically treated like a qualified distribution from a Roth account. When the worker separates from service, the account balance may be taken as cash or moved into a Roth plan or Roth IRA. There are some questions about how distributions from PLESAs will be apportioned between contributions and earnings, but distributions from a PLESA are considered a new type of automatic qualified Roth distribution.
One-Participant (Solo) 401(k) A solo 401(k) is a traditional 401(k) plan covering a business owner with no employees, or the owner and their spouse. These plans have the same rules and requirements as any other Section 401(k) plan. In a solo 401(k) plan, the business owner can make contributions to the plan both as a participant and as an employer, subject to qualified plan limits for elective deferrals and annual additions. Thus, a solo 401(k) enables the unincorporated business to contribute up to 20% into the plan for the owner, and the owner can also personally defer up to $24,500 in 2026 (plus the applicable age-based catch-up amount). The limit is 20% (not 25%) for the account of an owner of an unincorporated business due to the owner being self-employed as described below for Keogh plans. In other words, the employees of an unincorporated business can receive contributions up to 25%, but an owner who works at an unincorporated business may only receive contributions up to 20%. Also, half the self-employment tax is deducted from the self-employment income before multiplying times the adjusted contribution rate.
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New solo 401(k) plans for sole proprietors and single member LLCs are permitted to receive salary deferrals until the due date of the employee’s tax return for the first year of the plan. This is different than the general rule that salary deferrals must be made before the income is earned. However, it makes total sense because the sole worker here is an owner and thus can make employer contributions up until this time. Why not also let the same person make salary deferrals until the due date of the tax return as well? We are trying to encourage people to save for their retirement. We are also trying to increase our capital in America. Thus, there are two deadlines for the first year of a new solo 401(k). The worker contribution must be made by April 15th of the following year. This is like an IRA. There is no extension for the worker contribution. However, the employer contribution has until the due date of the tax return, including extensions. This is the employer contribution due date for all employer plans except SIMPLE IRAs.
This new treatment gives new last-minute solo 401(k)s two advantages over last-minute SEP–IRAs. First, more money can go into them. SEPs are limited to 20% of the sole proprietor’s net self-employment income after subtracting half of their self-employment tax (SECA). These contributions to a SEP are counted as employer contributions. With a solo 401(k), the person can also contribute as the worker. Second, SEPs count as an IRA for back door Roth IRA calculations, but 401(k) money does not. Finally, SEP rollovers count as an IRA rollover under the Bobrow rules discussed in Module 6. The key here is that the solo 401(k) is new, not the business. A long established business might have enjoyed a great year and the owner needs to strengthen their retirement preparations.
STARTER RETIREMENT PLANS
Employers without a retirement plan may offer a “starter” retirement plan that is a worker deferral only plan. No organizational money can be contributed to these accounts. Only worker deferrals are allowed. The maximum annual contribution to these plans is $6,000 in 2026 with a $1,100 age 50 catch-up (which is a little less than allowed for IRAs), so why have them? Because Congress is trying to get employers, especially small employers, to help people start saving for their retirement. Essentially, employers sign up their people in bunches – not one by one like IRAs. In all, the employer has one, fairly easy to administer retirement plan for all its employees (except for those who opt out or do not meet the initial eligibility requirements). The firm does not contribute but it does establish and oversee the plan. The most difficult part of retirement planning for many people is just getting started somewhere. This provision should help tens of thousands of workers annually. a. “Starter 401(k) plans”: these plans must meet the automatic enrollment, con-tributions, eligibility, and employee notices requirements. They are treated as automatically satisfying the ADP nondiscrimination test. Essentially, everyone is assumed to start with a plan set initial contribution of 3-15% of compensation (unless they affirmatively opt out or choose a different number).
b. “Safe harbor 403(b) plans,” also known as “safe harbor deferral-only plans” can be thought of as “starter 403(b) plans” because the rules are the same as starter 401(k)s. These plans satisfy the “universal availability” requirements applicable to all 403(b) plans. Universal availability means if the organization offering a 403(b) allows any employee to contribution to the 403(b), it must allow all work-ers who are willing to invest at least $200/year to also contribute to the 403(b).
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Savings/Thrift Plan A savings/thrift plan is a qualified defined contribution plan similar to a traditional profit-sharing plan except that it provides for and encourages after-tax employee contributions to the plan. The typical thrift plan provides for after-tax employee contributions with matching employer contributions. Pure thrift plans, featuring only after-tax employee contributions, have generally been replaced with the Section 401(k) type of plan, especially the Roth 401(k). These plans should not be confused with the thrift plan established for federal government employees, including the military. That thrift plan is like the worker portion of 401(k)s and has its own set of rules which are beyond the scope of the CFP program.
Special Rules for Self-Employed Plans (HR-10 Plans, aka Keogh Plans)
An HR-10 plan, also known as a Keogh (self-employed) plan is an employer-sponsored retirement plan that covers one or more self-employed individuals, such as a sole proprietor or a partner. It can be set up as any type of defined benefit, defined contribution, or tax-advantaged retirement plan. However, the most common types of Keogh plans are profit-sharing plans, money purchase plans, SEPs, and target benefit plans, all of which are defined contribution plans. The IRS currently favors calling these plans HR-10 plans instead of Keogh plans, but the industry often calls them Keogh plans because that was the original name.
Member-owners of LLCs taxed as a sole proprietor or partnership are considered self-employed individuals for this purpose. However, if the LLC elects to be taxed as a C corporation, then there are no self-employed owners, and the LLC cannot establish a Keogh retirement plan. Limited liability partnerships (LLPs) can also offer Keogh plans. However, no S corporation can offer a Keogh plan because S corporations owners are not considered self-employed. A Keogh plan is fundamentally like any other qualified or tax-advantaged plan (it must comply with the same technical requirements) except for three differences: „ Self-employed individuals must calculate their retirement plan contribution based on net earnings from self-employment, instead of W-2 income. – Self-employed people must then subtract half their SECA (self-employment tax) before applying the adjusted contribution rate from the next step.
„ Self-employed individuals must use a net contribution rate in determining their allowable contribution to a Keogh defined contribution plan (for example, a profit-sharing plan). This rate is calculated by dividing the plan contribution percentage by (1 + the contribution percentage). For example, the maximum contribution for a self-employed participant in a plan with a 25% contribution formula is 20% [0.25 divided by (1 + 0.25)].
Net earnings from self-employment takes the place of compensation (W-2) income in applying the special rules applicable to Keogh plans. In calculating earned income of a self-employed individual, self-employment tax must be calculated, and a deduction of one-half of the self-employment tax must be taken before determining the Keogh deduction. This creates a circular calculation because the amount of self-employment tax (SE tax) deduction is not known before the calculation of earned income, and the amount of earned income cannot be derived without knowing the self-employment
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tax deduction. Following are the steps in determining the HR-10 plan/Keogh deduction:
1. Determine the net income of the business from Schedule C, IRS Form 1040, or the Schedule K-1 provided to the partner or the LLC member-partner.
2. Subtract the deductible amount of SE tax applicable from that income. 3. Multiply the result by the net contribution rate.
EXAMPLE: Keogh deduction Ken, a sole proprietor, earns $70,000 of Schedule C income. Ken’s business maintains a profit-sharing plan with a 25% contribution on behalf of all employees. Ken’s deductible contribution as an owner-employee of the business is calculated as follows:
Schedule C income:
Less deductible amount of SE tax paid:
Equals: Multiply by net contribution rate: $70,000 (4,945) [($70,000 × 0.9235 × 0.0765)]
$65,055 × 0.20
Maximum deductible contribution: $13,011
Note: The deductible amount of SE tax on Schedule C income at or below the Social Security taxable wage base may be calculated using this shortcut method: (The initial amount of self-employment income/profit x 0.9235 x 0.0765 = The amount to subtract from self-employment income). In Ken’s case: ($70,000 × 0.9235 × 0.0765) = $4,945. A second way to calculate the SE tax when the Schedule C income is less than the Social Security taxable wage base is to multiply the profit amount times 0.1413. This is the same as multiplying the Schedule C profit times .9235 and then multiplying times .153.
The point of these adjustments are to give the self-employed owner the same contribution rate as a worker. Observe that Ken’s compensation after half the SECA and the contribution to the profit-sharing plan is $52,044 ($70,000 - $4,945 - $13,011 = $52,044). If this number is multiplied times the 25% contribution rate the regular employees get, the result is $13,011. Thus, when comparing apples to apples, employees and self-employed owners are getting the same contribution rate. See the FP514: Tax Planning course to learn how to make this calculation when Schedule C income exceeds the taxable wage base.
Important concepts with respect to this contribution include the following: „ The maximum net contribution rate of 20% is determined by dividing 0.25 by (1 + 0.25). If the plan contribution percentage was 15%, divide 0.15 by (1 + 0.15) for a net contribution rate of 13.04%.
„ This calculation applies only to the owner-employee of the business (the self-employed individual); those individuals who work for the owner-employee are entitled to a full or unadjusted deductible contribution.
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„ The deductible contribution for the owner-employee is an above-the-line deduction on IRS Form 1040. In other words, it lowers the self-employed person’s AGI.
HR-10 plans/Keoghs vs. Other Qualified and Tax-Advantaged Plans
HR-10 plans/Keogh plans cover self-employed individuals who are not considered normal employees. The most important special rule for HR-10 plans/Keoghs is the definition of earned income. Earned income takes the place of compensation in applying the plan rules for Keoghs and is defined as the self-employed individual’s net business income after all deductions, including the deduction for Keogh plan contributions for the workers. In addition, the IRS has ruled that the SE tax must be calculated, and a deduction of one-half of the SE tax must be taken before determining the Keogh deduction.
PRACTICE QUESTIONS
Choose the best answer for the following questions. The answers can be found at the end of this module. 7. Robert’s Restoration Company is a small business with 20 employees. The business has adopted a SIMPLE 401(k). It now wishes to implement another plan on their behalf. Which one of the following plans, if any, may Robert’s Restoration adopt immediately? A. A simplified employee pension (SEP) plan B. A traditional profit-sharing plan C. A cash balance plan D. None of these
8. All of the following with respect to a Roth 401(k) are correct EXCEPT A. Employer Roth accounts offer the possibility of tax-free income in retirement.
B. Employer Roth accounts are not subject to required minimum distributions during the worker’s lifetime.
C. Employer Roth accounts are particularly effective for lower income workers.
D. the ability to make contributions to a Roth 401(k) is phased out based on the taxpayer’s AGI.
9. The deductible contribution to a money purchase plan on behalf of a self-employed individual whose income from self-employment is $20,000 and whose deductible SE tax is $1,413 is limited to A. $3,000. B. $3,717. C. $4,714. D. $5,000.
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