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401(k) plans can be a powerful tool in promoting
financial security in retirement. They are a valuable option for
businesses considering a retirement plan, providing benefits to employees
and their employers.
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Employers start a 401(k) for a host of reasons.
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On
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A well-designed 401(k) plan can help
attract and keep talented employees.
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It allows participants to decide how
much to contribute to their accounts on a before-tax basis.
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Employers are entitled to a tax
deduction for their contributions to employees’ accounts.
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A 401(k) plan benefits a mix of
rank-and-file employees and owner/managers.
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The money contributed may grow
through investments in stocks, mutual funds, money market funds,
savings accounts, and other investment vehicles.
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Contributions and earnings generally
are not taxed by the Federal government or by most State governments
until they are distributed.
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A 401(k) plan may allow participants
to take their benefits with them when they leave the company, easing
administrative burdens.
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This expanded version of the printed booklet highlights some of a 401(k) plan’s
advantages, some of your options and responsibilities as an employer
operating a 401(k), and the differences among the types of 401(k) plans.
For more information, a list of resources for you and for prospective
401(k) participants is included at the end of this booklet.
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When you establish a 401(k) plan you must take certain
basic actions. For instance, one of your first decisions will be whether
to set up the plan yourself or consult a professional or financial
institution – such as a bank, mutual fund provider, or insurance company
– to help you establish and maintain the plan.
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Initial Actions
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Here are four basic actions necessary to have a
tax-advantaged 401(k) plan:
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Adopt A Written Plan
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Plans begin with a
written document that serves as the foundation for day-to-day plan
operations. If you have hired someone to help with your plan, that person
likely will provide it. If not, consider obtaining assistance from a
financial institution or retirement plan professional. In either case, you
are bound by the terms of the plan document.
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Before beginning the plan document, however, you will
need to decide on the type of 401(k) plan that is best for you – a
traditional 401(k), a safe harbor 401(k), or a SIMPLE 401(k) plan.
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A traditional 401(k) plan offers the maximum
flexibility of the three types of plans. Employers have discretion to make
contributions on behalf of all participants, to match employees’
deferrals, or do both. These 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). In
addition, a traditional 401(k) allows participants to make pre-tax
contributions through payroll deductions. Annual testing ensures that
benefits for rank and file employees are proportional to benefits for
owners/managers.
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A safe harbor 401(k) plan is similar to a
traditional 401(k) plan, but, among other things, must provide for employer
contributions that are fully vested when made. However, the safe harbor
401(k) is not subject to many of the complex tax rules that are associated
with a traditional 401(k) plan, including annual nondiscrimination testing.
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Both the traditional and safe harbor plans are for
employers of any size and can be combined with other retirement plans.
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A SIMPLE 401(k) plan was created so that small
businesses could have an effective cost-efficient way to offer retirement
benefits to their employees. A SIMPLE 401(k) plan is not subject to the
annual nondiscrimination tests that apply to the traditional plans. Similar
to a safe harbor 401(k) plan, the employer is required to make employer
contributions that are fully vested. This type of 401(k) plan is available
to employers with 100 or fewer employees who received at least $5000 in
compensation from the employer for the preceding calendar year. In addition,
employees that are covered by a SIMPLE 401(k) plan may not receive any
contributions or benefit accruals under any other plans of the employer.
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Once your have decided on the type of plan for your
company, you will have flexibility in choosing some of the plan’s features
-- such as which employees can contribute to the plan and how much. Other
features written into the plan are required by law. For instance, the plan
document must describe how certain key functions are carried out, such as
how contributions are deposited in the plan.
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Arrange A Trust Fund For The Plan’s Assets
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A
plan’s assets must be held in trust to assure that assets are used solely
to benefit the participants and their beneficiaries. The trust must have at
least one trustee to handle contributions, plan investments, and
distributions to and from the 401(k) plan. Since the financial integrity of
the plan depends on the trustee, this is one of the most important decisions
you will make in establishing a 401(k) plan. If you set up your plan through
insurance contracts, the contracts do not need to be held in trust.
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Develop A Record Keeping System
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An accurate
record keeping system helps track the flow of money – contributions,
earnings and losses in participants’ accounts, plan investments, expenses,
and benefit distributions. If you have a contract administrator or financial
institution assist in managing the plan, that entity typically will help in
keeping the required records. In addition, a record keeping system will help
you, your plan administrator, or financial provider prepare the plan’s
annual return/report that must be filed with the Federal government.
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Provide Plan Information To Employees
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As you
put your 401(k) plan in place, you must notify employees who are eligible to
participate in the plan about your plan’s benefits and requirements. A
summary plan description or SPD is the primary vehicle to inform
participants and beneficiaries about the plan and how it operates. The SPD
typically is created with the plan document. You will need to send it to all
plan participants. In addition you may want to provide your employees with
information that emphasizes the advantages of joining your 401(k) plan.
Employee perks – such as pre-tax contributions to a 401(k) plan, employer
contributions (if you choose to make them), and compounded tax-deferred
earnings – help highlight the advantages of participating in the plan.
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Once you have established a 401(k) plan, you assume
certain responsibilities in operating the plan. If you hired someone to
help in setting up your plan, that arrangement also may have included help
in operating the plan. If not, another important decision will be whether
to manage the plan yourself or hire a professional or financial
institution to take care of some or most aspects of operating the plan.
Elements of a plan that need to be handled include:
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Participation
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Typically, a plan benefits a mix of rank-and-file
employees and owner/managers. However, some employees may be excluded from a
401(k) plan if they:
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Have not attained age 21;
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Have not completed a year of service;
or
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Are covered by a collective bargaining
agreement that does not provide for participation in the plan, if
retirement benefits were the subject of good faith bargaining.
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Employees cannot be excluded from a plan merely because
they are older workers.
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Contributions
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Another design option you will have in establishing and
operating a 401(k) plan is deciding on your business’s contribution (if
any) to participants’ 401(k) accounts.
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Traditional 401(k) Plan - If you decide to
contribute to your employees’ 401(k) accounts, you have further options.
You can contribute a percentage of each employee’s compensation to the
employee’s account (called a nonelective contribution), or you can match
the amount your employees decide to contribute (within the limits of current
law) or you can do both.
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For example, you may decide to add a percentage – say
50 percent – to an employee’s contribution, which results in a 50-cent
increase for every dollar the employee sets aside. Using a matching
contribution formula will provide additional employer contributions only to
employees who make deferrals to the 401(k) plan. If you choose to make
nonelective contributions, the employer makes a contribution to each
eligible participant’s account, whether or not the participant decides to
make a salary deferral to his or her 401(k) account.
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Under a traditional 401(k) plan, you may have the
flexibility of changing the amount of nonelective contributions each year,
according to business conditions.
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Safe Harbor 401(k) Plan - Under a safe-harbor
plan, you can match each eligible employee’s contribution, dollar for
dollar, up to 3 percent of the employee’s compensation, and 50 cents on
the dollar for the employee’s contribution that exceeds 3 percent, but not
5 percent, of the employee’s compensation. Alternatively, you can make a
nonelective contribution equal to 3 percent of an employee’s compensation
to each eligible employee’s account. Each year you must make either the
matching contributions or the nonelective contributions.
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SIMPLE 401(k) Plan - Employer contributions to a
SIMPLE 401(k) plan are limited to either:
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A dollar-for-dollar matching
contribution, up to 3 percent of pay; or
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A nonelective contribution of 2
percent of pay for each eligible employee.
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No other employer contributions can be made to a SIMPLE
401(k) plan, and employees cannot participate in any other retirement plan
of the employer.
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The maximum amount that employees can contribute to their
SIMPLE 401(k) accounts is $8,000 in 2003, with annual increases in $1,000
increments until the limit reaches $10,000 in 2005.
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An additional catch-up contribution is allowed for
employees aged 50 and over. The additional contribution amount is $1,000 in
2003, with annual increases in $500 increments until the limit reaches
$2,500 in 2006.
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Contribution Limits - Total employer and
employee contributions to all of an employer’s plans are subject to an
overall annual limitation - the lesser of:
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In addition, the amount employees can contribute (elective deferrals) to their
accounts before taxes under a traditional or safe harbor 401(k) plan is
limited to $12,000 in 2003, with annual increases in $1,000 increments until
the limit reaches $15,000 in 2006.
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Traditional and safe harbor 401(k) plans can allow the
following additional catch-up contributions for employees aged 50 and over:
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2003 - $2,000
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2004 - $3,000
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2005 - $4,000
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2006 - $5,000
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Vesting
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Employee salary deferrals are immediately 100 percent
vested – that is, the money that an employee has put aside through salary
deferrals cannot be forfeited. When an employee leaves employment, he/she is
entitled to those deferrals, plus any investment gains (or losses) on their
deferrals.
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In SIMPLE 401(k) plans and safe harbor 401(k)
plans, all required employer contributions are always 100 percent
vested.
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In traditional 401(k) plans, all employee
deferrals are 100 percent vested. You can design your plan so that employer
contributions become vested over time, according to a vesting schedule.
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Nondiscrimination
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Realizing 401(k) plan tax benefits requires that plans
provide substantive benefits for rank-and-file employees, not only for
business owners and managers. These requirements are referred to as
non-discrimination rules and cover the level of plan benefits for
rank-and-file employees compared to owners/managers.
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Traditional 401(k) plans are subject to annual testing to
assure that the amount of contributions made on behalf of rank-and-file
employees is proportional to contributions made on behalf of owners and
managers. Safe harbor 401(k) plans and SIMPLE 401(k) plans are not subject
to annual non-discrimination testing.
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Investing 401(k) Monies
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After you decide on the type of 401(k) plan, you can
consider the variety of investment options. One decision you will need to
make in designing a plan is whether to permit your employees to direct the
investment of their accounts or to manage the monies on their behalf. If you
choose the former, you also need to decide what investment options to make
available to the participants. Depending on the plan design you choose, you
may want to hire someone either to determine the investment options to make
available or to manage the plan’s investments. Continually monitoring the
investment options ensures that your selections remain in the best interests
of your plan and its participants.
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Fiduciary Responsibilities
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Many of the actions needed to operate a 401(k) plan
involve the use of discretion in making decisions regarding the plan or
exercising control over the assets of the plan -- whether you hire someone
to manage the plan for you or do some or all of the plan management
yourself. Using discretion in administering and managing the plan or
controlling the plan’s assets makes you or the entity you hire a plan
fiduciary to the extent of that discretion or control. Thus, fiduciary
status is based on the functions performed for the plan, not a title. Be
aware that hiring someone to perform fiduciary functions is itself a
fiduciary act.
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There are a number of decisions with respect to a plan
that are business decisions, rather than fiduciary decisions. For instance,
the decisions to establish a plan, to include certain features in a plan, to
amend a plan and to terminate a plan are business decisions. When making
these decisions, you are acting on behalf of your business, not the plan,
and therefore, you would not be a fiduciary. However, when you take steps to
implement these decisions, you (or those you hire) are acting on behalf of
the plan and thus, in making decisions, are acting as fiduciaries.
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Basic Responsibilities - Those persons or entities
that are fiduciaries are in a position of trust with respect to the
participants and beneficiaries in the plan. The fiduciary’s
responsibilities include:
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Acting for the exclusive purpose of
providing benefits to workers participating in the plan and their
beneficiaries and solely in the interest of those participants and
beneficiaries;
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Carrying out duties with the care,
skill, prudence, and diligence of a prudent person familiar with such
matters.
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Following the plan documents;
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Diversifying plan investments; and
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Defraying reasonable expenses of the
plan.
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These are the responsibilities that fiduciaries need to
keep in mind as they carry out their duties – whether they are managing
the whole plan or carrying out specific functions. The responsibility to be
prudent covers a wide range of functions needed to operate a plan. And,
since all these functions must be carried out in the same manner as a
prudent person would carry them out, it may be in your best interest to
consult experts in the various fields, such as investments and accounting.
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In addition, for some functions, there are specific rules
that help guide the fiduciary. For example, if your plan provides for salary
reductions from employees’ paychecks for contribution to the plan, then
these contributions must be timely deposited. The law states that this must
be accomplished as soon as it is reasonably possible to do so, but no later
than the 15th business day of the month following the payday. If you can
reasonably make the deposits in a shorter time frame, you need to make the
deposits at that time.
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Limiting Liability - With these responsibilities,
there is also some potential liability. However, there are actions you can
take to demonstrate that you carried out your responsibilities as well as
ways to limit your liability.
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The fiduciary responsibilities cover the process used to
carry out the plan functions rather than simply the end results. For
example, if you or someone you hire makes the investment decisions for the
plan, an investment does not have to be a “winner” if the fiduciary can
demonstrate it was part of a prudent overall diversified investment
portfolio for the plan. Since a fiduciary needs to carry out activities
through a prudent process, you should document the decision-making process
to demonstrate the rationale behind the decision at the time it was made.
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In addition to the steps above, there are other ways to
limit potential liability. The plan can be set up to give participants
control of the investments in their accounts. For participants to have
control, they must have sufficient information on the specifics of their
investment options. If properly executed, this type of plan limits your
liability for the investment decisions made by participants. You can also
hire a service provider or providers to handle some or most of the fiduciary
functions, setting up the agreement so that the person or entity then
assumes liability.
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However, even if you do hire a financial institution or
retirement plan professional to manage the whole plan, you retain some
fiduciary responsibility for the decision to select and keep that person or
entity as the plan’s service provider. Thus, you should document your
selection process and monitor the services provided to determine if a change
needs to be made.
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Some items to consider in selecting a plan service
provider:
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Information about the firm itself:
affiliations, financial condition, experience with 401(k) plans, and
assets under their control;
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A description of business practices:
how plan assets will be invested if the firm will manage plan
investments or how participant investment directions will be handled,
and proposed fee structure;
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Information about the quality of
prospective providers: the identity, experience, and qualifications of
the professionals who will be handling the plan’s account; any recent
litigation or enforcement action that has been taken against the firm;
the firm’s experience or performance record; the firm’s plans (if
any) to work with its affiliates in handling the plan’s account; and
whether the firm has fiduciary liability insurance.
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Once hired, these are additional actions to take when
monitoring a service provider:
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Review the service provider’s
performance;
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Read any reports they provide;
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Check actual fees charged;
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Ask about policies and practices (such
as trading, investment turnover, and proxy voting); and
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Follow up on participant complaints.
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For more information, see A Look at
401(k) Fees for Employers and a sample fee disclosure form |
Prohibited Transactions And Exemptions - There are
certain transactions that are prohibited under the law to prevent dealings
with parties that have certain connections to the plan, self-dealing, or
conflicts of interest that could harm the plan. However, there are a number
of exceptions under the law, and additional exemptions may be granted by the
U.S. Department of Labor, where protections for the plan are in place in
conducting the transactions.
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For example, there is an exemption that permits you to
offer loans to participants through your plan. If you do, the loan program
must be carried out in such a way that the plan and all other participants
are protected. Thus, the decision with respect to each loan request is
treated as a plan investment and considered accordingly.
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Bonding - Finally, persons handling plan funds or
other plan property generally must be covered by a fidelity bond to protect
the plan against fraud and dishonesty.
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Disclosing Plan Information To Participants
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Plan disclosure documents keep participants informed
about the basics of plan operation, alert them to changes in the plan’s
structure and operations, and provide them a chance to make decisions and
take timely action with respect to their accounts.
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The summary plan description (SPD) – the basic
descriptive document - is a plain-language explanation of the plan and must
be comprehensive enough to apprise participants of their rights and
responsibilities under the plan. It also informs participants about the
features and what to expect of the plan. Among other things, the SPD must
include information about:
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When and how employees become eligible
to participate in the 401(k) plan;
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The contributions to the plan;
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How long it takes to become vested;
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When employees are eligible to receive
their benefits;
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How to file a claim for those
benefits; and
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Basic rights participants have under
the federal retirement law, the Employee Retirement Income Security Act
(ERISA).
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The SPD should include an explanation about the
administrative expenses that will be paid by the plan. This document must be
given to participants when they join the plan and to beneficiaries when they
first receive benefits. SPDs must also be redistributed periodically during
the life of the plan.
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A summary of material modification (SMM) apprises
participants of changes made to the plan or to the information required to
be in the SPD. The SMM or an updated SPD must be automatically furnished to
participants within a specified number of days after the change.
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An individual benefit statement (IBS) shows the
total plan benefits earned by a participant and information on their vested
benefits. The IBS must be provided when a participant submits a written
request, but no more than once in a 12-month period, and automatically to
certain participants who have terminated service with the employer. In
addition, many plans choose to provide on a quarterly basis individual
account statements that show the assets in a participant’s account, how
they are invested, and any increases (or decreases) in investments during
the period covered by the statement.
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A summary annual report (SAR) is a narrative of
the plan’s annual return/report, the Form 5500, filed with the Federal
government (see Reporting to Government Agencies for more information). It
must be furnished annually to participants.
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A blackout period notice gives employees advance
notice when a blackout period occurs, typically when plans change record
keepers or investment options, or when plans add participants due to
corporate mergers or acquisitions. During a blackout period, participants’
rights to direct investments, take loans, or obtain distributions are
suspended. There are strict rules that apply before and during blackout
periods.
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Reporting To Government Agencies
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In addition to the disclosure documents that provide
information to participants, plans must also report certain information to
government entities.
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Form 5500-Series - Plans are required to file an
annual return/report with the Federal government. Depending on the number
and type of participants covered, most employers who have a 401(k) plan must
file one of the two following forms:
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Form 5500, Annual Return/Report of Employee
Benefit Plan, or
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Form 5500-EZ, Annual Return of One-Participant (Owners and Spouses)
Retirement Plan
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For 401(k) plans, the Form 5500 is designed to disclose
information about the plan and its operation to the IRS, the U.S. Department
of Labor, plan participants, and the public.
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Most one-participant plans (sole proprietor and
partnership plans) with total assets of $100,000 or less are exempt from the
annual filing requirement. A final return/report must be filed when a plan
is terminated regardless of the value of the plan’s assets.
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Form 1099-R - Form 1099-R, Distributions From
Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance
Contracts, etc. is given to both the IRS and recipients of distributions
from the plan during the year. It is used to report distributions (including
rollovers) from a retirement plan. See Form 1099-R and the Form 1099-R and 5498 Instructions for additional information.
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Distributing Plan Benefits
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Benefits in a 401(k) plan are dependent on a participant’s
account balance at the time of distribution.
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When participants are eligible to receive a distribution,
they typically can elect to:
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Take a lump sum distribution of their
account,
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Roll over their account to an IRA or
another employer’s retirement plan, or
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Purchase an annuity.
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Although 401(k) plans must be established with the
intention of being continued indefinitely, you (as an employer) may
terminate your plan when it no longer suits your business needs. For
example, you may want to establish another type of retirement plan in lieu
of the 401(k) plan.
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Typically, the process of terminating a 401(k) plan
includes amending the plan document, distributing all assets, and filing a
final Form 5500. You must also notify your employees that the 401(k) plan
will be discontinued. Check with your plan’s financial institution or a
retirement plan professional to see what further action is necessary to
terminate your 401(k). See Form 5310 and the Form 5310 Instructions for additional information.
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Even with the best intentions, mistakes in plan operation can still happen.
The U.S. Department of Labor and IRS have correction programs to help
401(k) plan sponsors correct plan errors, protect participants and keep the
plan’s tax benefits. These programs are structured to encourage you to
correct the errors early. Having an ongoing review program makes it easier
to spot and correct mistakes in plan operations. See the Resources section
for further information.
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Have you determined which type of
401(k) plan best suits your business?
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Have you decided whether to make
contributions to the plan, and, if so, whether to make nonelective
and/or matching contributions? (Remember, you can may design your plan
so that you may change your rate of contributions if necessary due to
business conditions.)
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Have you decided to hire a financial
institution or retirement plan professional to help with setting up
and running the plan?
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Have you adopted a written plan that
includes the features you want to offer, such as whether participants
will direct the investment of their accounts?
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Have you notified eligible employees
and provided them with information to help in their decision-making?
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Have you arranged a trust fund for
the plan assets or will you set up the plan solely with insurance
contracts?
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Have you developed a record keeping
system?
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Are you familiar with the fiduciary
responsibilities?
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Are you prepared to monitor the plan’s
service providers?
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Are you familiar with the reporting
and disclosure requirements of a 401(k) plan?
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For help in establishing and operating a 401(k) plan, you may want to talk
to a retirement plan professional or a representative of a financial
institution that offers retirement plans – and take advantage of the help
available in the following Resources section.
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To Find Out More…Expanded information on the
topics addressed in this publication is available on the IRS and U.S.
Department of Labor’s (DOL’s) Employee Benefits Security
Administration Web sites, www.irs.gov/ep and www.dol.gov/ebsa. For the
IRS, go to the IRS Web site and select More Topics in the Topics
section and then select Types Of Retirement Plans. For DOL, go to
the DOL Web site and select 401(k) Plans.
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The Web sites feature this publication as well as
additional information on 401(k) plans and other retirement plans, as listed
below. Publications can be ordered by calling the appropriate agency’s
toll free number – for the IRS, 1.800.TAX-FORM (1.800.829.3676) or for the
DOL, 1.866.444.EBSA (3272).
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The following items, issued by both the IRS and DOL, are
available on the Web and through the toll free numbers:
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Related Materials Available From The Department Of
Labor
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For small businesses:
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In addition, DOL sponsors two interactive Web sites –
the Small Business Advisor, available at the DOL Web site noted above,
and, along with the U.S. Chamber of Commerce and the Small Business
Administration, www.selectaretirementplan.org
which also has a glossary
of terms often used in reference to employer-sponsored retirement
plans.
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For employees:
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Related Materials Available From The IRS
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