Employer Deduction

You can usually deduct, subject to limits, contributions you make to a qualified plan, including those made for your own retirement. The contributions (and earnings and gains on them) are generally tax free until distributed by the plan.

Deduction Limits

The deduction limit for your contributions to a qualified plan depends on the kind of plan you have.

Defined contribution plans.   The deduction limit for a defined contribution plan depends on whether it is a profit-sharing plan or a money purchase pension plan.

Profit-sharing plan.   Your deduction for contributions to a profit-sharing plan cannot be more than 15% (25% for years beginning after December 31, 2001) of the compensation paid (or accrued) during the year to your eligible employees participating in the plan. You must reduce this limit in figuring the deduction for contributions you make for your own account. See Deduction Limit for Self-Employed Individuals, later.

Money purchase pension plan.   Your deduction for contributions to a money purchase pension plan is generally limited to 25% of the compensation paid (or accrued) during the year to your eligible employees. You must reduce this 25% limit in figuring the deduction for contributions you make for yourself, as discussed later.

Defined benefit plans.   The deduction for contributions to a defined benefit plan is based on actuarial assumptions and computations. Consequently, an actuary must figure your deduction limit.

In figuring the deduction for contributions, you cannot take into account any contributions or benefits that are more than the limits discussed earlier under Limits on Contributions and Benefits. However, for plan years beginning after December 31, 2001, your deduction can be as much as the plan's unfunded current liability.

Deduction limit for multiple plans.   If you contribute to both a defined contribution plan and a defined benefit plan and at least one employee is covered by both plans, your deduction for those contributions is limited. Your deduction cannot be more than the greater of the following amounts.

• 25% of the compensation paid (or accrued) during the year to your eligible employees participating in the plan. You must reduce this 25% limit in figuring the deduction for contributions you make for your own account.
• Your contributions to the defined benefit plans, but not more than the amount needed to meet the year's minimum funding standard for any of these plans.

For this rule, a SEP is treated as a separate profit-sharing (defined contribution) plan.

Deduction Limit for Self-Employed Individuals

If you make contributions for yourself, you need to make a special computation to figure your maximum deduction for these contributions. Compensation is your net earnings from self-employment, defined in chapter 1. This definition takes into account both the following items.

• The deduction for one-half of your self-employment tax.
• The deduction for contributions on your behalf to the plan.

The deduction for your own contributions and your net earnings depend on each other. For this reason, you determine the deduction for your own contributions indirectly by reducing the contribution rate called for in your plan. To do this, use either the Rate Table for Self-Employed or the Rate Worksheet for Self-Employed in chapter 5. Then figure your maximum deduction by using the Deduction Worksheet for Self-Employed in chapter 5.

Multiple plans.   The deduction limit for multiple plans (discussed earlier) also applies to contributions you make as an employer on your own behalf.

Where To Deduct Contributions

Deduct the contributions you make for your common-law employees on Schedule C (Form 1040), on Schedule F (Form 1040), on Form 1065, U.S. Return of Partnership Income, Form 1120, U.S. Corporation Income Tax Return, on Form 1120-A, U.S. Short-Form Corporation Income Tax Return, or on Form 1120S, U.S. Income Tax Return for an S Corporation, whichever applies.

You take the deduction for contributions for yourself on line 29 of Form 1040.

If you are a partner, the partnership passes its deduction to you for the contributions it made for you. The partnership will report these contributions on Schedule K-1 (Form 1065). You deduct them on line 29 of Form 1040.

Carryover of Excess Contributions

If you contribute more to the plans than you can deduct for the year, you can carry over and deduct the difference in later years, combined with your contributions for those years. Your combined deduction in a later year is limited to 25% of the participating employees' compensation for that year. The limit is 15% (25% for years beginning after December 31, 2001) if you have only profit-sharing plans (including SEPs). However, these percentage limits must be reduced to figure your maximum deduction for contributions you make for yourself. See Deduction Limit for Self-Employed Individuals, earlier. The amount you carry over and deduct may be subject to the excise tax discussed next.

Table 4–1. Carryover of Excess Contributions Illustrated

Table 4-1 illustrates the carryover of excess contributions to a profit-sharing plan.

Excise Tax for Nondeductible (Excess) Contributions

If you contribute more than your deduction limit to a retirement plan, you have made nondeductible contributions and you may be liable for an excise tax. In general, a 10% excise tax applies to nondeductible contributions made to qualified pension, profit-sharing, stock bonus, or annuity plans and to SEPs.

Special rule for self-employed individuals.   The 10% excise tax does not apply to any contribution made to meet the minimum funding requirements in a money purchase pension plan or a defined benefit plan. Even if that contribution is more than your earned income from the trade or business for which the plan is set up, the difference is not subject to this excise tax. See Minimum Funding Requirement, earlier.

Exception.   If contributions to one or more defined contribution plans are not deductible only because they are more than the combined plan deduction limit, the 10% excise tax does not apply to the extent the difference is not more than the greater of the following amounts.

• 6% of the participants' compensation for the year.
• The sum of employer matching contributions and the elective deferrals to a 401(k) plan.

Reporting the tax.   You must report the tax on your nondeductible contributions on Form 5330. Form 5330 includes a computation of the tax. See the separate instructions for completing the form.

Elective Deferrals (401(k) Plans)

Your qualified plan can include a cash or deferred arrangement (401(k) plan) under which participants can choose to have you contribute part of their before-tax compensation to the plan rather than receive the compensation in cash. (As a participant in the plan, you can contribute part of your before-tax net earnings from the business.) This contribution is called an elective deferral because participants choose (elect) to set aside the money, and they defer the tax on the money until it is distributed to them.

In general, a qualified plan can include a 401(k) plan only if the qualified plan is one of the following plans.

• A profit-sharing plan.
• A money purchase pension plan in existence on June 27, 1974, that included a salary reduction arrangement on that date.

Automatic enrollment in a 401(k) plan.   Your 401(k) plan can have an automatic enrollment feature. Under this feature, you can automatically reduce an employee's pay by a fixed percentage and contribute that amount to the 401(k) plan on his or her behalf unless the employee affirmatively chooses not to have his or her pay reduced or chooses to have it reduced by a different percentage. These contributions qualify as elective deferrals. For more information about 401(k) plans with an automatic enrollment feature, see Revenue Ruling 2000-8 in Internal Revenue Bulletin 2000-7.

Partnership.   A partnership can have a 401(k) plan.

Restriction on conditions of participation.   The plan cannot require, as a condition of participation, that an employee complete more than 1 year of service.

Matching contributions.   If your plan permits, you can make matching contributions for an employee who makes an elective deferral to your 401(k) plan. For example, the plan might provide that you will contribute 50 cents for each dollar your participating employees choose to defer under your 401(k) plan.

Nonelective contributions.   You can, under a qualified 401(k) plan, also make contributions (other than matching contributions) for your participating employees without giving them the choice to take cash instead.

Employee compensation limit.   No more than $170,000 ($200,000 for 2002) of the employee's compensation can be taken into account when figuring contributions.

SIMPLE 401(k) plan.   If you had 100 or fewer employees who earned $5,000 or more in compensation during the preceding year, you may be able to set up a SIMPLE 401(k) plan. A SIMPLE 401(k) plan is not subject to the nondiscrimination and top-heavy plan requirements discussed later under Qualification Rules. For details about SIMPLE 401(k) plans, see SIMPLE 401(k) Plan in chapter 3.

Limit on Elective Deferrals

There is a limit on the amount an employee can defer each year under these plans. This limit applies without regard to community property laws. Your plan must provide that your employees cannot defer more than the limit that applies for a particular year. For 2001, the basic limit on elective deferrals is $10,500. (For 2002, this limit increases to $11,000 and participants who are age 50 or over can make a catch-up contribution of up to $1,000.) If, in conjunction with other plans, the deferral limit is exceeded, the difference is included in the employee's gross income.

Self-employed individual's matching contributions.   Matching contributions to a 401(k) plan on behalf of a self-employed individual are not subject to the limit on elective deferrals. These matching contributions receive the same treatment as the matching contributions for other employees.

Treatment of contributions.   Your contributions to a 401(k) plan are generally deductible by you and tax free to participating employees until distributed from the plan. Participating employees have a nonforfeitable right to the accrued benefit resulting from these contributions. Deferrals are included in wages for social security, Medicare, and federal unemployment (FUTA) tax.

Reporting on Form W-2.   You must report the total deferred in boxes 3, 5, and 12 of your employee's Form W-2. See the Form W-2 instructions.

Treatment of Excess Deferrals

If the total of an employee's deferrals is more than the limit for 2001, the employee can have the difference (called an excess deferral) paid out of any of the plans that permit these distributions. He or she must notify the plan by March 1, 2002, of the amount to be paid from each plan. The plan must then pay the employee that amount by April 15, 2002.

Excess withdrawn by April 15.   If the employee takes out the excess deferral by April 15, 2002, it is not reported again by including it in the employee's gross income for 2002. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10% tax on early distributions.

If the employee takes out part of the excess deferral and the income on it, the distribution is treated as made proportionately from the excess deferral and the income.

Even if the employee takes out the excess deferral by April 15, the amount is considered contributed for satisfying (or not satisfying) the nondiscrimination requirements of the plan. See Contributions or benefits must not discriminate, later, under Qualification Rules.

Excess not withdrawn by April 15.   If the employee does not take out the excess deferral by April 15, 2002, the excess, though taxable in 2001, is not included in the employee's cost basis in figuring the taxable amount of any eventual benefits or distributions under the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.

Reporting corrective distributions on Form 1099-R.   Report corrective distributions of excess deferrals (including any earnings) on Form 1099-R. For specific information about reporting corrective distributions, see the 2001 Instructions for Forms 1099, 1098, 5498, and W-2G.

Tax on excess contributions of highly compensated employees.   The law provides tests to detect discrimination in a plan. If tests, such as the actual deferral percentage test (ADP test) (see section 401(k)(3)) and the actual contribution percentage test (ACP test) (see section 401(m)(2)), show that contributions for highly compensated employees are more than the test limits for these contributions, the employer may have to pay a 10% excise tax. Report the tax on Form 5330.

The tax for the year is 10% of the excess contributions for the plan year ending in your tax year. Excess contributions are elective deferrals, employee contributions, or employer matching or nonelective contributions that are more than the amount permitted under the ADP test or the ACP test.

See Notice 98-1 for further guidance and transition relief relating to recent statutory amendments to the nondiscrimination rules under sections 401(k) and 401(m). Notice 98-1 is in Cumulative Bulletin 1998-1.

Distributions

Amounts paid to plan participants from a qualified plan are called distributions. Distributions may be nonperiodic, such as lump-sum distributions, or periodic, such as annuity payments. Also, certain loans may be treated as distributions. See Loans Treated as Distributions in Publication 575.

Required Distributions

A qualified plan must provide that each participant will either:

• Receive his or her entire interest (benefits) in the plan by the required beginning date (defined later), or
• Begin receiving regular periodic distributions by the required beginning date in annual amounts calculated to distribute the participant's entire interest (benefits) over his or her life expectancy or over the joint life expectancy of the participant and the designated beneficiary (or over a shorter period).

These distribution rules apply individually to each qualified plan. You cannot satisfy the requirement for one plan by taking a distribution from another. These rules may be incorporated in the plan by reference. The plan must provide that these rules override any inconsistent distribution options previously offered.

Minimum distribution.   If the account balance of a qualified plan participant is to be distributed (other than as an annuity), the plan administrator must figure the minimum amount required to be distributed each distribution calendar year. This minimum is figured by dividing the account balance by the applicable life expectancy. For details on figuring the minimum distribution, see Tax on Excess Accumulation in Publication 575.

Minimum distribution incidental benefit requirement.   Minimum distributions must also meet the minimum distribution incidental benefit requirement. This requirement ensures the plan is used primarily to provide retirement benefits to the employee. After the employee's death, only incidental benefits are expected to remain for distribution to the employee's beneficiary (or beneficiaries). For more information about other distribution requirements, see Publication 575.

Required beginning date.   Generally, each participant must receive his or her entire benefits in the plan or begin to receive periodic distributions of benefits from the plan by the required beginning date.

A participant must begin to receive distributions from his or her qualified retirement plan by April 1 of the first year after the later of the following years.

1. Calendar year in which he or she reaches age 70½.
2. Calendar year in which he or she retires.

However, your plan may require you to begin receiving distributions by April 1 of the year after you reach age 70½ even if you have not retired.

If the participant is a 5% owner of the employer maintaining the plan or if the distribution is from a traditional or SIMPLE IRA, the participant must begin receiving distributions by April 1 of the first year after the calendar year in which the participant reached age 70½. For more information, see Tax on Excess Accumulation in Publication 575.

Distributions after the starting year.   The distribution required to be made by April 1 is treated as a distribution for the starting year. (The starting year is the year in which the participant meets (1) or (2) above, whichever applies.) After the starting year, the participant must receive the required distribution for each year by December 31 of that year. If no distribution is made in the starting year, required distributions for 2 years must be made in the next year (one by April 1 and one by December 31).

Distributions after participant's death.   See Publication 575 for the special rules covering distributions made after the death of a participant.

Distributions From 401(k) Plans

Generally, distributions cannot be made until one of the following occurs.

• The employee retires, dies, becomes disabled, or otherwise separates from service.
• The plan ends and no other defined contribution plan is established or continued.
• In the case of a 401(k) plan that is part of a profit-sharing plan, the employee reaches age 59½ or suffers financial hardship. For the rules on hardship distributions, including the limits on them, see section 1.401(k)-1(d)(2) of the regulations.

Certain distributions listed above may be subject to the tax on early distributions discussed later.

Qualified domestic relations order (QDRO).   These distribution restrictions do not apply if the distribution is to an alternate payee under the terms of a QDRO, which is defined in Publication 575.

Tax Treatment of Distributions

Distributions from a qualified plan minus a prorated part of any cost basis are subject to income tax in the year they are distributed. Since most recipients have no cost basis, a distribution is generally fully taxable. An exception is a distribution that is properly rolled over as discussed next under Rollover.

The tax treatment of distributions depends on whether they are made periodically over several years or life (periodic distributions) or are nonperiodic distributions. See Taxation of Periodic Payments and Taxation of Nonperiodic Payments in Publication 575 for a detailed description of how distributions are taxed, including the 10-year tax option or capital gain treatment of a lump-sum distribution.

Rollover.   The recipient of an eligible rollover distribution from a qualified plan can defer the tax on it by rolling it over into a traditional IRA or another eligible retirement plan. However, it may be subject to withholding as discussed under Withholding requirement, later.

Eligible rollover distribution.   This is a distribution of all or any part of an employee's balance in a qualified retirement plan that is not any of the following.

1. A required minimum distribution. See Required Distributions, earlier.
2. Any of a series of substantially equal payments made at least once a year over any of the following periods.
   1. The employee's life or life expectancy.
   2. The joint lives or life expectancies of the employee and beneficiary.
   3. A period of 10 years or longer.
3. A hardship distribution from a 401(k) plan. (No hardship distribution made after December 31, 2001, will qualify as an eligible rollover distribution.)
4. The portion of a distribution that represents the return of an employee's nondeductible contributions to the plan. See Employee Contributions, earlier.
5. A corrective distribution of excess contributions or deferrals under a 401(k) plan and any income allocable to the excess, or of excess annual additions and any allocable gains. See Correcting excess annual additions, earlier, under Limits on Contributions and Benefits.
6. Loans treated as distributions.
7. Dividends on employer securities.
8. The cost of life insurance coverage.

More information.   For more information about rollovers, see Rollovers in Publications 575 and 590.

Withholding requirement.   If, during a year, a qualified plan pays to a participant one or more eligible rollover distributions (defined earlier) that are reasonably expected to total $200 or more, the payor must withhold 20% of each distribution for federal income tax.

Exceptions.   If, instead of having the distribution paid to him or her, the participant chooses to have the plan pay it directly to an IRA or another eligible retirement plan (a direct rollover), no withholding is required.

If the distribution is not an eligible rollover distribution, defined earlier, the 20% withholding requirement does not apply. Other withholding rules apply to distributions such as long-term periodic distributions and required distributions (periodic or nonperiodic). However, the participant can still choose not to have tax withheld from these distributions. If the participant does not make this choice, the following withholding rules apply.

• For periodic distributions, withholding is based on their treatment as wages.
• For nonperiodic distributions, 10% of the taxable part is withheld.

Estimated tax payments.   If no income tax is withheld or not enough tax is withheld, the recipient of a distribution may have to make estimated tax payments. For more information, see Withholding Tax and Estimated Tax in Publication 575.

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