A k plan can have an automatic enrollment feature. These contributions qualify as elective deferrals. This has been an effective way for many employers to increase participation in their k plans.
For more information about k plans with an automatic enrollment feature, refer to Income Tax Regulations section 1. The law, under IRC section g , limits the amount that a participant can defer on a pre-tax basis each year. See the k Plan Contribution Limits.
If the plan document permits, the employer can make matching contributions for an employee who contributes elective deferrals to the k plan. For example, a k plan might provide that the employer will contribute 50 cents for each dollar that participating employees choose to defer under the plan. As mentioned earlier, employer matching contributions may be subject to annual tests to determine if nondiscrimination requirements are met.
If the plan document permits, the employer can make additional contributions other than matching contributions for participants, including participants who choose not to contribute elective deferrals to the k plan.
If the k plan is top-heavy, the employer may be required to make minimum contributions on behalf of certain employees. The rules relating to the determination of whether a plan is top-heavy are complex.
This can be a difficult concept for new k savers to grasp, but it's what makes a k plan a powerful savings tool.
Put simply, your earnings are plowed back in to the account so you earn interest on your original principal plus interest. Over the short term, the gains can appear small. But over the long term, you can see exponential results. For example, take the number two and double it, then double that number, and again.
After you have doubled two only 10 times you reach 2, Interest compounding works the same way. Assuming an eight percent average return, you can reasonably expect a one-time k savings contribution to double every seven years.
If you consider most folks have at least a year working life, their initial contributions could double at least five times. If you are adding to your original contribution each year and receive an employer match, you can see your savings have some real growth potential. Dollar cost averaging lets you buy low, sell high. Sophisticated investors use this strategy. Instead of looking and waiting for the bottom price at which to buy, you consistently use the same amount of money to buy securities over time.
When prices are high you buy fewer shares, but when prices are low you buy more shares. This tends to lower the average cost of all of your shares.
Since k savers make a contribution with every paycheck, by default they use this strategy. You can contribute more to a k than to an IRA. The next most common are domestic index funds. The more options available to you, the better your chances of finding a well-performing option with low fees. You should never turn down free money as long as most of it is remaining in your account. A self-directed plan allows you to manage your account on your own, similar to a more traditional brokerage account.
Once you have established a 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 to hire a professional or financial institution - such as a bank, mutual fund provider, or insurance company - to take care of some or most aspects of operating the plan. Elements of a plan that need to be handled include:. However, some employees may be excluded from a k plan if they:.
If you decide to contribute to your k plan, you have further options. Using a matching contribution formula will provide additional employer contributions only to employees who make deferrals to the k plan. If you choose to make nonelective contributions, the employer makes a contribution for each eligible participant, whether or not the participant decides to make a salary deferral to his or her k account.
Under a traditional k plan, you have the flexibility of changing the amount of nonelective contributions each year, according to business conditions. Each year you must make either the matching contributions or the nonelective contributions. Under an automatic enrollment k plan with a qualified automatic contribution arrangement, the plan is exempt from the annual IRS testing requirement that a traditional k plan must perform.
The initial automatic employee contribution must be at least 3 percent of compensation. Contributions may have to automatically increase so that, by the fifth year, the automatic employee contribution is at least 6 percent of compensation. The automatic employee contributions cannot exceed 10 percent of compensation in any year.
The employee is permitted to change the amount of his or her employee contributions or choose not to contribute but must do so by making an affirmative election.
A dollar-for-dollar matching contribution, up to 3 percent of pay; or 2.
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