A Look At The Legal Requirements Of A 401(k) Plan

by: Hale Stewart


All 401(k)s must comply with certain rules at all times the plan is in existence in order to be "qualified" -- receive tax-deferred status.

The code places a fiduciary obligation on all trustees.  This is a long-standing legal concept that is sacrosanct in legal circles.

There are also rules relating to minimum participation standards.

Today I'm going to take a look at the rules that are specifically mentioned in section 401. These must be present in all plans at all times in order for the plan to be "qualified" -- meaning it will receive tax-deferred status.

When I said "tax code" you froze, didn't you? Rest assured that I'll translate "code talk" into English so you get a better understanding of what's involved.

As a preliminary matter, here's a link to the code section 401 if you're so inclined. Next, I'll quote the "tax lingo" in bold (the exact words from the tax code) and then provide context that you'll need to understand what's really going on.

Second, this article is meant for anyone with a 401(k); the information is just as valuable for people implementing a plan as those participating in a plan.

Let's get started!

1.) "A trust created or organized in the United States ..." The word "trust" is not used by accident; it's there because when a lawyer hears that word, he/she thinks "fiduciary obligation." And that's the point. The tax code specifically places a fiduciary burden on the company that implements the plan along with the people that oversee the plan's day-to-day operations. There are hundreds of cases defining "fiduciary obligation" which say more or less the same thing: the trustee has a burden far beyond the "morals of the marketplace." It also means that a court will lower the legal boom on the company that violates this trust.

2.) The plan must be "for the exclusive benefit of his employees." When establishing the trust, the plan document can't say, "this trust is for the employee's retirement and capital expenditures and to pay back taxes..." That's not possible. The trust can only be for the benefit of the employees. Period. This prevents a great deal of potential malfeasance on the part of the company.

3.) "...if under the trust instrument it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries." Let's suppose that a company with a very well-funded 401(k) was facing an incredibly difficult financial situation -- for the sake of argument, their sales drop 50% in 12 months and their suppliers are clamoring for payment. The company might be tempted to dip into their retirement plan to pay the bills. This section says the trust must satisfy all existing liabilities -- its obligation to its beneficiaries -- before spending money on anything else.

4.) ...if the plan of which such trust is a part satisfies the requirements of section 410 (relating to minimum participation standards). According to this section, a specific percentage of the employees must benefit from the plan in order for it to be "qualified" -- receive tax-deferred treatment. The most widely used test is that at least 70% of "non-highly compensated" employees must benefit. If you work for a large company, you've probably experienced a small amount of HR harassment about signing up for your 401(k). This is why.

5.) "...if the contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees ..." 401(k) plans -- which, by definition, are for larger companies -- have a potential problem. C-Suite executives make more money and would be willing to contribute a lot more of their salary to the plan to take advantage of its tax-deferral. For reasons of equity, the drafters of this statute wanted to prevent that from happening. So they included several provisions that limit the potential benefit that executives can obtain from a plan.

Wasn't that easy -- or at least, not as difficult as you thought it would be? I hope so.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: Financial Advisors, Retirement Advice
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