Partnerships, corporations, sole proprietors and non-profit groups may establish 401(k) plans.

Generally, an employee may defer up to $14,000 plus an additional "catch up" contribution of $4,000 if age 50 or older.

Deferrals and employer contributions cannot exceed the lesser of 100% of each employee's compensation or $42,000 per employee. "Catch up" contributions are not included in this limit.

Total employer contributions to the plan cannot exceed 25% of total eligible compensation. Employee contributions are not included in this limit. The maximum compensation that may be considered for any employee is $210,000.

Employees that make more than $95,000 in the preceding year are considered HCEs in the current year. In addition, any employee owning more than 5% of the outstanding stock of the company in the current or preceding year is considered an HCE. All other employees are considered non-highly compensated employees (NHCEs).

This is important due to the average deferral percentage (ADP) test which limits the average deferral of HCEs as follows:

NHCE average <2% HCE average may be 2 times the NHCE average.

NHCE average 2-8% HCE average may be 2% greater than the NHCE average.

NHCE average >8% HCE average may be 1.25 times the NHCE average.

A 401(k) plan that has made a safe harbor election is not subject to the ADP test. There are two types of safe harbor contributions:

1.  3% non-elective contribution to all eligible employees.

2.  Matching contributions equal to 100% of the first 3% and 50% of the next 2% of employee deferrals.

Example:

John's compensation for the 2004 plan year is $40,000 and he has deferred $5,000 during the year. Based on the matching formula above, the employer matching contribution would be $1,600.

$5,000 is 12.5% of $40,000. However, the employer is only obligated to match based on the first 5% that John defers. The first three percent is matched at 100% ($40,000 x 3% = $1,200) and the next two percent is matched at 50% ($40,000 x 2% x 50% = $400).