Like all retirement plans, a 401(k) plan must meet certain tax requirements to be a qualified plan. It's important to consider how IRS-specific 401(k) requirements can impact your plan design and ultimately your plan's success. The big six 401(k) requirements are:

1. Election to receive contribution or cash. Under this rule, employees must be given the opportunity to have their employer contribute a portion of the employees' cash wages to the plan on a pretax basis. These deferred wages (elective deferrals) are not subject to federal income tax withholding at the time of deferral, and they are not reflected as taxable income on employees' tax returns.

Under a tax law change in 2006, the plan (if so provided for) can allow employees to make some or all of their 401(k) contributions pretax or as Roth 401(k) contribution (after-tax). The advantage of the Roth is that if certain requirements are met, the employee can receive Roth account earnings on a tax-free basis.

2. Maximum one-year eligibility. The IRS says that you cannot keep employees from participating in a 401(k) plan for more than one year. Effectively, it can mean up to 18 months since entry dates can be extended to subsequent semi-annual dates.

For example, under this type of plan design, an employee hired in February 2011 would be eligible to participate in February 2012 but would enter the plan on July 1, 2012.

Many plans use dual-eligibility requirements. That is, different eligibility requirements are used for employer matching and profit-sharing contributions. A plan may have immediate entry or a short waiting period for employee deferrals, but up to a one-year waiting period for employer contributions.

3. Annual 401(k) limits. Employees are limited to a maximum annual deferral in 2010 of the lesser of 100% of compensation or $16,500 plus $5,500 catch up if age 50 or older. It's a little more complicated than that, of course. As with all tax rules, it's all in the details.

401(k) plans are subject to meeting non-discrimination requirements referred to as the "average deferral percentage test" for employee contributions and "average contribution percentage test" for employer matching contributions. These tests govern the amount that can be contributed to your highly compensated employees.

The annual 401(k) limit is a personal limit, not a plan-specific one. While it's up to your payroll system to track and limit an employee's deferrals to the aforementioned percentage and dollar amount, sometimes it's beyond your control.

That's the situation that sometimes happens when an individual is hired during the year and whose former employer has a 401(k) plan to which the new employee contributed.

Best practice is to inform the new employee that the IRS will take into account 401(k) contributions made to all employer plans during the year. In either situation, it would be necessary to return excess contributions, which then become taxable compensation to the employee.

4. ADP and ACP tests. These tests limit deferrals by highly compensated employees. Highly compensated employees are individuals who own 5% or more of the company, earned $110,000 or more in 2009 or are certain family members.

Returning excess contributions to HCEs can sometimes be avoided by plan design. Here are a few plan sponsors can use:

* Using the top-paid group election allows the employer to restrict the number of HCEs to the highest paid 20% of employees.

* Making a safe harbor contribution of 3% to all employees with 100% vesting. This contribution automatically allows the plan to pass the ADP test.

* Making a safe harbor match of 100% of the first 3%, plus 50% on the next 2%, to a maximum of 5% with 100% vesting. This is an alternative type of safe harbor contribution which also allows the plan to pass the ADP test.

* Defining plan compensation to include only compensation earned as a plan participant.

Correcting excess deferrals by HCEs requires either the employer returning excess deferrals plus earnings within two-and-a-half months after the plan's year end, or contributing a qualified non-elective contribution or qualified matching contribution on behalf of non-highly compensated employees.

5. Vesting requirements. Employees must be fully vested in their elective deferrals. A 401(k) may require completion of a specific number of years of service for vesting in other employer or matching contributions. A typical vesting method is so-called 2-20 vesting. That is, an employee becomes 20% vested in his or her employer contribution accounts after two years of service, 20% a year thereafter, and 100% after six or more years of service.

Vesting schedules can have a significant impact on plan costs. Using the 2-20 vesting schedule as an example, an employee who terminates with four years of service would only receive 60% of his or her employer accounts.

The remaining 40% would be considered forfeiture and - depending on plan design - could be used to reduce future employer contributions, pay plan expenses, or be reallocated to remaining employees.

6. No distributions while a participant. While 401(k) participants can't take funds they've already contributed out of the plan prior to leaving the company, there are two ways - loans and hardship distributions - employees can access their accounts while employed. Plan sponsors and advisers have a wide range of opinions on which option is best.

Contributing Editor Jerry Kalish is the founder of The Retirement Plan Blog and president of National Benefit Services, Inc., a Chicago-based employee benefit consulting and administrative firm.

This article is for general information purposes only and should not be considered tax or legal advice. Consult your tax or legal adviser regarding the impact of tax laws on your individual situation.

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