Key Takeaways
- Pre-tax 401(k) deferrals reduce current taxable income; Roth 401(k) provides tax-free qualified distributions
- ADP test limits HCE deferrals based on NHCE participation: if NHCEs defer 2%, HCEs can defer 4%; if NHCEs defer 6%, HCEs can defer 8%
- Safe harbor 401(k) requires either 3% non-elective contribution to all OR 100% match on first 3% plus 50% on next 2% of deferrals
- QACA allows 3-month delayed safe harbor with 90-day auto-enrollment and 2-year cliff vesting on employer contributions
- Plan loans limited to lesser of $50,000 or 50% of vested balance; hardship withdrawals require immediate and heavy financial need
401(k) Plan Features
A 401(k) plan is a Cash or Deferred Arrangement (CODA) that attaches to a profit sharing or stock bonus plan. It is the most prevalent type of employer-sponsored retirement plan today, predominantly funded through employee elective deferrals with optional employer matching contributions. Understanding 401(k) features, testing requirements, and distribution rules is critical for CFP exam success.
Salary Deferrals: Pre-Tax vs. Roth
Employees can defer compensation to a 401(k) on either a pre-tax or Roth (after-tax) basis, depending on plan design.
Pre-Tax Deferrals (Traditional 401(k))
| Feature | Details |
|---|---|
| Tax treatment at contribution | Reduces current taxable income |
| Tax treatment at distribution | Taxed as ordinary income |
| Required minimum distributions | Required beginning at age 73 |
| Best for | Those expecting lower tax rates in retirement |
Roth 401(k) Deferrals
| Feature | Details |
|---|---|
| Tax treatment at contribution | No current tax deduction (after-tax) |
| Tax treatment at distribution | Tax-free if qualified |
| Qualified distribution requirements | 5 years from first Roth contribution AND age 59 1/2, death, or disability |
| Required minimum distributions | No longer required (SECURE 2.0, effective 2024) |
| Best for | Those expecting higher tax rates in retirement |
Key Difference: Unlike Roth IRAs, Roth 401(k)s have no income limits for contributions. Any employee can make Roth 401(k) deferrals regardless of income.
Employer Matching Contributions
Employer matching contributions incentivize employee participation and increase overall savings rates. Common matching formulas include:
Common Matching Formulas
| Formula Type | Example | Employee Defers 6% on $100,000 |
|---|---|---|
| Dollar-for-dollar up to X% | 100% match up to 3% | $3,000 match |
| Partial match | 50% match up to 6% | $3,000 match |
| Tiered match | 100% on first 3%, 50% on next 2% | $4,000 match |
| Discretionary | Varies year to year | Based on company decision |
Vesting: Employee deferrals are always 100% vested immediately. Employer matching contributions may vest according to a schedule:
- 2-6 year graded: 0%, 20%, 40%, 60%, 80%, 100%
- 3-year cliff: 0% until year 3, then 100%
ADP/ACP Testing: Ensuring Nondiscrimination
Traditional 401(k) plans must pass nondiscrimination tests annually to ensure that Highly Compensated Employees (HCEs) do not disproportionately benefit compared to Non-Highly Compensated Employees (NHCEs).
Highly Compensated Employee (HCE) Definition (2025)
An employee is an HCE if:
- >5% owner at any time during the current or prior year, OR
- Compensation exceeded $160,000 in the prior year (with optional top 20% election)
The Actual Deferral Percentage (ADP) Test
The ADP test limits elective deferrals of HCEs based on the average deferral percentage of NHCEs.
ADP Test Formula:
| If NHCE ADP is... | Maximum HCE ADP is... |
|---|---|
| 0% to 2% | 2 x NHCE ADP |
| 2% to 8% | NHCE ADP + 2% |
| Over 8% | 1.25 x NHCE ADP |
ADP Test Examples:
| NHCE Average Deferral | Maximum HCE Deferral | Calculation |
|---|---|---|
| 1% | 2% | 1% x 2 = 2% |
| 2% | 4% | 2% x 2 = 4% |
| 3% | 5% | 3% + 2% = 5% |
| 5% | 7% | 5% + 2% = 7% |
| 8% | 10% | 8% + 2% = 10% |
| 10% | 12.5% | 10% x 1.25 = 12.5% |
The Actual Contribution Percentage (ACP) Test
The ACP test applies to:
- Employee after-tax contributions (thrift contributions)
- Employer matching contributions
The ACP test uses the same scale as the ADP test.
Correcting Failed ADP/ACP Tests
If a plan fails, corrections must be made by March 15 (2.5 months after plan year end) to avoid a 10% excise tax:
| Correction Method | Effect |
|---|---|
| Corrective distributions | Return excess contributions to HCEs (reduces HCE percentage) |
| Recharacterization | Change pre-tax to after-tax contributions (reduces ADP but increases ACP) |
| QNECs (Qualified Non-Elective Contributions) | Employer contributes to all eligible NHCEs (increases NHCE percentage) |
| QMACs (Qualified Matching Contributions) | Employer adds match only for deferring NHCEs (increases NHCE percentage) |
Safe Harbor 401(k) Plans
Safe harbor 401(k) plans are exempt from ADP and ACP testing when specific contribution and notice requirements are met.
Safe Harbor Contribution Options
| Safe Harbor Type | Required Employer Contribution | Vesting |
|---|---|---|
| Non-Elective | 3% of compensation to ALL eligible employees | 100% immediate |
| Basic Match | 100% on first 3% + 50% on next 2% of deferrals | 100% immediate |
| Enhanced Match | At least as generous as basic match | 100% immediate |
Safe Harbor Basic Match Calculation:
Employee earning $100,000 who defers 5%:
- Match on first 3%: 100% x $3,000 = $3,000
- Match on next 2%: 50% x $2,000 = $1,000
- Total match: $4,000 (4% of compensation)
Key Point: Safe harbor contributions must be 100% vested immediately. No graded or cliff vesting is permitted on safe harbor amounts.
Notice Requirement
Employers must provide eligible employees with written notice at least 30 days (and no more than 90 days) before the beginning of each plan year describing safe harbor contribution formula and other plan features.
QACA: Qualified Automatic Contribution Arrangement
A QACA combines automatic enrollment with safe harbor provisions for a modified ADP/ACP testing exemption.
QACA Requirements
| Feature | Requirement |
|---|---|
| Automatic enrollment | Default deferral of at least 3%, escalating annually by 1% to at least 10% (15% max cap) |
| Employer contribution | Basic safe harbor match OR 3% non-elective |
| Vesting | 2-year cliff (not immediate) |
| Withdrawals | Participants may withdraw auto-enrolled amounts within 90 days |
| Notice | 30-90 days before plan year |
QACA Advantage: Unlike standard safe harbor, QACA allows 2-year cliff vesting on employer contributions rather than requiring immediate vesting.
Catch-Up Contributions
Participants age 50 or older by year-end may make additional catch-up contributions beyond the standard deferral limit.
2025 Catch-Up Limits
| Age | Standard Deferral | Catch-Up | Total |
|---|---|---|---|
| Under 50 | $23,500 | $0 | $23,500 |
| 50-59 | $23,500 | $7,500 | $31,000 |
| 60-63 | $23,500 | $11,250 | $34,750 |
| 64+ | $23,500 | $7,500 | $31,000 |
Catch-up contributions do NOT count toward the $70,000 annual additions limit.
In-Plan Roth Conversions
Many 401(k) plans permit in-plan Roth conversions, allowing participants to convert pre-tax amounts to Roth within the same plan.
In-Plan Roth Conversion Rules
| Feature | Details |
|---|---|
| Availability | Plan sponsor must elect to offer this feature |
| Amount | No dollar limit on conversion amount |
| Age restriction | Can be done at any age |
| Tax treatment | Converted amount is taxable as ordinary income in year of conversion |
| 10% penalty | Does not apply to conversions (even under age 59 1/2) |
| 5-year rule | Converted amounts subject to their own 5-year holding period for penalty-free withdrawal |
Strategic Use: In-plan conversions allow participants to convert at lower tax rates (e.g., after job loss or early retirement) while keeping funds in the plan's protected environment.
Hardship Withdrawals
Participants may take hardship withdrawals from their 401(k) if the plan permits and they have an immediate and heavy financial need.
Immediate and Heavy Financial Need (Safe Harbor Events)
| Qualifying Event |
|---|
| Medical expenses for participant, spouse, or dependents |
| Purchase of primary residence (down payment) |
| Tuition and educational expenses for next 12 months |
| Prevention of eviction or mortgage foreclosure |
| Funeral and burial expenses |
| Repair of damage to principal residence |
Hardship Withdrawal Rules
| Feature | Requirement |
|---|---|
| Amount | Limited to amount necessary to satisfy need |
| Source | May include deferrals, but plan may restrict to contributions only (not earnings) |
| Repayment | Cannot be repaid or rolled over |
| Taxes | Subject to ordinary income tax |
| Penalty | 10% early withdrawal penalty applies unless exception met |
| Loan first | IRS no longer requires taking loans before hardship |
SECURE 2.0 Emergency Withdrawals
SECURE 2.0 created new penalty-free withdrawal options:
| Type | Amount | Penalty |
|---|---|---|
| Emergency personal expense | Up to $1,000/year | 10% penalty waived |
| Domestic abuse victims | Lesser of $10,000 or 50% vested balance | 10% penalty waived |
| Disaster relief | Up to $22,000 per disaster | 10% penalty waived |
Plan Loans
401(k) plans may permit participants to borrow from their vested account balance.
Loan Limits
The maximum loan is the lesser of:
- $50,000, OR
- 50% of the participant's vested account balance
Reduced by: Highest outstanding loan balance in the prior 12 months.
Exception: If vested balance is under $20,000, the maximum loan is the lesser of:
- $10,000, OR
- The vested account balance
Loan Repayment Requirements
| Requirement | Details |
|---|---|
| Term | Generally 5 years maximum |
| Exception | Up to 15-30 years if used to purchase principal residence |
| Payments | Substantially level amortization, at least quarterly |
| Interest rate | Reasonable rate (typically prime + 1%) |
| Termination | Loan generally becomes due upon termination of employment |
| Default | Unpaid balance becomes taxable distribution + 10% penalty if under 59 1/2 |
Loan Repayment After Termination (TCJA 2017)
If an employee terminates with an outstanding loan, they may rollover/repay the loan by the tax filing deadline (including extensions) to avoid the distribution being taxable.
On the CFP Exam
Expect questions on:
- Calculating ADP/ACP test limits using the tiered formula
- Understanding safe harbor contribution requirements (3% non-elective OR 100%/50% match)
- Distinguishing pre-tax vs. Roth 401(k) taxation and distribution rules
- Applying plan loan limits ($50,000 or 50% of vested balance)
- Identifying hardship withdrawal qualifying events and consequences
A 401(k) plan's ADP test shows that NHCEs have an average deferral percentage of 4%. What is the maximum average deferral percentage permitted for HCEs?
Which statement about safe harbor 401(k) plans is CORRECT?
An employee with a vested 401(k) balance of $80,000 wants to take the maximum plan loan. She had no outstanding loans in the prior 12 months. What is the maximum she can borrow?