A letter of determination is a letter from the U.S. Internal Revenue Service to the sponsor of a 401(k) retirement plan that indicates that the plan meets legal requirements, complies with the relevant sections of the Internal Revenue Code, and is "qualified," meaning that it qualifies for special tax treatment.
Why a plan sponsor might seek a letter
A properly structured 401(k) plan -- one that is qualified under section 401(a) of the Internal Revenue Code -- is entitled to favorable tax treatment. For instance, participant contributions are made on a pre-tax basis, and participants aren't required to report them as taxable income until they receive a distribution from the plan.
But the rules that govern plan structures are complex, and the favorable tax treatment doesn't apply if the plan isn't structured properly. If a plan sponsor wants assurance that its plan complies with the Internal Revenue Code, it can apply to the IRS for a letter of determination.
After receiving the application, the IRS will examine the plan's governing documents. If the plan complies with all of the requirements, then the IRS will issue a "favorable" letter of determination. A favorable letter indicates that the plan complies with the rules in section 401(a) of the Internal Revenue Code and that the trust that holds the employees' funds is tax-exempt under section 501(a) of the code.
Simply put, a favorable letter gives the sponsor some protection in the event that a dispute over the plan's tax status arises later.
Pre-approved plan documents
Letters of determination aren't required. An employer that wants the assurance provided by a favorable letter can bypass the application process by adopting a "pre-approved plan," one of two types of template plans that are approved by the IRS. Such plans use standardized documents in a form that the IRS has already approved, and they come with a favorable determination letter as part of the package.
Limits of a letter's protection
Of course, a favorable letter of determination doesn't take any later amendments to the plan documents into account. Nor does it protect the sponsor in the event that the plan isn't managed in accordance with its plan documents.
How to obtain a letter of determination
In most cases, the sponsor of an individually designed plan (that is, one that doesn't follow one of the pre-approved IRS templates) will use IRS Form 5300 to apply for a letter. There are other forms applicable to sponsors seeking to modify a pre-approved plan (Form 5307) and to sponsors of a plan that is terminating (Form 5310).
Once the forms are submitted, the IRS will review the plan's documents. There is a 60-day window during which interested parties can submit comments, meaning that it will take at least 60 days after the date of application for the IRS to issue its letter.
For more information
See IRS Publication 794, "Favorable Determination Letter."
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.