What Is a Cash or Deferred Arrangement (CODA) in a 401(k)?

A Cash or Deferred Arrangement (CODA) is a provision within an employer-sponsored plan that is the fundamental building block of a 401(k) plan. It provides employees with a choice to either receive a portion of their compensation in cash as taxable income, or to defer that amount into a retirement plan. This election facilitates employee contributions to a 401(k), allowing individuals to save for their future. The rules governing these arrangements are outlined in Section 401(k) of the Internal Revenue Code.

Understanding the Core Arrangement

The plan’s structure allows for different types of contributions from both the employee and the employer. A primary source of funding comes from employee elective deferrals. These are the amounts that an employee chooses to have withheld from their paycheck and contributed directly to their 401(k) account. These contributions are always 100% owned by the employee, a concept known as vesting, which means the employee has an irrevocable right to these funds.

Many employers choose to encourage saving by offering employer matching contributions. This is a conditional contribution made by the employer that is directly tied to the employee’s elective deferrals. A common matching formula might be for the employer to contribute 50 cents for every dollar the employee defers, up to a certain percentage of the employee’s salary.

A third way money can enter the plan is through employer nonelective contributions. Unlike matching funds, these are not dependent on whether an employee chooses to make their own deferrals. The employer contributes a certain amount for all eligible employees, providing a retirement benefit even to those who do not contribute from their own pay.

Contribution Rules and Limitations

The Internal Revenue Service (IRS) establishes annual limits on the amounts that can be contributed to a 401(k) plan. For 2025, the limit on employee elective deferrals is $23,500. This cap applies to the total amount an employee can contribute from their salary across all 401(k) and similar plans in a single year. This figure is subject to cost-of-living adjustments and may change in future years.

To help workers nearing retirement boost their savings, the tax code allows for additional catch-up contributions for those age 50 and over. In 2025, this additional amount is $7,500, allowing eligible employees to contribute a total of $31,000. A new provision starting in 2025 allows those aged 60 to 63 to make an even larger catch-up contribution of up to $11,250, if their plan allows it.

There is also an overall limit on annual additions to a participant’s account. This limit includes all contributions: the employee’s elective deferrals, employer matching contributions, and employer nonelective contributions. For 2025, this total cannot exceed $70,000 or 100% of the participant’s compensation, whichever is less.

Tax Treatment of CODA Funds

The tax journey of funds within a traditional 401(k) plan unfolds in three distinct stages. The first stage is the contribution itself. When an employee makes a pre-tax elective deferral, that amount is excluded from their current year’s taxable income. For example, an individual earning $65,000 who contributes $10,000 to their 401(k) will only be taxed on $55,000 of income for that year.

The second stage involves the growth of the assets within the account. As the contributed funds are invested, any earnings, such as interest or dividends, accumulate on a tax-deferred basis. This means the account holder does not pay taxes on the investment growth each year. This allows the full amount of the earnings to be reinvested, accelerating the compounding of the account’s value.

The final stage is distribution, which typically occurs during retirement. When an individual takes a qualified withdrawal from their traditional 401(k), generally after age 59½, the amounts withdrawn are taxed as ordinary income. The tax rate applied depends on the individual’s total taxable income in the year of withdrawal. This structure effectively shifts the tax obligation from the working years to the retirement years.

Nondiscrimination Testing Requirements

To ensure that 401(k) plans benefit a company’s entire workforce and not just its highest-paid members, employers must conduct annual nondiscrimination testing. These tests hinge on the classification of employees into two groups: Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). For 2025, an HCE is generally defined as an individual who owns more than 5% of the business or had compensation over $155,000 in the prior year.

The two primary tests are the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. The ADP test compares the average salary deferral rates of HCEs to those of NHCEs. The ACP test performs a similar comparison but focuses on employer matching contributions and any after-tax employee contributions. To pass, the average contribution rates for the HCE group cannot exceed the NHCE group’s average by more than a specified amount.

If a plan fails these tests, the employer must take corrective action, which often involves refunding contributions to HCEs. To avoid this annual testing process, many employers design their plan as a Safe Harbor 401(k). By committing to specific employer contribution formulas, the plan is deemed to automatically satisfy the ADP and ACP tests.