Setting up a 401k Retirement Plan as a Small Business

By | November 12, 2015

What is a 401k Plan?

All right, let’s talk about 401(k) plans. I believe that everybody has probably heard of a 401(k) plan. Basically, the way that it works is everybody has a deferral option. And that option is you can keep your cash now as you earn it, or you can defer it into the plan. So, basically, you pay taxes on the money now by keeping it, or you defer taxation to when you actually withdraw monies from the trust. For example, you could put $5,000.00 into the plan in 2015, don’t pay any taxes on it, and you don’t pay until you withdraw the money in 20 or 30 years. Now the employer can also contribute to a 401(k) plan.


How much can you contribute to 401k Plan?

You can put in a match. You can put in a fixed contribution. He can put in a discretionary contribution, like something like a profit- sharing plan that would be determined on a year-by-year basis. 401(k) plans are flexible, and you can change the features in the plan to suit your needs. For example, 401(k) plans can provide for loans, they can provide for hardship distributions, and you can have best used vesting schedules. For example, on the profit-sharing contribution, you could have a six-year graded vesting schedule on it.


Eligibility for 401k Plans

As for eligibility to be in a 401(k) plan, the most stringent you can be is age 21 or you worked 1,000 hours of service in any prior year. Now, of course, you can have the eligibility requirements be, you know, you’re eligible to be in the plan as of your date of hire if you would like. And the plan document, though, is going to dictate who is eligible to be in the plan. So, whatever the plan document says, that is what you have to go by. And any size of employer can offer a 401(k) plan. We see them going all the way down from one person all the way up to millions of people.


Three Different Types of 401k Plan

You have the traditional type of 401(k), which has the most responsibility, and there’s lots of testing involved in it. Something we’ve been seeing a lot now in the last ten years and really picking up is safe harbor 401(k) plans. These are nice because they help you to avoid testing. As long as the employer provides a minimum contribution to the rank and file employees, highly compensated employees can defer large amounts. And there’s also something else that we’ve been seeing more and more of lately. It’s called automatic enrollment, and we’ll explain what this is. And this can help the employer to pass or avoid testing altogether. Now when it comes to 401(k) plans, there is no IRS model form, like you just can’t go to the website and download a 401(k) plan. But, there are a lot of retirement plan providers out there that offer plan documents, and these plan documents are approved by the IRS.


Traditional 401k Plans

Okay, so let’s talk a little bit about traditional 401(k) plans. This is going to be one of your most flexible types of plans, and it can allow for very high levels of contributions. For example, in 2015, an employee could defer a salary up to $18,000.00 into a 401(k) plan. If the employee was age 50, he or she could defer an additional $6,000.00 into it, so that’s a lot of money. Now the employer contributions into a 401(k) plan: they can be fixed or they can be discretionary every year. Okay, traditionally the employer is going to offer some kind of a match to go with the plan, and the match, for example, might be like 25 cents on the dollar, up to four percent of pay. But, like whatever kind of a match the employer would offer, that match would have to be stated in the plan and the employer does have to follow the terms of the plan. Employer contributions are not necessarily mandatory in a 401(k) plan. Like if the employer wants to write up the plan documents so that they don’t have to provide a match, then they could do that if they wanted to.


Employer Contributions to 401k Plan

Now the total employee and employer contributions are going to be limited to the lesser of 100% of compensation or $53,000.00. And that $53,000.00 would be between deferrals, matching contributions, and any profit- sharing contributions as well. The employer contributions can be deducted up to 25% of the combined compensation for all the plan participants.


Annual Testing of 401k Plans – ADP and ACP Test

Okay, now there is annual testing for 401(k) plans that we talked about before. You have nondiscrimination tests. They are the ADP test and the ACP test. The ADP stands for Actual Deferral Percentage, and basically all that that is is you’re taking the amount that the individual is deferring each year and you’re dividing it by their compensation. Okay, and you do it for groups. You do it for the entire group of the rank and file employees, and you do it for the entire group of the highly-compensated employees. And the rank and file and the highly-compensated employees are computed separately, and if the highly compensated defer too much, they actually have to return some deferrals at the end of the year.


Highly-compensated employees and 401k Plans

And the ability of the highly-compensated employees to defer is going to be closely tied to how much the rank and file employees defer. And then you have the Actual Contribution Percentage test, ACP, which works the same way as the ADP test. You take the matching contribution provided, divide it by the compensation, it gives you a percentage. It works the same way as the ADP. And it’s like I said before. These tests can limit the amount the highly-compensated employees can defer, and often very significantly. Like you might see a situation where somebody initially deferred like $18,000.00 and come the end of the year they might have to return $15,000.00 of it. And the Form 5500 is going to be required for most 401(k) plans


Safe Harbor 401k Plans

Another type of 401(k) plan is the Safe Harbor 401(k). These plans are a good choice if you’re looking for the benefits of a 401(k), but you don’t want the burden of annual nondiscrimination testing. This plan is like a traditional 401(k), but it does require you to contribute. You can choose either a matching contribution or a fixed percentage of pay. The minimum matching contribution is a full match of the employee’s first three percent of salary deferrals and then 50 cents on the dollar for the next two percent of deferrals for a total match of four percent of pay. The fixed contribution is three percent of compensation for each employee even if they choose not to make any salary deferrals. So, these are the minimum contributions required for a safe harbor. The plan can always be more generous than this. Safe harbor contributions and all employee contributions are immediately 100% owned or vested by the employee. So with these types of plans, you can’t use a gradual vesting schedule like you can in other plans, like a traditional 401(k). Also, before each year, you must provide employees a notice, and you have to explain the essential plan features and how to enroll.


What is a 401k Safe Harbor?

Safe harbor 401(k)s, again, don’t require nondiscrimination testing. And this is significant for a couple of reasons. First, when you have the nondiscrimination testing, it does require time. Sometimes you pay a third party to perform the testing. So with a safe harbor, you would keep your administrative costs lower than a traditional 401(k). Secondly, higher paid employees, including the owner, can defer the maximum salary deferrals allowed under the law without being tied to the lower-paid employee deferral rate. And, like most 401(k)s, safe harbors must file an annual Form 5500.


Automatic enrollment 401(k) plans

Okay, now let’s talk about automatic enrollment 401(k) plans. Whether you have a safe harbor plan or not, it could be an automatic enrollment plan. These types of plans, even though they’ve been around for a while, they have been gaining in popularity recently. Remember that this is an optional feature in plans, it’s not a required feature. And the way that this works is that it will automatically enroll employees in the plan at a certain deferral percentage rate. Traditionally what has happened with 401(k) plans and the reason why it can be difficult to get people to start deferring to them, is an employer will hire an employee, and they’ll sit down with them, and they’ll give them a deferral election form. And they’ll say, we have a 401(k) plan, and what we’d like for you to do is complete this deferral election form and tell us how much you would like to defer into the plan every payroll. And what happens is the employee, for whatever reason, maybe they’re just apathetic, they just never return the form, okay, and so they end up not being in the plan. And then the years go on, and sometimes even entire careers go on, and the employee just never returns the form because they, largely, they’re just apathetic about it, and they largely just really don’t think they have the money. And so, you have situations where people are not saving for their retirement.


Automatic enrollment 401(k) plan

So the way you got an automatic enrollment 401(k) plan works, though, is that same employee would come to the employer, and the employer would say, we’d like for you to fill out this deferral election form, but, by the way, we have an automatic enrollment plan, so if you don’t return this deferral election form, we’re automatically going to put you in at three percent, for example. It could be a different amount. And that way, what it does is: if that same employee does not return that deferral election form where they can opt to defer zero, or they can opt to defer ten percent, but if they don’t return it at all, then they will start at a certain percentage of pay, and generally that’s going to be three percent. And, some plans will actually increase this percentage every year, so the next year it’s four percent, the next year it’s five percent. And, something like this can significantly increase plan participation. The theory behind these types of plans is that the employees really don’t notice that their pay is missing, they don’t really miss the money, and then they end up staying in the plan.

This increases participation in these plans. It’s a little bit sneaky, I think, but it’s kind of a good sneaky. And what this does is: it helps the plans to pass nondiscrimination testing and it helps a lot of employees save for their retirement where they otherwise may not have.


Automatic enrollment feature to avoid annual nondiscrimination testing

You can use an automatic enrollment feature to avoid annual nondiscrimination testing. To do this, your automatic enrollment feature has to start with a three percent employee deferral and automatically increase it every year so that the employees contribute at least six percent of their compensation by the fifth year. With this type of automatic enrollment, the company is required to contribute to avoid testing. The required contribution, again, is either a match or a fixed percentage of compensation for all participants. And if you choose the match, it must be a full match on the first one percent of deferrals plus a 50% match for the next five percent of deferrals. If you choose the fixed contribution, it will be three percent of compensation for all eligible employees.


401k Pros and Cons

Okay, so 401(k) pros and cons. The key advantages of traditional 401(k) plans are that employees can contribute more salary deferrals than in other retirement plans. Remember, in the SIMPLE IRA plan, employees make salary deferrals but they have lower maximum annual limits. Also, the types of employer contributions are flexible. You can contribute any combination of matching, fixed and discretionary contributions. But keep in mind, you have to follow what your plan document says. The 401(k) plan’s enrollment terms are flexible. For example, if you have a work force that’s seasonal, or if your workers are under age 21, the 401(k) may be an attractive option to simplify your plan administration. You’re permitted, under the law, to draft the plan so you don’t need to cover employees under 21 and those working less than 1,000 hours during a plan year.


401(k) plans also have flexible plan features

401(k) plans also have flexible plan features, so they can offer loans to participants, hardship distributions, and designated Roth accounts. So if you contrast that to the IRA-based plans like SEPs and SIMPLEs where you aren’t permitted to offer any of those features. The 401(k)s offering optional features is attractive to employees. They might appreciate a loan from the plan, or a hardship distribution, but they do add administrative work for you and your business. And also, for 401(k)s you need a service provider to set up the plan. There’s generally more recordkeeping, we mentioned the testing, and overall maintenance involved than some of the other plan types.


How to Start a Small Business Retirement Plan

Starting a retirement plan. If you want to start a retirement plan, there are a lot of different services that you may need. You may need a record-keeper. This is going to be somebody who keeps track of the participant accounts in the plan. They’re going to process and track enrollment contributions and distributions. And this record-keeper could be somebody who’s at the business or possibly you could go out and employ a specialist to do this. It could even be the person who provided the plan to you. You may need a consultant or an adviser. This is going to be somebody who is going to offer advice about choosing and designing your plan investments. You may need an administrator service provider. This is going to be somebody who provides plan documents, required notices and filings. Generally, they will use an IRS-approved plan that they will provide to you. They may also serve as a record-keeper or consultant for the plan.

Other services that you may want to consider. A third party administrator, we call them TPAs. These people specialize in retirement plans. They will take care of the recordkeeping for you, and they may or they may not provide the plan document for you. You’re going to have plan vendors. They may handle every single aspect of the plan for you. And this could be a mutual fund company. It could be a bank, a broker, or a third-party administrator specializing in retirement plans. You also may need the services of accountants or attorneys. So, you need to understand what your service agreement covers and you need to understand how the fees are earned. So, there are some questions that you would need to ask your service provider, and these are very important.


401k Plan Language

You would need to ask who is responsible for updating the plan document for any law changes. You know, as a Manager of Revenue agents who go out and audit these plans, this is quite easily the largest failure problem that we see. In fact, these plans are not being timely updated for all the law changes. So you definitely want to know who’s responsibility is this. You also want to know who will provide recordkeeping services for the plan, who will give any required plan notices to the participants, that’s important as well. Who is going to be required to file the annual report, the annual return, the Form 5500 with the Department of Labor? Or is it filed with the IRS, if it’s a Form 5500EZ. You want to determine whether any nondiscrimination testing will be required and who is going to conduct the testing. Like, for example, in a 401(k) plan, you might have to do the ADP and the ACP test.

You need this accurate information to track who’s eligible to be in the plan, and their compensation amounts. You need accurate amounts for limits testing and to calculate contributions. You’ll also need to track deferral amounts for testing. Make sure you’re withholding and depositing salary deferrals. Another ongoing job is completing the Form 5500 if it’s required. And then, we mentioned that you have to make sure that your plan document is current for retirement laws, so even after you set up your retirement plan, you may need to amend it for changes in the law. If you have a service provider and they mail you amendments to sign by a due date, make sure you read them, and sign them. Plan amendments are an important legal document.


Common Small Business Retirement Plan Problems

When your plan isn’t well run, some of the most common mistakes are: not including all employees who are eligible for the plan, not using the correct definition of compensation for calculating contributions, and not signing required plan amendments on time. So recognizing that mistakes happen, IRS has a program to get your plan back on track.

And the program is called the Employee Plans Compliance Resolution System, and it’s made up of these three parts. The first two programs, the Self Correction and Voluntary Correction programs, encourage you to find and fix your plan mistakes. The third program, Audit Closing Agreement Program, is when we find a mistake when we audit your plan. You can correct it and pay a negotiated percentage of the tax that would be due if the plan were disqualified. As part of that, you have to fully correct the plan mistake and pay a sanction. So, once you realize you have a mistake in your plan, which program is right for you? Well, self-correction is great because it allows you to correct an error without contacting the IRS and paying a fee. And, if your mistake is insignificant, you can use self-correction at any time. Some problems, though, like late amendments, don’t qualify for self-correction. But, you could still correct this using the voluntary correction program. And this is where you submit an application to the IRS, describe your proposed correction, how you’ll correct it, and you pay a fee. When the IRS approves, they’ll give you a compliance statement. And if the IRS later audits your plan, the auditor will treat the errors you corrected as if they didn’t occur