SETTING UP A 401(k): THE ULTIMATE SMALL BUSINESS GUIDE
So you’re a small business owner and you’re thinking of setting up a 401(k)? This is a great thought! You will benefit in a number of ways by offering a retirement plan for you and your employees.
1) You’ll personally benefit by enabling yourself to put away pre-tax (or after-tax if you choose) savings.
2) Your employees will be able to do the same while adding an incentive for them to come aboard and stick around.
The problem with starting a 401(k), however, is that it’s complicated. There are so many rules and regulations around these plans that they can be labor intensive (aka expensive) to set up and maintain.
This guide will help you understand the process and know your roles and responsibilities as a plan sponsor…but before we go down that rabbit hole, consider first looking into an IRA-based company retirement plan.
IRA-based plans are much easier and cheaper to set up and maintain because the rules are simplified. A good way to think of an IRA-based plan is like training wheels to get you started, then as your business grows and more complexity is necessary, you can upgrade to more advanced plan, like a 401(k).
IRA Retirement Plan Options
While I won’t go into much depth about IRA retirement plans, I think it’s important to at least consider them before moving forward with a 401(k) plan.
Here are the key features for both SEP IRA and SIMPLE IRA plans.
SEP IRA vs Simple IRA
|FEATURE||SEP (Simplified Employee Pension)||SIMPLE IRA (Savings Incentive Match Plan for Employees)|
|Plan Set Up||Fill out form 5305-SEP and keep for your own records, set up IRA accounts for each eligible employee at a financial institution.||Fill out either form 5304-SIMPLE or 5305-SIMPLE and keep for your own records, set up IRA accounts for each eligible employee at a financial institution. Must have less than 100 employees earning $5,000 or more this year.|
|Eligibility Minimums||Employees who have worked at least 3 of the last 5 years, are 21 or older, and earned at least $600 for business year.||Employees who have earned at least $5,000 in the previous two years and are reasonably expected to earn $5,000 this year.|
|Contributions||Employer makes optional contributions, but must contribute the same percentage of each participant’s pay.||Employees can elect for salary deferral. Employers must either match deferrals dollar for dollar up to 3% of compensation or contribute 2% of compensation to all eligible employees regardless of if they opt for salary deferral or not.|
|Contribution Maximum||The lesser of $55,000 or 25% of pay.||Employee deferrals cannot exceed $12,500 ($15,500 if age 50 or older).|
|Vesting||All contributions are 100% vested immediately.||All contributions are 100% vested immediately.|
Both plans provide easy setup and administration with low costs, but they also both have limitations that may be incompatible with your goals.
A SEP IRA is great if you run a very small operation and want to save the maximum 25% (or a high percentage of salary). When you have many employees, though, it becomes very expensive to contribute the same percentage to all your eligible employee’s salaries.
A SIMPLE IRA makes more sense when you have multiple employees and can live with the contribution limitations. You can also view it as a “starter” plan that can be upgraded to a 401(k) plan later. SIMPLE IRA assets can be rolled into a 401(k) after two years.
If neither of these plans are compatible with your objectives, then it makes sense to take on the greater complexity and cost for more flexibility to achieve your objectives with a qualified plan.
SETTING UP A 401(k): WHAT YOU NEED TO KNOW
There are a number of important aspects of setting up a 401(k) properly. The remainder of this guide will answer the following questions.
- What are my fiduciary responsibilities as a plan sponsor?
- Who does what to successfully establish and maintain a company retirement plan?
- What are the different options available when designing a plan tailored to my business?
- What are the costs?
- Where should I get started?
401(k) FIDUCIARY RESPONSIBILITY
As a plan sponsor for a qualified plan regulated under ERISA (Employee Retirement Income Security Act), you need to understand that you must act in a fiduciary capacity. A fiduciary makes decisions that are in the best interest of plan participants and their beneficiaries.
While the basic premise of a fiduciary is pretty straightforward (putting the needs of others above your own), ERISA law defines specific roles and responsibilities to be adhered to in maintaining a qualified retirement plan.
The named fiduciary is the person, or title, named in the plan document itself and oversees the plan in its entirety. Depending on the size of the company, the named fiduciary could simply be the owner’s name or the title of the person responsible for the plan.
It’s the responsibility of the named fiduciary to ensure that the various activities necessary for the plan are getting done properly and at a reasonable cost. Most named fiduciaries won’t have the necessary skill, or time, to carry out these activities on their own. It’s their job to put the right vendors in place who do have the necessary skills.
3(16) Plan Administrator
The 3(16) plan administrator is responsible for, you guessed it, the administrative roles in maintaining a plan. Again, depending on the size of your company, this role could be the owner of the business, a title within the business, or even outsourced to a third party.
It’s important to distinguish a 3(16) plan administrator from a third-party administrator (TPA). The 3(16) plan administrator controls how the plan is to be administered. A TPA is hired by the plan administrator to execute the actual administrative tasks necessary based on those decisions. Because the TPA merely does technical work and doesn’t make any decisions over the plan, it does not bear a fiduciary responsibility.
Investment Advisors: 3(21) vs 3(38) & Non-Fiduciary
The named fiduciary may transfer the fiduciary responsibilities pertaining to investment management to a professional, or retain it. To make it more confusing, there are three levels of involvement a financial professional can assume.
Non-Fiduciary Investment Advisor
When the investment professional only provides generalized financial education to plan sponsors and participants. With this option, plan sponsors retain the fiduciary responsibility pertaining to investing plan assets.
A 3(21) fiduciary investment advisor may be hired to give specific advice on which types of securities the plan should offer and will help individual participants choose which securities to choose in their accounts.
A 3(38) fiduciary investment advisor does the same things as a 3(21) IA but also takes on the role of managing the participant’s accounts and making changes to the allocation of assets if deemed necessary.
Investment professionals often play a key role in establishing and maintaining a company-sponsored retirement plan. When interviewing someone, It’s important that you find out which role they will play in your plan.
ROLES AND RESPONSIBILITIES
Now that you know the different fiduciary roles in a retirement plan, it’s important to also understand the technical roles necessary to implement and maintain such a plan.
The plan sponsor is the employer who wants to provide retirement solution for itself and its employees. A 401(k) plan is a great way of incentivizing employees to come work for you and retain them, especially if you provide a match.
Why an IRS approved plan, though? Why not just open a trust account for each employee and fund that? Tax shelters, that’s why. A 401(k) is a tax efficient way of doing this as all employer contributions and costs are deductible and all savings are tax-sheltered until withdrawn from the plan.
The plan sponsor oversees the plan by making the decisions about how the plan is designed and which vendors will carry out the various tasks necessary to implement the plan.
Third Party Administrator (TPA)
The TPA executes certain tasks like drafting the 401(k) plan document, processing contributions, generating statements, filing the annual IRS form 5500, non-discrimination testing, and more. The TPA has no decision making power over the plan, it simply executes the technical work.
The record keeper also handles administrative type tasks, but these tasks pertain to investment account activity and balances, performance reports, providing a web portal for participants, and more. The record keeper’s tasks are downstream from the TPA’s.
When plan sponsors seek guidance on setting up a retirement plan, they often will seek out a financial professional. You need to understand that there is a difference in how financial professionals are compensated, which could influence their recommendations.
A registered representative is a financial professional who is compensated through commission on sales of financial products. They represent brokers like Merrill Lynch, Edward Jones, and Northwestern Mutual to name a few.
At the risk of sounding too cynical, there are many great registered representatives who will give you sound recommendations. However, you should be clear on costs because there are some professionals who will recommend a product that pays them a higher commission over a product that may be better for you and your participants.
Remember, keeping costs reasonable is a key part of your fiduciary duty to plan participants.
An investment advisor is a financial professional who is compensated by fees, either for a percentage of assets under management or a fixed fee. The fee structure can be set up as exclusively one or the other, or a combination of the two.
The technical title for an IA is investment advisor representative (IAR). An IAR represents a registered investment advisor (RIA). Most consumers won’t recognize even the largest of RIAs, which I think is a good thing because it forces them to focus on building trust on a more individualized level rather than relying on brand recognition.
A trustee holds and keeps track of contributions flowing into the plan. The plan sponsor may retain administrative and investment management roles if they wish (although not advisable), but selecting a trustee is required.
If the company sponsoring a plan were to custody plan assets, they may be tempted to pull money from the plan in hard times. The assets in the plan belong to the plan participants and must be safeguarded by a third-party trustee.
With the roles and responsibilities covered, let’s talk about the actual plan and how it will function.
Unlike an IRA-based plan where the features are decided for you in exchange for ease and affordability, you have more flexibility with a 401(k) plan and can pick and choose certain features to accomplish certain objectives.
The primary objectives of a 401(k) plan have to do with employee attraction and retention, and/or providing a tax-efficient way for business owners to save for themselves. These objectives tend to shift depending on the size of the company.
Employee attraction and retention
As your business grows, you’ll need more help. A generous 401(k) is a valuable tool to attract and retain talented employees. To accomplish this end, you’ll want to include certain features like shortened eligibility requirements, matching, a graded vesting schedule, and profit sharing.
Maximize savings for yourself
Perhaps you run a small business and you’re objective is more centered on saving for yourself. Likely, you have a much higher compensation than your employees, making it difficult to maximize your own salary deferral due to non-discrimination testing. In this case, you’d benefit from a safe-harbor feature and new comparability profit sharing.
Whether your objectives are employee or self-centric, let’s dive into each feature.
Eligibility means that you must allow employees who meet certain criteria to participate in the plan. Employees can choose not to participate, but if they are age 21 or older and have performed one year of service (generally 1,000 hours or more in the year), you must allow them to participate.
Of course, you can allow employees to participate who are younger than 21 and/or have worked less than one year if you choose, those are just the minimum standards.
Both you and your employees can contribute to their accounts. Your employees contribute by deferring a portion of their salary (up to $18,500 in 2018, plus $6,000 if age 50 or older) and you can make matching and/or non-elective contributions. The cumulative contributions of you and an employee cannot exceed $55,000 in 2018 ($61,000 if an employee is age 50 or older).
Matching is not required but is a good way to attract and retain employees. You choose a percentage of your employee’s deferral that you will match, then put a cap based on the employee’s total compensation (e.g. 100% match up to 4% of the employee’s compensation).
Even if your objective is to benefit yourself, you’ll still want to have employees participate to avoid the plan failing nondiscrimination testing. Matching is a good incentive to increase participation.
Safe Harbor 401(k)
You can’t force employees to participate in the company plan. If enough employees don’t participate, your plan will fail nondiscrimination testing, which limits the amount you may participate.
The way around this is to opt for a safe harbor 401(k) plan where nondiscrimination testing is waived. The tradeoff, however, is that you either have to make a non-elective contribution or match employee deferrals.
A non-elective contribution is an employer contribution made regardless of an employee’s actions. The minimum non-elective contribution to meet safe harbor requirements is 3% to all eligible employees.
The matching alternative requires you to match 100% of employee contributions for the first to 3% of salary deferral, then match 50% of the next 2% of salary deferral.
Regardless of which option you choose, all safe harbor contributions are 100% vested immediately.
Adding a profit-sharing component to your company 401(k) plan is a really effective way to increase contributions to yourself or your employees beyond salary deferrals and matching. A profit sharing contribution is made by the employer and is not required.
When setting up a 401(k), you must select an approved allocation method to determine how the profit sharing contribution is divided. The standard allocation method is to use a flat percentage of employee compensation (e.g. 10% of each employee’s pay). There are other allocation methods that permit “tilting” the profit sharing contribution to certain employees based on criteria such as age, compensation (social security integration), or job title (new comparability). These “tilting” methods are particularly helpful to small business owners whose objective it is to save for their own account.
Traditional and Roth
A traditional contribution to a 401(k) plan is “pre-tax”, meaning that the amount of pay an employee defers to their account isn’t recognized as income for tax purposes. However, when the funds are eventually distributed from the plan, they are fully taxable at the income tax rate.
A Roth deferral is taxed as income in the same year as the deferral is made, but the tradeoff is that any gains distributed in the future (minimum 5 years and after age 59 ½) are tax-free.
It’s impossible to know which type of contribution is better because we don’t know what tax rates will be in the future. Regardless, many employees will want to opt to pay taxes now in exchange for tax-free distributions in the future. Allowing Roth contributions will allow your employees to contribute a lot more “after-tax” funds than they could if they were contributing to a Roth IRA.
Most 401(k) providers offer a vast array of investment options to choose from, but you also don’t want to overwhelm the participants with too many. As a fiduciary, you are charged with the responsibility of providing a wide enough range of options covering conservative investments to aggressive ones.
If you’re savvy enough with investments, you may do this on your own, but most sponsors aren’t. Working with a financial professional to help you select the menu of options available to participants will help you fulfill your fiduciary responsibility and in the case of working with a 3(21) or 3(38) advisor, transfer the responsibility altogether.
Vesting is the amount of time it takes contributions to an employee’s account to become irrevocable. Any contributions made by an employee deferral is always 100% immediately vested because they’ve already earned the income, they are simply deferring the receipt of it.
However, employer contributions can be set up so that the employee has to work for a minimum period of time before those contributions become irrevocable. There are three vesting options plan sponsors can choose; immediate, cliff, and graded.
Immediate vesting is simple, you can choose to grant your employees 100% vesting immediately. Your employees will love it, but this undermines the incentive to keep employees from leaving.
Cliff vesting allows you to say that employees have 0% vesting until they have completed three years of service. While three years is the maximum you can opt for, you can also choose one or two years.
Graded vesting grant incremental vesting percentages for each year of service. The IRS minimum allows you to grant nothing for the first year and at least 20% per year thereafter. 100% vesting will have occurred after completing six years of service. But, again, you can be more generous and grant more each year if you choose.
|Years Completed||Vested %|
Auto-enrollment has become increasingly popular in recent years because of the fiduciary scrutiny that has taken place. Plan sponsors don’t want to be sued for shirking their fiduciary responsibility to act in the best interest of their employees.
One way to avoid this is to add an auto-enrollment feature where employees are automatically enrolled into the company 401(k) plan once they become eligible. Further, the default percentage of salary being deferred can be set to automatically increase each year along with the default investment allocation.
If the employee doesn’t wish to participate or would prefer a different percentage of salary deferral/investment options, they have to actively make a “negative election”.
The plan sponsor has the option to allow employees to roll over previous employer 401(k) or IRA assets into the company 401(k) plan. The only reason you wouldn’t want to allow this is if the plan sponsor pays fees based on AUM, which is usually paid for by the employee, discussed in the next section.
Without getting into the details about the problems around participants taking loans from their 401(k) accounts, you can choose to make this feature optional or not.
401(k) loans have many restrictions and create more complexity to your plan, however, the added cost for such complexity is usually the burden of the participant utilizing a loan.
Unfortunately, some of your employees, or yourself, may have an emergency situation where taking a loan from their 401(k) balance may be necessary. Including this option could provide a much needed option when such a scenario presents itself.
Asset Based Costs
The majority of a company sponsored retirement plan costs are associated with the total assets within the plan. As discussed earlier, some financial professionals charge commissions, others a fee. Either way, the cost is tied to the assets in the plan and are usually paid for out of the participant’s accounts.
Commissions have a larger up-front cost for all new assets into the plan, with a smaller “12b-1” ongoing annual fee.
Advisory fees are an annual fee based on total assets in the plan, usually assessed quarterly.
Regardless of which method the financial professional’s cost structure, they are likely to utilize mutual funds or exchange-traded funds as investment options. Funds have their own cost known as the expense ratio, which is also tied to assets being managed.
Mutual fund/ETF expense ratios can range from as little as 0.02% to greater than 2% in some instances. What determines the expense ratio is the level of activity the fund manager participates.
Generally, ETFs tend to be more passive with lower expense ratios while mutual funds tend to be more actively managed and cost more. Either of them can range a lot, so be sure to keep the expense ratio in mind just as keenly as your financial professional’s costs.
You generally will only see fixed costs with “unbundled” plans, where the various vendors aren’t under the same umbrella. Often the administrative duties performed by the TPA are based on a fixed fee per participant. This cost is either paid for by the plan sponsor directly or can be “bundled” into the asset-based cost and the financial institution pays the TPA.
Whether your plan is set up to pay asset-based costs or fixed cost, there are likely transactional costs included. Here’s a list of possible transactional costs including, but not limited to:
- Ticket charges for trades
- Paper statements
- Enrollment kits
- Plan set up or conversion
- Audits (only necessary for larger plans)
- Minimum fees for plans with smaller amounts of assets and/or participants
- Surrender charges for insurance based plans
- Attorney fees for when complex issues arise necessitating and ERISA attorney
Each provider will vary on these expenses, so be sure to look very carefully at the proposals they provide.
SETTING UP A 401(k): EXECUTION
Now that you have the basic information, how do you get started?
One option is to reach out directly to plan providers such as Vanguard, John Hancock, Transamerica, etc. They will put you in contact with a sales associate who will pitch you on their product and why it’s great for your business. As you may expect, they all will have the “right” product for your business, so be sure to reach out to at least three providers for adequate comparison.
The alternative option is to start with a financial professional, preferably one who isn’t tied to any one provider. You’ll be more likely to receive unbiased advice on what type of plan makes the most sense for your business and which features to choose.
To be fair, most professionals will already have preferred providers they work with, but they aren’t necessarily restricted to such providers. I’d also recommend that you talk with at least three professionals.
Either way, always keep your fiduciary duty to make decisions based on the best interest of the plan participants top of mind. While some fiduciary responsibilities may be transferred, the “named fiduciary” status cannot be abdicated entirely by the plan sponsor.
You may come across the phrase “co-fiduciary” where a third party will share this responsibility, which can provide great peace of mind, but it does not absolve you of you of it.