Chapter 20
Choosing a Plan for Your Business
IN THIS CHAPTER
Finding the plan for you
Looking at examples
Getting rewarded for your plan
Making a change when you need to
Running a retirement plan is a significant responsibility for any employer. A company isn’t required to offer a plan, but if it does, it must comply with the applicable laws and regulations — whether the plan covers only a couple of employees or more than 100,000.
In this chapter, I compare plan options from various types of 401(k)s to various types of IRAs. I also talk about earning credit for setting up a plan.
You’re not alone if the first plan you choose isn’t the plan you really need. I walk you through the process of switching plans, which isn’t pleasant but can be for the best.
Selecting a Plan That’s Right for You
Most small businesses want one of the plans that are primarily funded by employee contributions. Each plan has pros and cons. Table 20-1 summarizes the main features of the different plans funded primarily by employee contributions.
TABLE 20-1 401(k) & IRA Options
Feature/Requirement | Regular 401(k) | Safe Harbor 401(k) | QACA 401(k) | SIMPLE IRA | SEP IRA | Payroll Deduction IRA | Solo 401(k) |
|---|---|---|---|---|---|---|---|
Maximum under-50 employee contribution | $19,500 | $19,500 | $19,500 | $13,000 | 25% of W-2 | $6,000 | $58,000 |
Maximum 50-and-over employee contribution | $6,000 | $26,000 | $26,000 | $16,000 | 25% of W-2 | $7,000 | $64,500 |
Minimum employer contribution | None* | 3% | 3% | 1 or 2% | 0% | 0% | 0% |
Vesting | Up to 6 years | Immediately | 2 years | Immediately | Immediately | Immediately | Immediately |
Loans | yes | yes | yes | no | no | no | no |
Top-heavy rules | yes | no | no | no | no | no | no |
Discrimination testing | yes | no | no | no | no | no | no |
Set-up fees | yes | yes | yes | no | no | no | yes |
Complex document | yes | yes | yes | no | no | no | yes |
Form 5500 | yes | yes | yes | no | no | no | yes* |
Summary plan description | yes | yes | yes | no | no | no | yes |
Summary annual report | yes | yes | yes | no | no | no | no |
Employee termination paperwork | yes | yes | yes | no | no | no | no |
Document amendments | yes | yes | yes | no | no | no | yes |
Employer investment responsibility | yes | yes | yes | no | no | no | n/a |
Administrative fees | yes | yes | yes | no | no | no | yes |
Form 5500 is required when assets exceed $250,000.
So, how do you choose which type of plan to offer yourself and your employees? Because there are so many options, you have many issues to consider, including the following:
- How much do you, the owner, want to save for retirement? This is important because the maximum amount that can be contributed during 2021 ranges from $6,000 to $58,000.
- Do you have employees who work more than 1,000 hours per year? If you do, you may need to include them.
- Do you need a good plan to help you hire and retain the employees required to run a successful business? Offering a retirement plan can help you attract the quality employees you need, especially if your business is in a competitive or niche field.
- How much do you earn from your business? The amount you may contribute is tied to your earned income.
- How long has your business been in existence? This is important if you have employees because you must be able to meet the same eligibility rules as your employees.
- How much do your employees earn? This is important because higher-paid employees are more likely to contribute. If you have mostly lower-paid employees, they will be less likely to contribute, which will limit how much you can contribute to a regular 401(k).
- How much are you willing to contribute for your employees? If it is less than 2 percent of pay, you need to consider a payroll-deduction IRA or a regular 401(k). If it is 2 percent or more, consider a safe harbor or QACA 401(k) or a SIMPLE IRA (see Chapter 18 for more on those types).
- Are you a solo entrepreneur? If so, a SEP IRA is your best option unless you want to contribute more than 20 percent of your net income, which you can do if you’re a sole proprietor or 25 percent of your W-2 if your business is a Sub S or C corporation. A Solo 401(k) is your best option if you want to contribute more.
- Are your employees only or mostly family members? If so, a SEP IRA is a good option because you can structure employees’ compensation so that the business will contribute the same percentage of pay for all eligible employees, excluding these contributions from all taxes including FICA.
- Do the key employees own 60 percent or more of the plan assets? If the answer is yes, consider a payroll-deduction IRA, a safe harbor 401(k), a QACA 401(k), or a Simple IRA.
- Are you willing to pay the fees necessary to set up and operate a 401(k) and to also deal with the complexity of a 401(k)? If not, consider one of the IRA-based plan alternatives.
You can change plans at any time; therefore, one type of plan may be best only for a year or two.
Considering Real-Life Examples
Even with all this comparative information, choosing among retirement plan options is often still difficult. The next sections contain examples of small-business owners who found attractive and affordable plans.
Meeting a small business’s needs with a SEP
Larry and Helen run a hunting and fishing lodge. They have only one employee, who works less than 500 hours per year, so she isn’t eligible for a plan. Larry and Helen each have annual earnings that are less than the Social Security maximum taxable wage base (see Chapter 2 for those limits). As a result, any contributions they make as employee deferrals to either a regular, Safe Harbor, QACA 401(k), or a SIMPLE IRA would be subject to FICA and other employer payroll taxes. Contributions to a SEP aren’t subject to these same taxes because the business operates as a chapter S corporation.
They decided to establish a SEP through a mutual fund company. All they had to do was complete one easy form and an IRA application for each of them. Contributions to the plan are deposited into the IRAs set up for this purpose. Larry and Helen can invest in any of the mutual funds, ETFs, stock, bonds, and CDs the company offers for retirement plans. The plan has no set-up fee, no annual fees, and no compliance hassles.
Larry and Helen’s business can make contributions during the year, or they wait until the end of the year to determine how much to contribute. The contribution amount is flexible (up to a maximum of 25 percent of their W-2 income), and no contribution is required.
Reaching personal contribution goals with the SIMPLE plan
Manoj and Sarla are medical professionals who have three full-time employees. Manoj and Sarla each have earnings of $170,000. The total gross annual pay for their three employees is $145,000.
The two doctors want to contribute around $17,000 each to a retirement plan. The three employees are willing to contribute a total of $9,800 to the plan. This means Manoj and Sarla will be contributing more than 78 percent of the total employee contributions during the first year. This would create a top-heavy situation with a 401(k) (remember, the cutoff is 60 percent), so their best alternatives are a safe harbor 401(k), QACA, or a Simple IRA.
Each plan would permit them to meet their contribution goals and offer an attractive plan that would help to retain their employees. Manoj and Sarla decide to go with a SIMPLE IRA rather than the safe harbor or QACA 401(k) to avoid the cost of setting up and running a 401(k). Assuming they are each over age 50, the SIMPLE limit for deferrals is $16,500, which gets them close to their desired contribution.
To start the plan, all they did was complete a couple of forms supplied by the financial organization they selected and had each employee, including themselves, complete an IRA application.
Manoj and Sarla decide on a dollar-for-dollar employer matching contribution limited to the first 3 percent of pay.
Table 20-2 shows how Manoj and Sarla’s plan works.
TABLE 20-2 Sample SIMPLE Plan
Employee | Employee Annual Income | Employee Contribution | Employer Contribution | Total Contribution |
|---|---|---|---|---|
Manoj | $170,000 | $16,500 | $5,100 | $21,600 |
Sarla | $170,000 | $16,500 | $5,100 | $21,600 |
Lela | $55,000 | $4,400 | $1,650 | $6,050 |
Alicia | $45,000 | $2,700 | $1,350 | $4,050 |
Monica | $45,000 | $2,700 | $1,350 | $4,050 |
Manoj and Sarla’s employees, Lela, Alicia, and Monica, can select any of the funds offered by the financial organization that are appropriate for an IRA. The employer simply needs to send the money to be invested each pay period. The participants can go online anytime to access their accounts, change investments, and do much more.
Adopting the standard 401(k) for a growing business
Margaret left her employer six months ago to start her own business producing training programs for the medical community. Her clients are drug companies that want effective educational materials that inform the medical community on how to best use specific drugs. Margaret and an outside investor own the business.
Because her training programs are highly technical, Margaret had to recruit seasoned personnel. During the interview process, she promised candidates that she would set up a 401(k).
Because her business can’t handle the additional expense, Margaret isn’t willing to make an employer contribution. She’s the only participating owner. Three non-owner employees are eligible to participate in the 401(k) plan, and this number is expected to grow. One of the employees earns $95,000 and wants to contribute 10 percent of pay. Another employee earns $55,000 and wants to contribute 8 percent of pay. The third employee isn’t interested in participating. The three non-owner employees are contributing an average of 6 percent of pay (10 plus 8 plus 0 equals 18 divided by 3 = 6). The maximum Margaret can contribute is 6 plus 2 or 8 percent because the 401(k) nondiscrimination requirements for a traditional 401(k) limit her to the average percentage of pay the other employees contribute plus 2.
Margaret’s contributions are expected to be well below 60 percent of the total employee contributions, so a possible top-heavy status isn’t a concern. Table 20-3 summarizes the plan’s first-year contributions and shows how employee contributions impact owner contributions.
TABLE 20-3 How Employee 401(k) Contributions Affect Owner Contributions
Employee | Employee Annual Income | Dollar Amount Contributed | Percent of Pay Contributed |
|---|---|---|---|
Margaret | $165,000 | 13,200 | 8 percent |
Alan | $95,000 | $9,000 | 10 percent |
Pen-Li | $55,000 | $4,400 | 8 percent |
Cheryl | $40,000 | $0 | 0 percent |
Attracting employees with a QACA 401(k)
Rocco and Wes own and run an engineering consulting firm that employs nine other people. The owners are in their fifties and earn $140,000 each. They want to contribute the $19,500 + $6,500 catch-up maximum to their 401(k)s. Rocco and Wes are willing to contribute 3 percent of each eligible employee’s pay to help attract and retain good employees in a highly competitive area.
They like a qualified automatic contribution arrangement (QACA) plan because it allows them to contribute the maximum regardless of how much the employees contribute. They like the fact that only employees who contribute get an employer contribution and that it won’t be vested until after two years of service. They expect their employees to contribute an average of about 5 percent of pay. As a result of nondiscrimination rules, Rocco and Wes would be able to contribute only about 7 percent of pay — or $10,150 — each to a regular 401(k). The QACA 401(k) allows them to contribute the $19,500 + $6,500 catch-up maximum, regardless of how much the other employees contribute. They and all other participants also receive the employer matching contribution.
Table 20-4 lists the first-year contributions and shows how the combined employee/employer contributions actually work.
TABLE 20-4 Qualified Automatic Contribution Arrangement 401(k) Contributions
Employee | Employee Annual Income | Employee Contribution | Employer Contribution | Total Contribution |
|---|---|---|---|---|
Rocco | $145,000 | $26,000 | $5,075 | $31,075 |
Wes | $145,000 | $26,000 | $5,075 | $31,075 |
Chitra | $60,000 | $3,600 | $2,100 | $5,700 |
Willard | $55,000 | $3,300 | $1,925 | $5,225 |
Denise | $54,000 | $2,700 | $1,620 | $4,320 |
Laxman | $47,300 | $473 | $473 | $946 |
Russell | $43,450 | $1,304 | $869 | $2,173 |
Irene | $36,930 | $1,108 | $739 | $1,847 |
Darren | $32,110 | $321 | $321 | $642 |
Sandi | $28,725 | $0 | $0 | $0 |
Indu | $25,850 | $517 | $388 | $905 |
Working through all these options isn’t easy, and it can take a lot of time. Finding someone who can help a small business that wants to start a plan is also challenging because most financial organizations and financial advisors focus on 401(k) plans as this is the most profitable segment of the market. I am willing to help a small business pick the best plan for a one-time $200 fee. If an IRA-based plan is the best option, you will also receive a guide that will help you set up the plan. Email me at [email protected].
Getting Credit to Set Up
The government provides help for employers to set up a 401(k), SEP, SIMPLE IRA, and other types of retirement plans by providing a tax credit of up to $5,000 for three years. The credit may be used for the ordinary and necessary costs of starting and operating a plan. Your business qualifies for the credit if
- The business had 100 or fewer employees who received at least $5,000 in compensation from the preceding year.
- The business had at least one plan participant who was a non–highly compensated employee (NHCE) (See Chapter 12 for details about HCEs and NHCEs.)
- In the three years before the first year you’re eligible for the credit, your employees weren’t substantially the same employees who received contributions or accrued benefits in another plan sponsored by the business, a member of a controlled group that includes your business, or a predecessor of either.
The rules about controlled businesses are too complex for me to go into here. Just be aware that if you, your spouse, and/or the other owners own more than 50 percent of one business and more than 50 percent of another business, the businesses may be part of a controlled group. Check with your accountant if this may be the case.
The credit is 50 percent of the start-up costs, up to the greater of $500, or the lesser of $250, multiplied by the number of NHCEs who are eligible to participate in the plan or $5,000. First, there must be at least one NHCE participant. If there is at least one, you qualify for at least a $500 credit. If there are more than two NHCEs, then the credit is $250 times the number of NHCEs not to exceed $5,000.
You can claim the credit for ordinary and necessary costs to
- Set up and administer the plan
- Educate your employees about the plan
You can claim the credit for each of the first three years, and you may start to claim the credit in the tax year before the plan becomes effective because it takes a while to design and set up a plan. Use Form 8881 to claim the credit.
Tough to understand, right? Just to confuse you further: A business that doesn’t have any NHCEs isn’t eligible for the credit. A business with one NHCE can claim a $500 credit for each of the first three years. A business with 10 NHCEs can claim a $2,500 ($250 times 10) credit for the first three years.
Changing Service Providers
The need to change service providers is common for a variety of reasons. Costs, investment performance, and poor service are frequent reasons for changing service providers. Selecting a new service provider and smoothly transitioning from one service provider to another isn’t easy. It’s best to have someone who has lots of experience lead this process — either a fee-for-service consultant or an investment advisor.
Finding a fee-based consultant is challenging because the organizations where they are members permit only members to access their membership directors. These two organizations are the American Society of Pension Professionals and Actuaries and the National Institute of Pension Administrators.
Investment advisors that specialize in the 401(k) business usually have experience in helping employers select new service providers. Obtain a written agreement of what services will be provided and how the advisor will be paid.
Trident Retirement Services, LLC, and Guideline, who I mention in Chapter 19, both have extensive experience handling service provider changes. In both cases, they become the new service provider. Guideline’s fees for the first year after the plan is converted are $129 per month plus $8 per active participant per month. You have the option of dropping to the $49 or $79 plus $8 per active participant fee level after the first year. The conversion fee charged by Trident Retirement Services, LLC, is normally $1,000, but it may be more if there are complications.
An independent consultant or investment advisor will help you search for a new provider. Advisors with lots of experience in the business are familiar with numerous service providers. They can determine which ones may be a good fit for your plan. Among the various factors involved are
- Total asset value
- Average participant account size
- Number of participants
- Total annual contributions
- Type of employees
- Services required
- Desired investment options
A question I usually ask is, “How high up in the organization can I go if I have a problem?” Encountering problems over several years of administering a 401(k) plan is normal. I knew and had access to the CEO in many instances for the service providers I recommended during my days of providing this type of service.
The process for changing a service provider usually follows these steps:
Notify the old service provider.
The change requires transferring the plan assets from the old to the new service provider. You need to inform the old service provider in writing when you have selected the new service provider. The old service provider needs to hand off to the new service provider all plan information including participant account balances, loan information (unpaid loan balances, loan amortization schedules, and so on), and plan documents.
Both service providers work together to complete the transfer. The old service provider will probably charge an exit fee, and the new one will probably charge a conversion fee.
The old service provider may or may not regret losing you as a client. In any event they will be cooperative because messing up can expose them legally.
Adopt new plan documents.
The new service provider may want you to adopt a new plan document because it’s much easier for them to work from their standard plan document than have to struggle through your old one. Plan documents are usually at least 150 pages long, so you can see why working with the old one is more difficult.
This is a great time for you to consider changes to your plan rather than just keeping all the current plan provisions. I always did this with my clients when they were changing to a new service provider. I provided a summary of the key plan provisions and my recommended changes. I was always able to suggest changes that were incorporated into the new plan document.Select new investment options.
It may or may not be possible to retain all the current investments. It also may or may not be desirable to do so. In fact, I always made the future investment structure the first item to consider before deciding which service providers to pursue. Should the investment menu be restructured? Should the number of options be increased or decreased?
I use one former client as an example: This specific client had a plan with approximately $100 million of plan assets. The investment menu included 12 separate mutual funds plus a group of Target Date Funds (TDFs). A mutual fund window was also available that enabled participants who wanted to pick their own mutual funds to do so. Total participant fees were approximately 0.75 percent annually. I met with the CEO, CFO, and human resource director before doing anything else to discuss the future investment structure. I told them I thought I could greatly simplify the operation of the plan and reduce the cost to the 0.20 to 0.25 percent range. They agreed this would be of interest, which enabled me to hone in on one specific potential service provider.
I was able to successfully move this plan to that service provider and to reduce the cost to 0.20 percent. The new plan investment menu was limited to Target Date Funds plus an open mutual fund window. All participants’ accounts were moved into the TDFs. More than 90 percent of the participants left their money invested in the TDFs. The other participants decided to pick their own funds utilizing the mutual fund window.
Endure the blackout period.
All activity stops because the old service provider must provide all participant account information to the new service provider. This is impossible to do if there is continuing account activity. This is called a blackout period during which participants can’t touch their money. Participant accounts must be frozen during the transfer process. This means
- New contributions can’t be deposited.
- No investment changes are possible.
- New loans can’t be made.
- No benefits can be paid.
The blackout period can last up to two months. Participants must be given written notice of the coming blackout at least 30 days in advance. This gives them an opportunity to consider changes prior to the blackout. Participants must seriously consider the fact that they won’t be able to make investment changes during the blackout period. This is a serious issue because the market can drop substantially during the blackout. A participant can cash out and move the entire account into the lowest risk option such as a money market fund; however, doing so will result in a missed opportunity if the market increases a lot during the blackout. As a result, blackouts are troublesome. It is imperative that you make every effort to be sure your participants understand these implications.
Manage the transition.
New contributions flow to the new service provider during the blackout period. Determining how they will be invested is another important decision. One option is to have participants submit new investment instructions and to follow them. Another option is to mirror or map the participant’s old investment selections and put the money into new funds that are the same or the same type as the current ones.
A decision must also be made regarding how the existing funds will be invested when they are transferred to the new service provider. The new service provider won’t be able to end the blackout until it has loaded and reconciled all the transferred participant information. The money will sit in cash unless a different decision is made. This is great if the market drops during this period, but it isn’t so good if there is a substantial increase. Sitting in cash simplifies and expedites the transfer process.
Reenroll employees.
All eligible employees must be informed of any plan changes plus the new investment options. They need to be told what action to take when the blackout ends, and obviously, they must be told when the blackout has ended giving them access once again to their accounts.