Setting up a 401(k) plan, and making it comply with IRS regulations, is a cumbersome task for most business owners. Small business owners are often confused about how to set up their 401(k) to satisfy the fairness rules for complying with the 401(k) nondiscrimination test while simultaneously allowing them to maximize tax benefits for themselves. In this article we’ll discuss how to comply with the 401(k) nondiscrimination test while still maximizing your tax benefits as a small business owner.
In this blog you will learn:
- How to structure a retirement plan for your business
- Why you may be having difficulty getting people to participate in your 401(k) plan
- Who the parties are that get involved with the 401(k) nondiscrimination test
- What a 401(k) nondiscrimination test is
- How to comply with the 401(k) nondiscrimination test
- What happens if a 401(k) plan fails the nondiscrimination tes
How to structure a retirement plan for your business
Let’s say you’re a business owner and you have made the decision to offer a retirement plan to your employees. Or, maybe you are considering offering a plan to your employees for the first time.
Don’t just assume a plain old 401(k) is the best option!
High earning employees often want to know how to get more into the plan, while for lower earners it tends to be much less of a priority. How do you set it up so that it’s fair and makes everyone (more or less) happy? There are several choices for business owners who want to create a retirement plan for their business. Before setting up your plan, consider the following:
- What are the objectives I want to achieve by offering this plan? Is it just a retirement vehicle or will it be used as part of my exit planning strategy?
- Is the plan more likely to be participated in by high or low earning employees?
- How generous do I want the plan to be for my staff?
- How competitive is the hiring market in my industry?
- What is the level of expense I am willing to take on to administer this plan?
- What is my appetite for going through the administrative headache of having to comply with the 401(k) nondiscrimination test?
Write the answers down on a piece of paper and use them as you choose the plan type that makes sense. Here are some thoughts on a few of the major types of plans and when they make sense.
The most commonly known type of employer sponsored retirement plan is the 401(k) plan. How to structure a 401(k) depends a great deal upon the business owner’s age, role in the business, and income relative to the staff’s ages and incomes. It also depends upon how generously the business owner wants to give to the staff.
Many business owners are establishing these plans to help themselves get a tax deduction at the same time as offering a great benefit to their employees. If this is your goal, consider that creating a basic 401(k) for your staff will generally cost one to three thousand dollars a year in administrative costs. From the business owner’s perspective, this is often seen as expensive.
How do you structure your 401(k) so that it makes financial sense for both you and your company?
- Suppose you think the employees are not going to be contributing much. For example, many of them may be earning low salaries and may not even be eligible for the plan. In this case, you should probably structure the 401(k) as a match. You’d be matching zero or a very low contribution rate in this scenario.
- On the other hand, let’s say you want to be viewed as having a generous 401(k) arrangement. This is useful if you are in tech or another industry with a competitive hiring market. You may want to structure the 401(k) with a flat contribution rate. For example, you would contribute 3% for each employee. Or, you could make it discretionary and contribute a certain percentage based upon job title.
Safe harbor 401(k) plan
A safe harbor is a 401(k) plan with matching that is structured so it allows you to ignore all of the 401(k) nondiscrimination tests. In other words, the 401(k) plan can be completely imbalanced as long as you meet the safe harbor requirements. The deadline to create a safe harbor plan is October 1st.
There are certain contribution and disclosure requirements that the plan must meet in order to retain its status as a safe harbor plan. Safe harbor plans differ from traditional 401(k) plans, for example, in their employer contribution requirements. This can sometimes make them more expensive, but nonetheless this option is very popular with business owners.
If you are creating a retirement plan to help you sell your business, there are ways to do this such as an ESOP or a leveraged ESOP, or Employee Stock Ownership Plan. This is a scenario in which the business owner sells the business over time to the employees.
An ESOP is usually more viable for businesses earning $5 to $10MM in annual revenues or more. One major benefit is the ESOP can give the business owner a great deal of liquidity even before they sell the business or retire.
Participation is critical to complying with the 401(k) nondiscrimination test
Whichever plan type you choose, it’s important to maximize employee participation in your plan if you want to make complying with the 401(k) nondiscrimination test easy. Consider this when selecting a plan type.
Your communications with employees should be geared towards educating them and helping them understand the benefits of using the retirement vehicle you set up. Don’t just assume they’ll participate on their own. Many may not be aware of the tax benefits of doing so. And there may be other reasons why they hesitate. It’s not always easy for employees to feel that contributing to their 401(k) plan is a great option.
For example, the proposed Biden plan could potentially discourage people from contribution to their 401(k). Currently if you are in the top tax bracket, your Federal income tax rate is 37%. If you put money in to a 401(k), then it’s saving you that 37% Federal tax on that contribution. The Biden plan proposes to limit that savings. It is proposed that the entire contribution will be capped around 26%.
That’s a big difference! That means if you’re putting in $20,000 per year and you lose the ability to deduct 11% of that, that’s a $2,200 difference per year. When this difference compounds year or year, it can result in a significant difference in how much wealth you can accumulate.
What people are thinking about to mitigate this is to switch over to Roth 401(k) contributions instead of putting into their regular 401(k). This is all a hypothetical scenario, as Biden has not yet taken office, but it serves to illuminate the difficulties that some participants may face in electing to contribution to their 401(k) plans.
This is why being on top of your 401(k) nondiscrimination testing is so important for business owners.
Who are the parties involved with the 401(k) nondiscrimination test?
So, you chose the plan type and set it up. What’s next?
Now you have to worry about minimizing fines, taxes, and paperwork headaches from failing to comply with the 401(k) nondiscrimination test.
No worries! In a little bit, we’ll tell you about some techniques for complying with the 401(k) nondiscrimination test while still maximizing your own tax benefits. But first, let’s review what the test is and the role of each party involved.
If you are offering a 401(k) plan, and/or a 401(k) match, you need to be aware of what a 401(k) nondiscrimination test is, and how it works. In short, 401(k) nondiscrimination testing makes sure that there is a certain balance between what the owners are getting and what the employees are getting.
Many of the 401(k) nondiscrimination test rules come from the Department of Labor. In the past, the only money a retiree would have was their pension and so there were a lot of protections designed around that. As it shifted over towards 401(k)’s, the DOL still wanted to make sure that there were protections and that they were fair.
If your company is offering a 401(k) plan, it needs to be participated in somewhat equally by employees at all income levels. If the plan serves only highly compensated employees, it’s not a fair use of the company’s funds (in the eyes of the IRS).
The parties actively involved in a 401(k) nondiscrimination test are the following.
The plan sponsor establishes the 401(k) plan for its employees. The company is typically the plan sponsor, but it is also possible for third parties to sponsor the plan. The plan sponsor has a fiduciary obligation to act in the best interests of all plan participants. This means avoiding conflicts of interests and keeping fees fair to all participants, among other responsibilities. Plan sponsors usually establish a 401(k) committee and designate one person to be a plan administrator.
The employer is the company whose employees are being offered the 401(k) plan. Employers often set up these plans to encourage employee retention. A 401(k) plan is offered as a benefit to the company’s employees.
Employees normally are grouped into two main categories for the purposes of 401(k) nondiscrimination testing.
Highly compensated employees
Who fits the definition of “highly compensated”? According to the IRS, an employee who earned more than $125,000 in 2019 or $130,000 in 2020 qualifies as highly compensated. Anyone who owns more than 5% of the company (regardless of their income) is also considered highly compensated.
A highly-valued, or “key” employee, meets these criteria, according to ForUsAll.
- Is an officer earning $170,000 or more
- Owns more than 5% of the company, or is the parent, child, or spouse of someone who does
- Owns more than 1% of the company and earns more than $150,000
Non highly compensated employees
Everyone who does not fall into the category of a 1) highly compensated employee or 2) a key employee qualifies as a non-highly compensated employee.
Third party administrator
The third party administrator (TPA) is usually an actuarial firm. The TPA is critical to your success in complying with the 401(k) nondiscrimination test. It performs many administrative functions that are critical for compliance, such as:
- Creating plan documents
- Generating account statements for both the employer and employees
- Calculating vested percentages
- Preparing DOL filings for the business owner to sign
- Conducting 401(k) nondiscrimination tests each year
Notice the last point. The test must be conducted by an independent third party. The TPA runs the 401(k) nondiscrimination test, not the employer or the plan sponsor.
The recordkeeper keeps track of the plan participants who are in the 401(k) plan, which investments each person owns, and any subscriptions or redemptions. Although they aren’t directly involved in the 401(k) nondiscrimination test, they do play a big role in keeping the plan’s books and records in order behind the scenes. Usually the large investment custodians such as Fidelity, Vanguard, and Principal will act as recordkeepers for 401(k) plans.
The investment advisor, also called the investment manager, puts together a roster of investments for the 401(k) plan participants to choose from. The investment advisor’s role is to ensure that there is sufficient diversity of investment choices so that participants can invest their money without taking concentrated risk and putting all their eggs in one basket.
The custodian safekeeps the plan’s assets. Custodians are not directly involved with the 401(k) nondiscrimination test, but like the recordkeeper they play a key part in ensuring that things run smoothly behind the scenes and that the plan’s records are in order.
What is a 401(k) nondiscrimination test?
Now that we’ve talked about what one is and why you need one, what actually is a 401(k) nondiscrimination test?
A 401(k) nondiscrimination test is an IRS regulation that protects non-highly compensated employees. The type of tests conducted vary depending on the specific of what you offer, but basically the tests look at how much income is being deferred and how much of the plan assets come from highly compensated and highly valued employees. The test also examines how you are contributing to employee accounts.
The three types of tests are:
- Actual Deferral Percentage (ADP) test
- Actual Contribution Percentage (ACP) test
- 416 Top Heavy test
Here’s a little more about each type of test. As per the IRS:
The ADP test looks at the difference between how much the highly vs. non highly compensated employees are deferring, on average, as a percentage of their total compensation. If the highly compensated group is deferring more than the non-highly compensated group by a certain amount, it’s a red flag.
Similarly, the ACP test examines the difference between highly and non-highly compensated employees, but this time it combines deferrals with after tax contributions and matching contributions. This total amount is then compared against the employee’s total compensation.
The top heavy test, according to the IRS, asks if the assets held in the plan for key employees is more than 60% of all plan assets.
How to comply with the 401(k) nondiscrimination test
Why would a company fail the 401(k) nondiscrimination test? Common reasons are:
- Due to poor communication or education, you couldn’t get enough non highly compensated people to participate in the plan
- You made the eligibility criteria too strict, and couldn’t get enough non highly compensated people to participate in the plan
- Perhaps you didn’t contribute enough in matching contributions to particular groups of employees
For certain companies, compliance with 401(k) nondiscrimination testing is inherently very difficult. For example, we work with many family-owned businesses. In these cases, there are multiple highly valued (key) employees because many people hold 5% of the company or more.
What happens if a 401(k) plan fails the nondiscrimination test?
If you fail the 401(k) nondiscrimination test, what happens?
It depends on why you failed, but generally you have a few options to remedy the situation:
- Even out the non-highly compensated employee contributions by making more contributions into the plan
- Even out the non-highly compensated employee contributions by making matching contributions into the plan
- Remove or limit the amount of contributions that your highly compensated employees are making (called “corrective distributions” or “refunds”)
How long do you have to correct the errors if you fail to comply with 401(k) nondiscrimination testing? Correct them by these deadlines, according to Employee Fiduciary.
- If you fail the ADP or ACP test, corrections must occur by two and a half months after the plan year ends.
- The final deadline for the ADP and ACP corrections is twelve months after the plan year ends.
- If your plan is found to be top heavy, you have 12 months following the last day of the plan year to fix it.
What happens if you fail the 401(k) nondiscrimination test and you don’t fix it?
Your plan loses its qualified status. This means you and your employees lose the tax benefits associated with your investments in the plan. In short, it’s a tax headache. If you can avoid it, you should!
Conclusion about how to comply with the 401(k) nondiscrimination test (while still maximizing your own tax benefits)
As you can see, the process of setting up, running, and complying with regulations for a 401(k) is quite involved. We’re happy to offer any insights; please contact us.
Drobylen, Eric. (2020, January 22nd). Employee Fiduciary. 401(k) Testing – Deadlines Employers Should Know. https://www.employeefiduciary.com/blog/401(k)-testing-deadlines
ForUsAll. (2018, August 22nd) 401(k) Nondiscrimination Testing: A Simple Guide for Improving Your Results. https://www.forusall.com/401(k)-blog/401(k)-nondiscrimination-testing/#fix
Internal Revenue Service. Retirement Plans. Definitions. https://www.irs.gov/retirement-plans/plan-participant-employee/definitions
Maxey, Daisy. (2020, Nov 14). Barron’s. Here’s How Biden’s 401(k) Plan Would Affect High Earners. A Split Congress Stands in the Way. Retrieved from https://www.barrons.com/articles/heres-how-bidens-401-k-plan-would-affect-high-earners-a-split-congress-stands-in-the-way-51605287157