How to Set Up a 401k for a Small Business
While there are many types of retirement plans available, the 401(k) is one of the most popular among small businesses. The way it works is that your employees will be able to deduct a certain amount of money from their paycheck (based on limits that are imposed by the plan's provisions and IRS rules) to be deposited into the plan. As the employer, you will also contribute to their plan based on how much they are depositing and what kind of plan you've chosen.
The following is an overview of the benefits of setting up a 401(k) plan, the types of plans available, how to choose the plan that best suits your company, and what your responsibilities will be.
What Are the Benefits of Setting Up a 401k Plan for Your Small Business?
There are several types of retirement plans to choose from, including traditional 401(k)s, SIMPLE IRAs, and SEP IRAs. However, 401(k) plans tend to suit small businesses particularly well for several reasons:
Attract and Retain Quality Employees
As a small business, you're probably not the only game in town. If you want to hire highly qualified employees with a lot of experience, you'll need to convince them to choose to work for you over other potential employers. If you don't have a retirement plan such as a 401(k) available, they're likely going to choose a company that does. Their future's financial security is at stake, after all.
Encourages Employees to Stay
If you don't currently have a 401(k) plan in place, implementing one can help anchor your employees to your business. The more you do for your current employees, the more loyal they will be. Without a retirement plan, more experienced employees may begin looking for work elsewhere, especially if they are getting older and are beginning to plan more for their future. It also makes it easier for competitors to lure your best employees away from you if they can offer something you don't have, such as a 401(k) plan.
Shows Employees That You Care About Them and Their Future
There's no better way to motivate your employees than by showing them that you actually care about them and their futures. They'll be more willing to work harder and be more productive if they know that you appreciate their effort and are helping to support their future by setting up a 401(k) plan.
There Are Tax Benefits
401(k)s offer tax benefits for both the employer and the employee. As the employer, you'll be able to deduct any contributions that you make to your employees' 401(k) plans. Smaller businesses with less than 100 employees can claim a $500 tax credit for the first three years after you've implemented a 401(k) plan to help offset administration fee costs.
As for your employees, the money they put towards their plan won't be taxed along with the rest of their income. Once they retire and begin withdrawing funds from their account, they will be taxed at an income tax rate (and only on what they withdraw) instead of a capital gains tax rate.
The First Step: Decide Which Type of 401(k) Plan You Will Offer
Once you've decided to set up a 401(k) plan for your employees, select what type of plan will suit your business best. You can choose from these different types of 401(k)s:
Traditional 401(k) Plan
The traditional 401(k) is the most well-known of all the 401(k)s out there. You are not required to match contributions or profit-share if you do not want to; however, you can contribute up to $56,000 pre-tax every year through profit-sharing, matching employee contributions, and salary deferrals. This limit breaks down into $19,000 in salary deferrals, $19,000 in employee matching, and $18,000 in employer profit-sharing contributions. An additional $6,000 can be contributed to employees over the age of 50 in what's known as catch-up contributions. Most plans now also offer the option of after tax contributions via a Roth provision.
401(k)s require administration, so expect to pay plan administration fees, custodian fees, advisor fees, ETF and mutual fund expense ratios (which are fees for your plan's investment options), recordkeeping fees, and trading commissions.
This Plan Offers The Greatest Flexibility
The traditional 401(k) plan does have the highest administration costs out of all the 401(k) options and the IRS will require annual testing to make sure that your plan is fair for your employees. However, it's also the most flexible plan available for small businesses with at least eight employees. You can structure how you match employee contributions any way you want (including profit-sharing) as long as you abide by the contribution limits and you include your matching guidelines in your plan documents.
Additionally, you can set your plan's own eligibility requirements and a schedule for your contributions over time instead of right away, which can be a good option if you're worried about your employees potentially leaving early. You can also create brokerage options in your 401(k) plan in addition to choosing from a selection of mutual funds, which allows employees to trade in stocks and bonds. Finally, many 401(k) providers will allow you to build a borrowing component into your plan.
Safe Harbor 401k Plan
Safe Harbor 401(k) plans are the most commonly used 401k plan now. They are similar to traditional 401(k) plans in that the contribution limits are exactly the same; however, maximizing contributions is easier since Safe Harbor 401(k) plans are exempt from yearly compliance testing. This is an advantage because annual compliance testing can result in plan assets being returned to high-earning employers, which in turn would increase their tax bill and reduce what they're putting away for retirement.
Safe Harbor 401(k) plans cost about the same as traditional 401(k) plans because they have similar fees. Some providers offer cost savings for such plans since there is no annual compliance testing. Safe Harbor 401(k) plans tend to be most suited for businesses that have high employee turnover rates or too many plan assets among owners and/or highly paid employees. If this is the case with your business, you're better off with a Safe Harbor 401(k) plan than a traditional 401(k) since you're more likely to violate annual compliance testing.
Requires a Minimum Employer Contribution
Although the fees are the same as a traditional 401(k) and your provider may offer cost savings, there are added costs due to the higher matching requirements of a Safe Harbor 401(k). In order to qualify for a Safe Harbor 401(k) plan, you will need to match at least 4 percent if you're matching employee deferrals. There are two ways you can do this--you can match 100 percent of your employee deferrals with 4 percent, or you can match 100 percent of your employee deferrals up to 3 percent and then match 50 percent up to 5 percent.
There's also a second contribution option, which is called non-elective contributions. This option allows you to contribute up to 3 percent of an employee's annual pay to their plan even if the employee doesn't contribute themselves. The contribution structure is the same as a traditional 401(k) plan.
Savings Incentive Match Plan for Employees (SIMPLE 401k)
If you have a small business with fewer than 100 employees, the SIMPLE 401(k) plan is another excellent option. Both employees and employers can make pre-tax or tax-deductible contributions to the plan and it's incredibly easy to set up. Unlike the previous two plans, SIMPLE 401(k)s do not have nearly as many service fees (there typically are no administration fees), nor are there IRS filing requirements.
The potential drawback is that the maximum contribution limit is only $26,000. Employees can contribute $13,000 and employers can match that $13,000 in full. Employees 50 or older can contribute an additional $3,000.
You won't have much flexibility when structuring matching contributions either. You can match dollar-for-dollar up to 3 percent of employees' annual pay. You can also temporarily reduce the contribution you're matching to 1 percent--but you can't match less than 3 percent for more than two years in a five-year period. If you choose non-elective contributions, you can contribute 2 percent of every employees' annual pay to their account, whether or not they contribute anything themselves. Additionally, you can't vest contributions to a SIMPLE 401(k) over time.
SEP-IRA (simplified employee pension)
SEP IRAs are tailored for self-employed individuals or very small companies. If you run a small business but are the sole employee or only have a few employees working for you, a SEP IRA is an ideal option because of how easy it is to set up and how versatile it is. For example, it's easy to trade individual stocks and bonds online with a SEP IRA and you're never locked into a contribution percentage as long as you make proportional contributions to all of your employees.
SEP IRA’s have no minimum contribution requirement, and the plan allows you to contribute up to the lesser of $56,000 or 25 percent of your annual compensation. The only costs involve account maintenance fees and normal trading and investment costs.
Which One To Choose?
The various 401(k) plans all have potential advantages and drawbacks based on what your company's needs are. Some of the important factors to consider include the size of your company, how much you want to contribute, what kind of features you want (such as the ability to borrow against the plan), and what kind of flexibility you want.
For example, if you have a company with less than eight employees, a SEP IRA is a good option. If you want as much flexibility as possible, traditional 401(k)s and SEP IRAs are the best choices. If you have high employee turnover, you may want to look into a Safe Harbor 401(k). If you're not looking to make substantial contributions, a SIMPLE IRA might be the best alternative.
Next: Choose Which Contribution Type is Best for Your Business
Once you've chosen what kind of 401(k) plan you want to implement, decide what contribution type will suit your business best. Here is a brief synopsis of the different contribution types you can participate in:
Non-elective contributions refer to contributions that you make to an employee's 401(k) account whether or not they are making elective deferrals into their account. This is done through profit sharing. If you decide to do this, you have three options:
Pro-rata contribution - Pro-rata contribution distributes a uniform contribution percentage to all employees.
Integrated contribution - Integrated contribution provides compensation earned in excess of the integration level, which is typically the Social Security taxable wage base.
New compatibility - New compatibility contribution allows different allocation rates for different employees.
Matching contributions allow you to match whatever your employees defer from their paycheck into their 401(k) account. You can generally structure how you match your contributions (although this depends on the type of plan you have as well) and can change it on a yearly basis if your matching contributions are discretionary so that it's more in line with how your business is doing. An example of a match formula might be 50 percent of elective deferrals up to 5 percent of compensation. This means that if an employee defers 5 percent of their paycheck to their 401(k) plan, you would contribute 2.5 percent to their plan on top of that.
If you offer a Roth IRA within your 401(k) plan, the contribution limits are the same as the traditional pre-tax 401(k) contributions. Additionally, you are contributing after-tax dollars, although this does mean that when employees withdraw funds from this account, they won't have to pay tax.
Contributions limits for 401(k) plans have changed for 2019 and are generally adjusted regularly to keep up with cost of living and other factors. Here is a quick look at the contribution limits for the various 401(k) plans in 2019 for employees that you can match:
Traditional 401(k) - Employees are limited to contributions of $19,000.
Catch-ups - Employees 50 and older can contribute an additional $6,000 contribution.
SEP IRA - The contribution limit of a SEP IRA is $56,000.
SIMPLE 401(k) - The contribution limit for SIMPLE 401(k) plans is $13,000. Its catch-up limit remains at $3,000.
It's worth noting how many employees actually take advantage of these limits. According to Vanguard's How America Saves, 13 percent of employees with retirement plans deferred the maximum amount in 2017, while 14 percent of employees ages 50 and older took advantage of catch-up contributions.
Create a Written Plan Document
If you don't hire a professional or financial institution to set up and maintain your company's 401(k) plan, you will have to write a plan document that establishes the terms and conditions of the 401(k) plan you've chosen. Because it's a legally binding contract, it's a good idea to seek the help of a professional. The document needs to include the type of 401(k) plan you've chosen, what features the plan has (including contribution amounts and employee eligibility), and how you will contribute and distribute funds.
Arrange a Trust Fund For The Plan's Assets
In order to set up a 401(k) plan, you will have to establish a trust fund that holds all of the plan's assets. Such a trust fund will guarantee that the funds will only be used by participating employees and their beneficiaries. Part of the process of establishing the trust fund requires you to choose a trustee who will handle the contributions, plan the investments, and handle distributions.
Ensure You Have a Recording System in Place
You'll want an accurate way to keep track of all of the contributions your employees are making as well as the contributions that you are making, which means that you will want some sort of recording system. Without a recording system, it will be difficult to keep track of all of the details.
Keep All The Details in Order
Besides tracking you and your employees' contributions, keep track of earnings and losses, distributions, expenses, and plan investments. You can do this yourself using payroll software or a SaaS payroll service, although you may want to consider outsourcing to a professional or financial institution to ensure that no mistakes are made (it can also be a bit of a time-consuming task to do it yourself).
Provide Employees With a Summary Plan Description (SPD)
Write up a summary that includes a description of your plan to hand out to your qualifying employees. Because it's an optional program, make sure that your employees fully understand the details of the plan you've chosen.
Inform Employees of The Benefits and Advantages of Participating in a 401(k)k Plan
The summary should include information pertaining to eligibility, contributions, distributions, claims, and their rights and responsibilities. It should also include information on the features and benefits of the plan. Keep in mind that this is required by the Employee Retirement Income Security Act.
Roll Plan Out
Once your employees have signed on to the plan, be sure that you keep up your side of the agreement by abiding by all of the terms and conditions listed in the plan (such as matching what you say you're going to match). If you make changes to the plan, such as to the contributions you're making, inform employees of these changes ahead of time.
Ongoing Fiduciary Responsibilities For a 401(k) Plan
As the plan's sponsor, you will have a lot of fiduciary responsibilities to keep up with. It's your responsibility to put the financial interest of your participating employees over your own. You will be held liable for any actions or lack of actions on behalf of the plan, so be aware of the requirements. All of this housekeeping is a good reason to outsource your fiduciary duty.
Decide Who Will Be Responsible For Fiduciaries
If you don't want to be responsible for all the minutiae of the plan, outsource your fiduciary responsibilities to a qualified professional or financial institution. They will monitor the administration of the plan and its investments on your behalf. When outsourcing, be sure to look for the following:
A professional with fiduciary liability insurance.
A professional willing to sign off on the 5500sf form as a fiduciary.
A professional that will explain their process for determining investments.
A professional that can provide references.
You should also ask how often they communicate and how often they will send representatives to your business to help prepare for audits and to provide employee education.
Make Sure You're Aware of The Requirements
The following are the fiduciary requirements you'll be responsible for (unless you decide to outsource to a qualified professional):
Following the summary plan description.
Diversifying the investment options in your plan.
Making decisions based on your employees' best interests.
Minimizing expenses to help offset the costs of the plan and its investments.
Monitoring the plan's investment performance and replacing investments when they are no longer appropriate.
Monitoring all of your and your employees' contributions.
Educating your participating employees on their plan's investment options.
Keeping the plan document updated when changes are made.
As a small business, you'll want to do everything that you can to stay competitive in the job market. This means offering employees incentives to come work for you, including financial incentives, such as retirement plans.