As a fiduciary retirement plan advisor with more than 30 years of experience in the small business retirement plan space, we understand the unique challenges that small business owners face when it comes to offering 401(k) plans to their employees. We strive to provide the best advice and guidance to help small business owners make informed decisions about their 401(k) plans. In this comprehensive guide, we will explore everything you need to know about small business 401(k) plans, from the benefits of offering a plan to your employees to the different types of plans available.

Why Offer a 401(k) Plan?

Offering a 401(k) plan to your employees can have many benefits, both for your employees and your business. For employees, a 401(k) plan provides a way to save for retirement and potentially lower their tax burden. For businesses, offering a 401(k) plan can help attract and retain top talent, as well as provide tax benefits.

According to a recent survey by the Transamerica Center for Retirement Studies, 71% of small to medium-sized businesses in the U.S. now offer a 401(k) plan to their employees. This is a significant increase from just a decade ago when only about half of small businesses offered retirement plans. The trend towards offering 401(k) plans is expected to continue as more employers recognize the importance of helping their employees save for retirement and stay competitive in the job market.

With the tight labor market and low unemployment rates, competing for top talent is more challenging than ever before. Offering a 401(k) plan is one way to stand out from other employers and attract highly skilled workers. In fact, a recent survey found that 68% of job seekers said that the availability of a retirement plan was an important factor in their decision to accept a job offer. By offering a 401(k) plan, you can show potential employees that you are invested in their future and value their long-term financial security.

Types of 401(k) Plans

When it comes to choosing a 401(k) plan for your small business, it’s important to understand the various types available and their respective advantages and disadvantages. In this section, we’ll take a closer look at some of the most common types of 401(k) plans, including traditional 401(k) plans, safe harbor 401(k) plans, and SIMPLE 401(k) plans. We’ll discuss the benefits and drawbacks of each, so you can make an informed decision about which plan is right for your business and your employees.

Traditional 401(k) Plan

A traditional 401(k) plan allows employees to make pre-tax contributions to their retirement savings. Employers can also make contributions to the plan on behalf of their employees. The contributions and earnings in the plan are tax-deferred until the employee withdraws the money in retirement.

What makes a traditional 401(k) plan distinct is its flexibility. In 2023, employees can contribute up to $22,500 in pre-tax dollars to their account each year, with those over age 50 able to make an additional catch-up contribution of $7,500. Employers can also choose to match some or all of the employee’s contributions, up to certain limits set by the IRS. This flexibility allows employees to save more for retirement while reducing their taxable income.

Another advantage of traditional 401(k) plans is that they offer a wide range of investment options. Typically, employees can choose from a variety of mutual funds with exposure to different risk levels, asset classes, and more. Target-date funds, or managed accounts that automatically adjust asset allocation based on an employee’s age and risk tolerance, are a popular option.

While traditional 401(k) plans are generally easy to administer and cost-effective for both employers and employees, they do have some drawbacks. One potential disadvantage is the vesting schedule for employer contributions. In some cases, employees may need to work for a certain number of years before they become fully vested in employer contributions. Additionally, withdrawals made before age 59½ are typically subject to a 10% penalty, which can discourage some employees from participating in the plan.

Overall, traditional 401(k) plans are a great option for small businesses looking to offer retirement benefits to their employees while also enjoying tax benefits themselves. By understanding the unique features and advantages of these plans, you can make an informed decision about whether they are right for your business and your workforce.

Safe Harbor 401(k) Plan

A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but it includes certain employer contributions that are required by law. This type of plan is designed to ensure that highly compensated employees do not receive a disproportionate share of the plan’s benefits.

Safe harbor 401(k) plans require employers to make contributions on behalf of their employees, which can be either matching or non-elective. Matching contributions are based on the amount an employee contributes to their account, while non-elective contributions are a set percentage of each eligible employee’s compensation. These contributions must vest immediately and are not subject to discrimination testing, making them an attractive option for small businesses that want to avoid complex compliance requirements.

One significant advantage of safe harbor 401(k) plans is that they allow highly compensated employees to contribute the maximum amount allowed by the IRS without being subject to additional testing. In addition, these plans can help small business owners attract and retain top talent by providing more generous benefits packages than their competitors.

ADP and ACP Testing

One common issue that businesses with a large number of highly compensated employees (HCEs) face are the possibility of failing the IRS’s annual ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) tests. These tests ensure that a 401(k) plan does not unfairly benefit HCEs at the expense of other employees. If a plan fails these tests, it may have to return some contributions to HCEs or make additional contributions to non-HCEs.

This can be a significant headache for small business owners, as failing these tests can result in costly penalties and administrative burdens. However, safe harbor 401(k) plans are specifically designed to help businesses avoid these issues.

Safe Harbor Plans and ADP/ACP Testing

Safe harbor 401(k) plans are exempt from the ADP and ACP testing requirements, provided they meet certain contribution requirements. This means that businesses with many HCEs can offer their employees generous retirement benefits without worrying about violating IRS regulations.

By offering a safe harbor 401(k) plan, small to medium-sized businesses can attract and retain top talent while also avoiding costly penalties and administrative headaches associated with traditional 401(k) plans. Safe harbor plans provide certainty for both employers and employees, making them an attractive option for any business looking to offer robust retirement benefits without the added stress of compliance testing.

Safe Harbor Drawbacks

However, safe harbor 401(k) plans also have some drawbacks. For one thing, they typically require higher employer contributions than traditional 401(k) plans, which can be a financial burden for some small businesses. Additionally, employers must provide annual notices to employees about the plan’s features and contribution requirements, adding another layer of administrative complexity.

Overall, safe harbor 401(k) plans can be an excellent choice for small to medium-sized businesses looking for a retirement plan that is easy to administer and compliant with federal regulations. By weighing the advantages and disadvantages of this type of plan against your business’s unique needs and goals, you can determine whether it is the right choice for you and your employees.

SIMPLE 401(k) Plan

A SIMPLE 401(k) plan is an excellent option for small businesses that want to offer their employees a retirement savings plan without the administrative complexity and cost of traditional 401(k) plans. This type of plan is designed for businesses with fewer than 100 employees, making it an ideal choice for startups, small businesses, and sole proprietors.

One of the advantages of a SIMPLE 401(k) plan is its low administrative costs. Unlike traditional 401(k) plans or safe harbor 401(k) plans, there are no annual compliance tests or complex reporting requirements. This can save small business owners time and money while still offering valuable retirement benefits to their employees. While administrative costs are lower, we should note that filing a 5500 is still required.

Employees can contribute up to $15,500 in pre-tax dollars to their account each year, with those over age 50 able to make an additional catch-up contribution of $3,500. Unlike a traditional 401(k) plan, you as the employer will be required to either match up to 3% of each employee’s pay or make a non-elective contribution of 2% of each eligible employee’s pay. These contributions are tax-deductible for the employer and tax-deferred for the employee. Employees are vested in any and all contributions.

One disadvantage of a SIMPLE 401(k) plan is that it has lower contribution limits compared to traditional or safe harbor 401(k) plans. This may not be ideal for highly compensated employees who want to maximize their retirement savings contributions.

In summary, a SIMPLE 401(k) plan is an excellent choice for small businesses looking for an affordable and easy-to-administer retirement savings plan. While it may have lower contribution limits than other types of plans, its simplicity and low administrative costs make it an attractive option for both employers and employees alike.

Alternatives to 401(k) Plans for Small to Medium-Sized Businesses

While traditional, safe harbor, and SIMPLE 401(k) plans can be excellent options for small to medium-sized businesses looking to offer retirement benefits to their employees, they are not the only choices available. Depending on your business’s unique needs and goals, you may want to consider one of the following alternatives:

Simplified Employee Pension (SEP) Plan

A Simplified Employee Pension (SEP) plan is a type of retirement plan that allows employers to make tax-deductible contributions on behalf of their employees but does not allow employee contributions. These plans are easy to set up and administer, making them an attractive option for small businesses.

SEP plans are that they allow employers to contribute up to 25% of each eligible employee’s compensation, up to a maximum of $66,000 per year (for 2023).

That being said, employer contributions must be made equally for all eligible employees, regardless of their position or salary. This means that highly compensated employees will receive the same percentage contribution as lower-paid employees.

Simple IRA Plan

A Simple IRA plan is similar in many ways to a SIMPLE 401(k) plan but with some differences. It allows both employers and employees to make contributions towards the employee’s retirement account. Both parties receive tax deductions on their contributions which can reduce their overall tax bill.

One benefit of a Simple IRA plan is its low administrative costs compared with other types of plans. However, it has lower contribution limits than other types of plans like traditional or safe harbor 401(k)s.

Defined Benefit Plan

A defined benefit plan is another alternative worth considering for small business owners looking for robust retirement benefits. These types of plans provide retirees with a fixed income based on factors such as length of service and salary history.

The main advantage of defined benefit plans is that they provide retirees with guaranteed income in retirement. However, these types of plans can be costly and complex to administer due to actuarial calculations needed at setup and ongoing management.

Cash Balance Plan

A cash balance plan combines aspects from both defined benefit plans and defined contribution plans as 401(k)s. It provides participants with a guaranteed annual rate while also offering flexibility in terms of investment options.

Cash balance plans are most appropriate for small businesses with owners or partners that make $300,000 a year or more in compensation, have less than 26 employees, and own businesses that produce stable, predictable cash flow. These plans need to be in place for 3 to 5 years.

If you’re considering a cash balance plan, it’s important to work with a financial advisor who can help you determine whether it’s the right choice for your business and guide you through the process of setting up and administering the plan due to its administrative complexities. One potential downside is that these types of plans can have higher administrative fees compared with other types of plans.

401(k) Plan Administration and Compliance

Once you have established a 401(k) plan for your business, it is crucial to ensure that the plan is properly administered and maintained in compliance with all applicable laws and regulations. This includes tasks such as monitoring plan investments, providing regular plan disclosures to employees, and filing annual reports with the IRS.

Monitoring Plan Investments

As a fiduciary responsible for administering your company’s 401(k) plan, you must act in the best interests of your employees when selecting investment options for the plan. This means that you need to monitor the performance of each investment option regularly and make changes if necessary.

It is essential to establish an investment policy statement (IPS) that outlines the criteria used to select investment options. The IPS should also define how often investments will be monitored, who will be responsible for monitoring them, and what actions will be taken if an investment fails to meet its objectives.

A fiduciary retirement plan advisor can be an invaluable asset to a plan sponsor when it comes to monitoring plan investments and reducing fiduciary liability. One way they can do this is by serving as a 3(21) or 3(38) fiduciary. A 3(21) fiduciary provides investment advice and recommendations to the plan sponsor, who retains ultimate decision-making authority. In contrast, a 3(38) fiduciary assumes full responsibility for selecting, monitoring, and replacing investments in the plan. By hiring a 3(21) or 3(38) fiduciary, the plan sponsor can offload some of their fiduciary responsibilities and reduce their potential liability while ensuring that their employees’ retirement savings are in good hands. Additionally, a retirement plan advisor can help the employer understand their obligations under ERISA and ensure that they are maintaining compliance with all applicable laws and regulations.

Providing Regular Plan Disclosures to Employees

One of your responsibilities as a plan sponsor is to provide your employees with regular disclosures about their retirement savings plans. This includes information about fees associated with the plan, investment options available, and how contributions are allocated.

The Employee Retirement Income Security Act (ERISA) requires that certain disclosures be provided at specific times. For example, participants must receive a Summary Plan Description (SPD) within 90 days of becoming eligible to participate in the plan. Other disclosures must be provided annually or upon request.

Filing Annual Reports with the IRS

Plan sponsors are required by law to file annual reports with the Internal Revenue Service (IRS). These reports include Form 5500 and any related schedules. The purpose of these reports is to provide detailed information about the operation of the plan throughout the year.

Form 5500 includes information about participant demographics, contributions made during the year, distributions made from the plan, expenses associated with operating the plan, and any loans taken out by participants. It is important to ensure that these reports are filed accurately and on time since failure to do so can result in substantial penalties.

By properly administering your company’s 401(k) plan and staying compliant with all applicable laws and regulations, you can help ensure that your employees have access to valuable retirement benefits while minimizing risk for yourself. Working with a qualified financial advisor can help you navigate these complexities while also ensuring that your company’s retirement savings plans remain competitive within your industry.

Conclusion

Offering a retirement plan to the employees of your small business can be a valuable benefit that helps attract and retain top talent, while also providing tax benefits for your business. By understanding the different types of retirement plans available and working with a fiduciary retirement plan advisor, you can find the right plan for your business and ensure that it is administered in compliance with all applicable laws and regulations.