Small employers desiring to establish or enhance a retirement plan for their employees have many different options available and may take advantage of some unique plan design opportunities. However, there are compliance issues that typically only impact small retirement plans that the small employer should be made aware. In addition, sponsoring a retirement plan may take up valuable time for the small employer with fewer internal resources and may be another employee cost that the employer would rather not incur.
Before joining Newfront Retirement Services, I spent 30 years of my career working as a third-party administrator (TPA) in the small plan market. That experience provided valuable insight into the challenges that small employers face when establishing and maintaining a retirement plan. Likely the most common roadblocks for small employers are time and cost. Small employers may not have the knowledge or expertise to comply with all the regulatory requirements that come with plan sponsorship and may fall prey to service providers promising low administration fees, which can be synonymous with a “self-service” arrangement.
Why should small employers have a retirement plan? How do small employers navigate all the plan options? How do small employers find the best service providers? How can small employers reduce costs and meet fiduciary obligations? Let’s see if we can help …
What is the employer’s objective?
One of the first questions that should be answered is whether the employer intends to make employer contributions to the plan. If that answer is yes, then it should be determined at what percentage of compensation the employer is willing to contribute on behalf of the employees. I have experienced a wide range of responses from small employers, which can vary between none to 5% (and sometimes more).
The other question for the business owner is how much they would like to fund for their own retirement. If the owner is older than the rank-and-file employees by more than 10 years, there are unique plan design opportunities if the employer is willing to commit to some level of employer-funded contributions for the employees. That it usually accomplished by some combination of safe harbor 401(k) plan in conjunction with a profit-sharing contribution. That type of plan design can be quite beneficial for both the business owner and the employees.
If the employer wants to encourage employees to save for their own retirement, then the retirement plan may include employer matching contributions. The employer commits to making an employer match solely for employees who elect salary deferral contributions.
Depending on the type of plan adopted, the plan may be subject to annual non-discrimination testing to demonstrate that the contributions under the plan do not discriminate in favor of highly compensated employees (HCE).
- Note: HCE includes anyone who owns more than 5% of the business (family attribution between spouses and lineal ascendants and descendants), and anyone who earns more than the IRS annual limit in the prior year (e.g., $135,000 in 2022 for the 2023 year). Knowing who is considered an HCE is one of the most important determinations when designing a retirement plan.
How do I determine the right retirement program for my small business?
The first step is identifying the service partnerships that will be needed. Regardless of the type of plan, you will need an investment advisor to assist you with the plan investments offered through the retirement program. Investment advisors can be a great ally when navigating the myriad of investment options and plan types available.
IRA options (payroll deduction IRAs, SEPs or SIMPLEs) are generally offered through banks or other financial institutions. The bank or financial institution will handle all the paperwork and will likely offer some investment education to the employees. However, these are IRA accounts that belong to the employee. The options under those arrangements are limited and employer involvement is also limited. The contribution caps are reduced, so the IRA backed retirement plans may not provide the flexibility and contribution levels desired to meet retirement savings goals.
Qualified plans (401(k), 403(b), and profit-sharing) are the most flexible retirement plans; however, these retirement plans require a service team consisting of investments advisors, third-party administrators (TPA), recordkeepers and plan document providers. Some providers offer “bundled” arrangements that may include annual administration services, recordkeeping services and legal plan documents.
An “unbundled” arrangement is when the employer retains the services of an independent TPA firm for the annual compliance administration and plan document services but uses an investment platform independent of the TPA for the recordkeeping services. Some small employers prefer using a TPA because of the level of hand holding offered by dedicated service professionals familiar with the plan. Other small employers prefer using the bundled approach because everything they need is available through a centralized website.
Small employers may be offered retirement services through their payroll company. Sounds like a great plan because they have the deferral information readily available; however, consider whether you would get your hair styled at a nail salon. You may be better served by a service provider that specializes in retirement plans.
- Best Practices: Build your retirement services team with great care and due diligence. Read the service agreements with your providers taking great care in noting your responsibilities versus the service providers. Read the legal plan documents before you sign them to make sure that you fully understand all the provisions contained therein, especially any required employer contributions.
How do I select the retirement services team?
With so many options, small employers are often overwhelmed when beginning this process. Start with an investment advisor partner that you can trust. The investment advisor should have a practice devoted to retirement plans and should be certified and registered. From there, a good advisor who is knowledgeable in the retirement plan market can assist you with deciding between a bundled or unbundled arrangement and/or a single employer plan or a multiple/pooled employer plan.
The important part of building your team is understanding your internal resources and the amount of assistance you may need to operate the plan. That team may be different for a small employer with 10 employees and a small employer with 60 employees.
Research the service providers, check to see if any are under investigation by any government agencies, in particular the Department of Labor. Obtain several different quotes and make sure that you understand the services provided and the fees being charged for those services.
What should we expect regarding costs to offer a retirement program?
Fees can vary depending on the size of the service provider, the provisions contained in your plan (more complexity can increase costs) and the number of employees covered by the plan. The employer is a fiduciary with respect to a qualified retirement plan. A fiduciary has the duty of care and prudence with respect to the investments offered in the plan and a duty to monitor the service providers, fees, and investment performance on a frequent and regular basis. The investment advisor can be a great partner when it comes to benchmarking plan administration expenses and investment options.
A few words of caution:
- Do not sacrifice quality for cost. The regulations that govern retirement plans are complicated and you will want service providers who have the expertise to keep your plan compliant.
- As the saying goes, you get what you pay for. Nothing is free, so be very wary of providers offering retirement plan services “at no additional cost.” The service provider is getting paid from somewhere and it may be an expense against the investment funds in the plan. For a new plan, that can be a huge percentage of an employee’s account. Until the plan is established, the employer should pay for the plan related expenses out of pocket (deductible as a business expense).
- Providers should be paid reasonable fees for the services they perform. All plans are not created equal and more complex plan designs may require more service than a plan of similar type without all the bells and whistles.
Are there any start-up tax credits available?
Indeed, there are tax credits up to $5,000 for three years! Your small business will qualify for the credit if your have fewer than 100 employees making at least $5,000 and your plan includes at least one non-HCE. In addition, those employees could not have been covered by another plan your company sponsored or any related employer sponsored (related by virtue of a controlled group of entities).
Who can help meet the fiduciary obligations?
Qualified retirement plans require fiduciaries to act in the sole interest of the plan participants to provide retirement benefits. ERISA (Employee Retirement Income Security Act) requires fiduciaries to act with care and diligence under the prudent man standards. Further, fiduciaries must offer diversified investments and operate the plan in accordance with the legal plan documents. Therefore, it is vitally important that you have a great service team including an investment advisor, third-party administrator, recordkeeper and plan document provider. Each of these parties play a distinct role in assisting the plan sponsor with maintaining the overall compliance and complying with fiduciary obligations.
What compliance issues impact small employer plans?
Qualified retirement plans offer higher limits than the IRA options. The trade-off for higher limits is annual nondiscrimination testing that must be performed to demonstrate that the benefits under the plan do not significantly favor HCEs and owners. Below are a few of the most common tests for qualified plans that will impact small employers:
- Actual Deferral Percentage (ADP) Test — If your plan includes 401(k) salary deferrals, the deferrals must satisfy the actual deferral percentage (ADP) test under IRC §401(k)(3). An actual deferral percentage is calculated for each participant and is the ratio of the deferral for the year to annual compensation.
The plan may prove non-discrimination if the average of ADPs for the HCEs is less than or equal to 1.25 times that for the NHCEs or if the HCE ADP is less than or equal to 2 times or 2% plus the ADP of the NHCEs.
- Actual Contribution Percentage (ACP) Test — If your plan includes 401(m) matching contributions, the match must satisfy the actual contribution percentage (ACP) test under IRC §401(m)(3). An actual contribution percentage is calculated for each participant (like the ADP Test) and is the ratio of the match for the year to annual compensation.
The plan may prove non-discrimination if the average of ACPs for the HCEs is less than or equal to 1.25 times that for the NHCEs or if the HCE ACP is less than or equal to 2 times or 2% plus the ACP of the NHCEs.
- Participation/Coverage Testing — Retirement plans are required to make benefits available to a non-discriminatory group of employees. Under IRC §410(b), minimum coverage may be demonstrated by satisfying either the 70% ratio percentage test or the average benefits test.
- Top Heavy Test — A plan is top-heavy for the current year if the account balances of the key employees are at least 60% of the total plan account balances as of the last day of the prior plan year, or in the case of the first plan year, the last day of the current plan year.
Key Employees — Officers with gross compensation of at least $185,000 (indexed), 1% owners with compensation of at least $150,000 and more than 5% owners (including family attribution). Yes, the owner’s child who works for the business is considered an HCE even if their compensation is well below $135,000.
If a plan is considered top heavy — the small employer may be required to contribute 3% of compensation to any non-key participant who is employed on the last day of the plan year.
Is there a way to avoid the compliance testing?
Safe harbor 401(k) plans are a great way to avoid compliance testing. Safe harbor 401(k) plans are a special type of 401(k) plan that provide for fully vested employer contributions (either 3% of each participant’s compensation or in the form of a matching contribution up to 4% of each participant’s compensation that elects to make salary deferral contributions). Safe Harbor 401(k) plans are exempt from the ADP Test, and in certain circumstances, will also satisfy top heavy minimum contribution requirements. Safe harbor 401(k) plans can be a great plan design for small employers with a modest contribution required for the employees.
Small employer plans do not have to be difficult or expensive to achieve the retirement savings goals of the business owner(s) and employees. A well-designed retirement program and a great service team are the best offense in maintaining a healthy tax qualified plan. The Retirement Services team at Newfront is available to assist you with questions regarding the EVOLVE 401(k) available through ALLtech or other retirement plan questions that may arise at 401kHelp@newfront.com
Helpful Quick Links
- Retirement Plans Startup Costs Tax Credit
- Choosing a Retirement Solution for your Small Business
- IRS Retirement Contribution Limits by Plan Type
- 401(k) Plans Opportunities and Challenges for Small Business
- Retirement Plan Operation and Maintenance
- 401(k)ology — Related Employers
- 401(k)ology — Safe Harbor 401(k) Plan