The #1 reason my employers put a retirement plan in place is to help recruit and retain higher caliber employees. Today we will begin the conversation on 401k plan options.
Although they may wish to offer a retirement plan to help achieve this goal, they may not have the budget to offer the full 4% company match necessary to qualify for the Safe Harbor 401(k) Plan or they may not be in the position to offer a company match at all. If this is the case, we are generally talking about offering what’s known as the Traditional 401(k) Plan. We touched on the pros and cons of the Traditional Plan in last week's class so we’ll dive a bit deeper today.
Let's start with the benefits of the Traditional 401(k) Plan. The biggest advantage of the Traditional Plan is that you have the maximum flexibility to customize the program as the plan sponsor. The primary commitment you have under this arrangement is to pay for any administrative fees that are associated with the plan. Once again, this program allows you to offer a minimal company match or no match at all. A lot of my plan sponsors who are putting a plan in place for the first time find themselves in this situation. I get it. If I'm an employer who is putting a retirement benefit in place for the staff, I'm taking on a whole new expense just by offering this program. To add a company match on top of this new expense can be a lot to bite off at once.
If I'm trying to incentivize my employees to participate in the retirement benefit, I may wish to implement a small match or maybe a stretch match. A stretch match is when you offer a company match as a percentage of a dollar. For example, you could set up a formula where the employer is matching $0.25-on-the-dollar up to 8% of the employee’s compensation. In this situation, the employer is incentivizing the participant to contribute 8% of their own compensation in order to receive the total 2% maximum employer match. In comparison, a formula of a dollar-for-dollar match up to 2% only incentivizes the employee to contribute 2% of their compensation. These is just one example of how you can customize the matching schedule within the Traditional 401(k) Plan.
In order to reward service and loyalty, you might want to consider allowing employees to contribute their own money to the plan shortly after starting employment but require that they work for a longer period of time before they receive any potential company contributions. The Traditional 401(k) allows you to set two different eligibility requirements to enroll in the plan versus receiving any employer contributions. This may keep you from making unnecessary contributions to any "revolving door" employees. You can assign an eligibility requirement of up to 1 year for employees to contribute their own money to the plan and up to 2 years to receive employer contributions. Again, there are no employer contributions required within the Traditional 401(k) Plan.
Since many of my employers wish to use the 401(k) as a retention vehicle, I always make sure to discuss the concept of vesting schedules. As a plan sponsor, you will dictate how long an employee must work for you before they can leave with a portion of the company contributions or the total balance of the employer contributions. This is what's known as a vesting schedule. For example, one of the more common vesting schedules is known as the Six-year Graded Vesting Schedule. This program says that an employee who leaves in their first year of employment will receive 0% of any company contributions made to their account. After that, the employee will become 20% vested for each additional year of employment with the company. After 6 years, the employee is considered fully vested and is free to leave the company and take their full 401(k) balance with them including employer contributions. Please note that an employee is always considered to be 100% vested in the money that they contribute to the plan. We will discuss other vesting schedule options in a future class but, for today, we just need to know that the Traditional Plan offers maximum flexibility when it comes to vesting schedules.
So what's the catch? The Traditional 401(k) allows you this level of flexibility but you are required to pass compliance testing. Once again, will review compliance testing in greater detail later in our sophomore year but these tests are meant to make sure the plan isn't discriminating against the Non-Highly Compensated Employees (NHCE’s are those making less than $130,000/year). If you are truly putting the plan in place for the benefit of the NHCE’s first and the business owner and Highly Compensated Employees second, this shouldn't be an issue. However, employers who wish to put the Traditional 401(k) in place predominantly for the benefit of the owners and Highly Compensated Employees HCE’s may run into an issue with compliance testing as the plan might be considered discriminatory or top-heavy. If this is the case, I would generally recommend the Safe Harbor 401(k). Should the plan fail compliance testing, the business owners and HCE’s may be asked to take a taxable distribution of their contributions or the employer may be required to make a contribution to the participants to get the plan back into compliance. As this is never a favorable outcome, I always suggest a plan sponsor reviews the details of the various compliance test before proceeding with the Traditional 401(k) Plan. We will cover these tests in Classes 209 and 210.
If you are taking this course to decide which 401(k) Plan is right for you, it’s still a little too early to make this determination. Please join us next week when we discuss the pros and cons of the Safe Harbor 401(k) Plan. After next week’s class, the waters should be a little less murky…