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More About Small Business Retirement Plans

A few weeks ago, I discussed IRA based small business retirement plans and the Individual or Solo 401k.  This week, we are going to continue with the topic of small business retirement plans, but we are going to compare the various Defined Contribution Plans. 

The first type of plan we will look at is the traditional 401k plan.  This is by far the most common type of plan found in the workplace.  Recently, many plans have begun offering a Roth option for these plans as well.  The benefit of these plans is that they permit a high level of employee salary deferrals, which relived many companies (who use to use pension plans) of funding their employees retirements.  Essentially, it shifted the risk of providing for employee retirements from the employer to the employee.  This sounds terrible for the employee, doesn’t it?  Well, in this day and age of pensions going broke, employees job-hopping every 5 years, and corporate downsizing and layoffs, it is probably best that we all take our retirement into our own hands.  The contribution limits for these plans are capped at $18,000 per year in 2015 for the employee, if under age 50, or $24,000 per year if over age 50.  For the combined employee and employer contribution, the maximum is up to the lesser of 100% of compensation or $53,000.  Any employer with one or more employees can open this type of plan.  This type of plan can be subject to discrimination testing, which is a complicated calculation that attempts to make sure that highly compensated employees are not receiving more benefit from the plan than non-highly compensated employees.  In this type of plan, employee contributions are always 100% vested immediately, and employer contributions can vest according to the terms of the plan. 

Another type of defined contribution plan is the Safe Harbor 401k.  A safe harbor 401k operates in a similar fashion to a regular 401k, but without the discrimination testing for highly compensated employees. The safe Harbor plan gets around this testing because the employer must decide to match either a specified amount of employee contributions or give 3% of compensation to all participants in the plan.  Traditional 401k plans do not have this requirement for the employer, although the employer may elect to make employee contributions.  Another big benefit of this to the employees is that all contributions to these types of plans, including employer matching contributions, are immediately fully vested.  This type of plan is also open to any business with one or more employees, and has the same contribution limits as the traditional 401k plan.

Another version of the 401k plan is called the Automatic Enrollment 401k plan.  This plan is again similar to the regular 401k, except that the employer automatically deducts the employee’s wages by a fixed percentage and places that money into the plan.  The employee is allowed to opt out of this plan, or contribute a different percentage, but by default they will be enrolled in the plan at the default contribution rate.  The goal of this type of plan, for an employer, is to increase the percentage of participation in their plan.  However, this plan may still be subject to annual nondiscrimination testing.  The limits for contributions to this plan are the same as other 401k plans. 

Another option for small businesses is the Profit-Sharing Plan.  Profit sharing plans allow discretionary employer contributions.  There is no requirement to contribute to employee accounts in any given year, regardless of profitability.  However, if contributions are made, the employer must use a formula for determining how those contributions get divided among employee accounts.  The most common method is to contribute a percentage based on the employees compensation compared to the total compensation of the firm.  For example, if the firm has a total payroll of $1,000,000 per year, and one employee makes $100,000 per year, that employee would receive 10% of the total profit sharing contribution.  Profit sharing plans can be used in conjunction with other plans, and the business can have any number of employees.  These plans are popular in cyclical business where cash flows vary widely from year to year.  They can have higher administrative costs than other arrangements, and they may also be subject to testing to ensure that they do not discriminate in favor of highly compensated employees.  The limits on contributing to these plans are 25% of compensation or $53,000 in 2015, and the vesting schedule on these plans are set by the plan terms.

If you own a small business and would like more information about any of these plans, please call us at 904.685.1505, or email us at info@vanwiefinancial.com.