Design a 401(k) Plan Like a Pro in 6 Steps Blog Feature
Eric Droblyen

By: Eric Droblyen on March 31st, 2021

Print/Save as PDF

Design a 401(k) Plan Like a Pro in 6 Steps

Provider Shopping | Plan Design

Small businesses can have dramatically different goals for their 401(k) plan. The process of matching business goals to available 401(k) plan options is called plan design. Expert plan design can help a business minimize contribution expenses, improve employee participation, and/or avoid nondiscrimination test failures. As a business owner, you should settle for no less than expert plan design guidance from your 401(k) provider. The entire process can take 30 minutes or less.

At first blush, 401(k) plan design can seem intimidating - but it doesn’t need to be. In fact, only five plan features are selected during the process - eligibilitycompensation, contributions, vesting, and distributions and loans

Here is my 6-step process for 401(k) plan design. You can use it to design a new plan or evaluate the design of an existing plan like a professional in minutes.

Step #1 – Define the “Employer” 

401(k) plans must pass certain nondiscrimination tests annually to prove they don’t disproportionately benefit the employer’s Highly-Compensated Employees (HCEs). The coverage test is one of them. To pass this test, a plan must cover (or benefit) a sufficient percentage of non-Highly Compensated Employees (non-HCEs). The consequences for failing this test can be severe – including retroactive contributions to employees and plan disqualification

Related employers – members of controlled group or affiliated service group - are considered a single employer for purposes of the coverage test. Often, a 401(k) plan must cover the employees of all related members to pass the test. 

If you have an ownership interest in two or more business, you must have a clear understanding of their controlled or affiliated service group status. Otherwise, your 401(k) plan could fail to cover all the employees necessary to pass the coverage test.

High 401(k) Fees

Step #2 – Understand the Differences Between Safe Harbor and Traditional 401(k) Plans 

401(k) plans come in two basic types – traditional and safe harbor. Traditional 401(k) plans are subject to annual ADP/ACP and top heavy testing, while safe harbor plans automatically pass these tests by meeting certain contribution and participant disclosure requirements. 

Safe harbor plans are the most popular with small businesses – who often struggle to pass the ADP/ACP and top heavy tests. They come in two basic sub-types – conventional and Qualified Automatic Contribution Arrangements (QACAs). A QACA includes an automatic enrollment feature. 

Before you start choosing features for your 401(k) plan, you want to understand the major differences between traditional and safe harbor 401(k) plans. Your choice will dictate your plan’s cost, design options, and annual administration responsibilities.

Feature

Traditional 401(k) Plan

Safe Harbor 401(k) Plan (Conventional)

Safe Harbor 401(k) Plan (QACA)

Employer Contributions 

Not Required

Required. Employers must make a qualifying safe harbor contribution to plan participants. Options include:

  • Basic match – 100% of elective deferrals up to 3% of compensation, plus 50% on the next 2% (4% total).
  • Enhanced match – Must be at least as much as the basic match at each tier of the formula. 100% up to 4% of comp is most common.
  • Nonelective contribution – 3% (or more) of compensation.

HCEs can be excluded from safe harbor contributions. Annual allocation conditions (e.g., 1,000 hours of service) can’t apply. 

Safe harbor contributions must be 100% immediately vested. 

Required. Employers must make a qualifying safe harbor contribution to plan participants. Options include:

  • Basic match – 100% of elective deferrals up to 1% of compensation, plus 50% on the next 5% of compensation (3.5% total). 
  • Enhanced match – Must be at least as much as the basic match at each tier of the formula. 100% up to 3.5% of comp is most common.
  • Nonelective contribution – 3% (or more) of compensation.

HCEs can be excluded from safe harbor contributions. Annual allocation conditions (e.g., 1,000 hours of service) can’t apply. 

Safe harbor contributions can be subject to a 2-year cliff schedule.

Automatic Enrollment

Optional

Optional

Required. 

ADP/ACP Testing

Required

Not required unless one of the following conditions apply: 

  • Elective deferrals are subject to shorter eligibility requirements than safe harbor contributions.
  • A match that’s subject to the ACP test is contributed by the employer.
  • Voluntary (after-tax) contributions are made by participants.

Same as conventional SH Plan

Top Heavy Testing

Required

Not required unless one of the following conditions apply:

  • Elective deferrals are subject to shorter eligibility requirements than safe harbor contributions.
  • A match that’s subject to the ACP test is contributed by the employer.
  • Voluntary after-tax contributions are made by participants.
  • A profit sharing contribution is made by the employer.

Same as conventional SH Plan

Participant Disclosure

Not required.

Match-based plans must distribute a safe harbor notice to participants prior to initial plan eligibility and then 30-90 days before the start of each new plan year. 

Nonelective-based plans have no notice requirement if “maybe” contribution does not apply.

Same safe harbor notice requirements apply. 

Automatic enrollment notice requirements apply. 

Reasons to Choose

  • Your plan will pass ADP/ACP and top heavy testing.
  • No employer contribution requirement.
  • You want to apply a vesting schedule and/or allocation conditions to employer contributions.
  • Your plan is top heavy. A top heavy minimum contribution will cost about the same as the 3% nonelective contribution. The 4% match could cost less if plan participation is low.
  • Your plan will fail ADP/ACP testing. Safe harbor plans will allow HCEs to maximize annual contributions without risk of refund.
  • The same benefits as a conventional safe harbor plan, but cheaper match requirement and 2-year vesting on safe harbor contributions.

Reasons to Avoid

  • Your plan will fail ADP/ACP or top heavy testing. A failed ADP/ACP test usually means contribution refunds for HCEs, while a failed top heavy test means a 3% required contribution. 
  • Cost of safe harbor contributions.
  • Automatic enrollment adds administrative complexity – especially when an escalator is in place. Mistakes can be expensive to fix. 

Step #3 – Choose Your Employee and Employer Contributions

At this point, you’re ready to start picking the features of your 401(k) plan. I recommend you start with plan contributions. I choose them in the following order – 1) employee contributions, 2) safe harbor contributions, and 3) discretionary contributions.

Employee Contributions

These contributions are deducted from employee wages based on a deferral election – which can be a dollar amount or percentage of pay. While all 401(k) plans allow employees to make pre-tax elective deferrals, you can also allow Roth or voluntary contributions. 

  • Roth contributions – are subject to the same IRC Section 402(g) limit and distribution rules as pre-tax elective deferrals. These contributions can be withdrawn tax-free because they are taxed made. Their earnings can also be withdrawn tax-free when certain conditions are met. 
  • Voluntary contributions - these are after-tax contributions like Roth contributions, but are far less common. The reason – their ACP test requirement make them a poor fit for most 401(k) plans. The exception being “solo” (owner-only) 401(k) plans

Adding an automatic enrollment feature to your plan can be a way to increase employee contributions. Automatic enrollment involves enrolling eligible employees at a default deferral percentage unless the employee affirmatively elects a different rate – including zero. You have three options:

  • Automatic Contribution Arrangement (ACA) – the most basic type. The plan document specifies the default deferral percentage that will be automatically deducted from wages.
  • Eligible automatic contribution arrangement (EACA) – the default deferral percentage must be uniform and an annual notice that describes the feature must distributed to plan participants. Participants may be allowed to withdraw automatic contributions, including earnings, within 90 days.
  • Qualified Automatic Contribution Arrangement (QACA) – is a type of safe harbor 401(k) plan. The default deferral rate must start at no less than 3% and increase at least 1% annually to no less than 6%.  The default deferral rate can be as high as 10% for the initial year, 15% for later years. 

However, adding an automatic enrollment feature to your plan will increase its administrative complexity – especially if the default deferral percentage “escalates” annually. The automatic wage deferral can also upset surprised employees. That said, I recommend you avoid the feature if employee participation won’t be a problem.

Safe Harbor Contributions

By now, you should know whether a traditional or safe harbor plan is right for you. If you want a safe harbor plan, you must choose the nonelective or matching contribution you’ll make to plan participants. All eligible participants will receive a nonelective contribution, while only participants that contribute themselves will receive a matching contribution. Reasons to choose one contribution over the other include:

Nonelective Contribution

Matching Contribution

  • No safe harbor notice requirement if “maybe” contribution does not apply.
  • Often the best choice if you want a new comparability profit sharing contribution.
  • Can cost less than a matching contribution when employee participation is high.
  • Provides a base retirement benefit regardless of an employee’s ability to save for themselves.
  • Can cost less than a nonelective contribution when employee participation is low.
  • A matching contribution can motivate employees to save for themselves.

Discretionary Contributions

At this point, you’re ready to consider discretionary employer contributions. Your two basic options are matching and profit sharing contributions. You can add both, either, or none to your plan. 

  • Matching contributions – when added to a safe harbor plan, a discretionary match can be exempt from the ACP test when its formula is based on 6% or less of compensation and 4% or less in total. “Stretch” matches are popular with traditional plans. A stretch formula is based on a high percentage of compensation so plan participants must defer at a high rate to receive the full amount.
  • Profit Sharing – there is no more flexible type of employer contribution. These contributions can also be allocated using dramatically different formulas. The most flexible formula is new comparability – which is subject to special testing to prove nondiscrimination.

Discretionary contributions can be subject to a 3-year cliff or 6-year graded vesting schedule. They can also be subject to annual allocation conditions (e.g., 1,000 hours of service, employment on last day of plan year). The exception – a discretionary match added to a safe harbor plan. To automatically pass the ACP test, the match can’t include allocation conditions.

Step #4 – Define Plan Compensation

All 401(k) plans must define the compensation that will be used to allocate contributions to plan participants. When defining plan compensation for employees, you have three options for a starting point:

  • W-2 wages – Compensation reported in Box 1 of Form W-2.
  • 3401(a) wages – Compensation subject to Federal income tax withholding.
  • 415 safe harbor – Basically gross wages. Automatically adds back the pre-tax elective deferrals that reduce Form W-2, Box 1.

Most employers choose the W-2 option because it’s the most easily obtainable. They also tend to add back pre-tax elective employee deferrals when the 415 starting point is not used.

You can exclude forms of compensation from plan compensation, but your exclusions can’t discriminate against non-HCEs. Most employers exclude no more than the 414(s) “safe harbor” forms to avoid the need to test their plan compensation for nondiscrimination. These exclusions include:

  • Pre-entry compensation – pay earned by employees before they become plan-eligible
  • Certain fringe benefits – including reimbursements or other expense allowances, fringe benefits (cash and noncash), moving expenses, deferred compensation, and welfare benefits
  • HCE compensation – any portion of compensation paid to Highly-Compensated Employees (HCEs) can be excluded.

Regardless of the options you choose for employees, plan compensation for “self-employed individuals” - business owners who are taxed as a sole proprietor or partner – will be earned income. The starting point for calculating earned income is IRS Form 1065 - K‐1, Line 14(a) for partners and IRS Form 1040, Schedule C, Line 31 for sole proprietors. These amounts are then reduced by deductions related to Section 179 expenses and contributions made to employees. 

Step #5 – Define Employee Eligibility

Your plan’s eligibility requirements will dictate when your employees can enter the plan. You can let them in immediately or require them to meet minimum age and service conditions first. The maximum age and service conditions your plan can require are:

  • Elective deferrals and safe harbor contributions – age 21 and 1 year of service
  • Other contributions – age 21 and 2 years of service. If the service requirement is greater than 1 year, the contribution must be 100% immediately vested.

You have two options for crediting employee service for plan eligibility purposes:

  • Elapsed time – the easiest method for crediting service. Only time of employment is important. Hours worked are irrelevant.
  • Elapsed hours – employees must work a specified number of hours during an Eligibility Computation Period (ECP). An ECP can’t be more than 12 months long or require the employee to work more than 1,000 hours of service. An employee’s initial ECP commences on their hire date.

Once an employee has met your plan’s minimum age and service conditions, you must let them in on the next “entry date” – which you much define. Your options include immediate, monthly, quarterly, and semi-annual. 

You can exclude certain employees from plan participation altogether as long as annual coverage testing can pass. Union employees and non-resident aliens with no U.S income can be excluded from your plan with no impact to coverage testing

Step #6 – Choose Your Distribution and Loan Options

At this point, you’ve determined the rules for getting money into your 401(k) plan. Now, you must determine the rules for getting money out. A 401(k) account withdrawal is called a distribution. There are two basic types– post-termination and in-service. To give plan participants even greater access to their account, you can add a participant loan feature to your plan.

Post-termination distributions

These distributions are made to participants that terminated employment. Many 401(k) plans only permit a lump sum distribution option, but you can also allow partial or installment payments. You can add an involuntary distribution provision to force out small account balances – which is defined as under $5,000.

In-service distributions

These distributions are made to participants who are still employed. You have no obligation to offer in-service distribution options, but plan participants tend to appreciate their availability. Your options are subject to the following limitations:

  • Elective deferrals (including Roth), safe harbor contributions, QNECs and QMACs can’t be distributed until age 59.5
  • Discretionary matching and profit sharing contributions can be distributed at any age.
  • Employee rollover and voluntary contributions can be distributed at any time.
  • Hardship distributions can be allowed at any time.

Participant loans

Your plan can allow or prohibit participant loans. Loans are often very popular with employees, but the feature can add administrative complexity for you. You should understand the participant loan rules before you add the feature to your plan.

Expert 401(k) Plan Design Can Save You Thousands!

401(k) plan design is a big deal that shouldn’t be undervalued by business owners because there is no such thing as a one-size-fits-all 401(k) plan. It’s not uncommon for a small business to save tens of thousands by choosing one 401(k) plan design over another and yet still meet their plan goals.

The kicker? Expert plan design can take 30 minutes or less with the help of a design pro. A small price to pay to maximize the benefits of your 401(k) plan.

New call-to-action

 

About Eric Droblyen

Eric Droblyen began his career as an ERISA compliance specialist with Charles Schwab in the mid-1990s. His keen grasp on 401k plan administration and compliance matters has made Eric a sought after speaker. He has delivered presentations at a number of events, including the American Society of Pension Professionals and Actuaries (ASPPA) Annual Conference. As President and CEO of Employee Fiduciary, Eric is responsible for all aspects of the company’s operations and service delivery.

  • Connect with Eric Droblyen