Over the years, our firm has helped design thousands of small business 401(k) plans. Throughout the plan design process, our advice to employers is always the same – keep 401(k) features as basic as possible to simplify annual plan administration. Complicating 401(k) features can seem like a good way to lower plan expenses during the plan design process, but in my experience, the approach often leads to more headache than savings during annual plan administration.
Employers must define six major 401(k) features during the plan design process - eligibility, compensation, contributions, vesting, distributions, and loans. Below are the options that would simplify the administration of these features the most.
All 401(k) plans must define when employees are eligible to join. Employers can allow new employees to join their plan immediately or make them wait until minimum age and service requirements are met. Employers can also exclude classes of employees if the IRC section 410(b) coverage test can pass.
The simplest option to administer are no eligibility requirements at all – in other words, allow all employees to join immediately upon their date of hire. This choice means no future enrollment dates for employers to remember.
I recommend employers only consider more restrictive rules when necessary to keep out transient (short-term) employees or make employer contributions affordable.
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 can automatically satisfy ADP/ACP and top heavy requirements by making one of the following contributions to participants:
- 4% matching contribution
- 5% matching contribution (available for Qualified Automatic Contribution Arrangement (QACA) safe harbor plans only)
- 3% nonelective contribution
In a recent plan design study, we found about 75% of small business 401(k) plans make a safe harbor contribution to participants. These contributions are popular because small business plans often struggle to pass the ADP/ACP and top heavy tests.
Safe harbor contributions simplify 401(k) plan administration dramatically. They make annual plan testing a non-event for employers, while costing about the same as a top heavy traditional plan. I recommend them to all small businesses who can afford them.
401(k) plans must define the compensation to be used when allocating contributions to participants. This definition is called “plan compensation.” Most employers base plan compensation on W-2 wages that have been grossed up for pre-tax salary deferrals.
Employers can exclude types of compensation from plan compensation if the exclusion does not discriminate against non-Highly Compensated Employees. Some exclusions are automatically considered nondiscriminatory (e.g., compensation earned prior to plan entry, fringe beneﬁts), while others (e.g., bonuses, overtime) must pass special nondiscrimination testing.
The simplest option to administer are no compensation exclusions at all. Exclusions make plan compensation harder to calculate, and in my experience, rarely lower the cost of employer contributions by much.
401(k) participants are only entitled to the vested portion of their account. When they take a distribution, any unvested portion of their account must be forfeited to the plan. A 401(k) plan can use these forfeitures to pay plan expenses or reduce future employer contributions. Elective deferrals and most safe harbor contributions are always 100% vested, while other contributions can be subject to vesting – up to a 3-year cliﬀ or 6-year graded schedule.
The simplest option to administer are no vesting requirements at all. Vesting schedules force employers to track employee service to properly distribute participant accounts. I recommend employers avoid them unless the forfeitures are worth the effort.
401(k) withdrawals are called distributions. 401(k) plans must define a participant’s distribution options once they terminate employment. All plans allow a lump sum payment - basically, a single payment of the participant’s entire vested account balance - while some also allow installment and/or partial payments.
401(k) plans can also allow participants to take a distribution while they are still employed. These “in-service” distributions can be allowed once participants attain a certain age or experience a financial hardship.
To simplify distribution administration as much as possible, employers should keep their optional forms of distribution to a minimum.
A 401(k) plan can allow or prohibit participant loans. Loans are often very popular with employees but add administrative complexity for the employer, who often must sign oﬀ on loan requests and deduct loan payments from payrolls.
Participant loans may be the most difficult 401(k) feature to administer properly. For this reason, I recommend employers avoid them if they can get away with it. Otherwise, I recommend they limit the number of loans a participant can have outstanding at any time to one.
401(k) Plan Design Matters!
Proper 401(k) plan design is important. It’s not uncommon for an employer to save thousands of dollars in plan expenses by choosing one design over another while still meeting their plan goals. With the help of a qualified 401(k) provider, the process can take 30 minutes or less. Time well spent, in my view.
Proper plan design can also help employers reduce the time necessary for plan administration. Choosing the simplest options can save an employer tens of hours. They can also help employers avoid plan operational failures – which can be time-consuming and/or expensive to fix.
The simplest 401(k) plan design options are certainly not for every employer, but I recommend all employers view them as “defaults” (i.e., baselines) during the design process. Doing so can make it easier to avoid a more complicated than necessary 401(k) plan.
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