When designing a 401(k) plan there are a variety of features and options that can be included. Choosing the right plan design for your company can considerably reduce the risk of IRS compliance issues.. To understand your plan’s compliance vulnerabilities, you should first understand the company characteristics that can indicate an increased risk of compliance issues.
What You Need to Know/Key Takeaways:
- A small participant base, low owner's wages, large wage discrepancies, and a high proportion of owners may increase compliance risks
- Plan design pitfalls, including matching a low percentage of employee deferrals or up to a high percentage of income can contribute to compliance testing issues.
- Short plan years, and unpredictable earnings can make in-year testing and preventive measures more difficult
- Best practices for plan design include the use of employer matching to encourage savings, coordinating automatic enrollment and matching, as well as using vesting instead of service requirements
Company Risk Characteristics: A small number of participants, low owner's wages, large wage discrepancies, and/or a high proportion of owners elevate compliance risk.
Risk: Small Number of Participants.
Small companies with fewer than ten participants have an increased likelihood of some compliance testing issues and should be particularly mindful of how low employee participation rates can impact compliance.. With fewer participants, it is more likely that key employees’ assets exceed 60% of plan assets. Further, in a smaller company, one HCE’s decision to defer a large amount or one NHCE deciding to unenroll can increase the HCE deferral rate or reduce the NHCE deferral rates beyond the IRS limits.
Approach: Owners should contribute consistently over the year observing NHCE deferral rates and adjusting their deferrals accordingly.
Risk: S-Corporations with low owner’s wages.
Generally, S-Corporation owners receive only have a portion of their income as W-2 earning eligible for 401(k) contributions and many elect to defer a high portion of their W-2 compensation to their 401(k). As the owner's K-1 income is not included in compensation, the can have a very high Actual Deferral Percentage.
Example, Alexis is an S-Corp owner who reports $70,000 of income on a K-1 and receives $30,000 in wages. If Alexis defers $9,000 (only half the annual limit and less than 10% of her total income) she will have an actual deferral percentage of 30%. It is unlikely that non-owners will reach a similar deferral percentage and very possible that the plan is outside ADP limits.
Approach: In this situation, owners who wish to contribute larger amounts to the 401(k) plan should consider increasing their W-2 wages and be aware that their wage deferral percentage is what is tested.
Risk: Large employee wage discrepancy. Large variances in employee pay can cause compliance issues.
Example: a business has one key employee/HCE earning $185,000 annually and wishing to defer 10% ($18,500) to the 401(k) plan and nine employees earning an average of $40,000 who can only defer an average of 3%. The ADP disparity of 7% (10%-3%) exceeds the IRS allowed 2% disparity. Further, the one key employee’s 401(k) account would likely constitute greater than 60% of total plan assets making the plan top heavy.
Approach: Key employees should be aware of compliance limits. Consider using matching and auto-enrollment in combination to help NHCEs save more.
Risk: High proportion of owners. Where a large proportion of those working in a business are partners or owners it is easy to fall outside of the limits for Top Heavy testing.
Example: ABC Law has 3 partners, 3 associates and one EA and two paralegals. Because the partners earn more, save more, and stay longer than other employees, partners 401(k) assets exceed 60% of plan assets and ABC Law needs to make Top Heavy minimum contributions
Approach: If owners’ accounts will hold more than 60% of assets, a safe harbor plan can be very cost effective as 3% contributions may be needed to non-key employees. Keep company information updated, as roster changes will affect compliance results.
Risk: Relatives are owners too. Family businesses, due to ownership attribution rules, can face the same challenges as businesses with a high proportion of owners. Employees who are the spouses, parents, children, and grandchildren of owners are treated as having the ownership stake of those relatives for determining key employee status.
Example: Alice & Ben own 100% of Family Farms and their 401(k) assets make up 40% of plan assets. Charles, Diana and Eric are Alice & Ben’s grandchildren work at Family Farms and together their assets make up 25% of plan assets. The grandchildren are considered Key employees and key employee assets are 65% of plan assets so the plan is top heavy.
Approach: If relatives are working for your company know that these employees may be considered highly compensated and key employees even if they are modestly compensated and do not hold any ownership themselves.
Risk: Employee options can equal ownership. Many new companies use stock options, grants or warrants as a way of rewarding early employees and this can result in a larger number of employee owners. Employees holding vested options will be considered owners for 401(k) purposes.
Approach: If your company has issued or will issue significant stock to employees you should review your outstanding stock and options before beginning a 401(k) plan to determine who at that time and in the future will be considered a Key employees If this is a significant proportion of employees you may wish to consider a Safe Harbor plan.
Many of these situations can be managed effectively through prevention. However, if your company possesses the above characteristics and owners or highly compensated employees want to be able to contribute the maximum amount each year without worrying about compliance testing you will need to have a safe harbor plan.
Design Pitfalls: Some employer contribution formulas increase compliance risk, while others miss out on Safe Harbor protections.
Matching employee deferrals above 6% of compensation is generous, but can trigger compliance issues:
- Very few employees may be able to defer 10% or more of their compensation, and those that are will often be HCEs or owners. This can lead to matching contributions disportionately accruing to owners and HCEs, resulting in a violation of ACP limits.
- Offering extremely generous matching can result in combined employee and employer contributions exceeding 100% compensation limit set by §415.
- When matching exceeds 25%, it is possible exceed the 405 limit which limits the deductibility of 401(k) contributions to 25% of gross wages.
Matching employee deferrals at a low rate—any amount below 25%—can be cost effective option but can create its own issues:
- If a company match fails to encourage broad employee participation, those who defer the most, and thus receive the most matching may be HCEs and owners causing the plan to be outside ACP limits.
- In combination, matching only a portion of employee up to a high percentage of compensation creates a significant risk of ACP testing failure and compliance issues generally. Before a selecting such a matching formula, talk to employees about 401(k) contributions and contact a compliance specialist to make sure that this is the best way to accomplish your goals.
Some employer contribution formulas have comparable employer costs as Safe Harbor plans but not offer the benefits of Safe Harbor protections.
- A 100% match to 7% of compensation is not eligible for Safe Harbor but a 100% match up to 6% of compensation is.
- Offering 100% matching to 2% and 50% matching to 6% is not eligible for Safe Harbor but offering 100% matching to 3% and 50% to 5% is.
- Offering a 50% match to 8% is a great match but is not a safe harbor match
Generally, if you are considering employer contributions totaling of 3% of compensation or more, there may be a way to meet you goals with a formula that meets safe harbor requirements and thus avoids the need for compliance testing. Guideline can help!
Mitigation Challenges: Short-year plans and unpredictable income create challenges for in-year testing and projections.
Late-year plans. Beginning a 401(k) plan later in the year can have have a few effects:
- Newly established Safe Harbor plans beginning after October 1st are not exempt from compliance testing until the following January 1st.
- If some key employees or HCEs make a maximum contribution in a short year the risk of falling outside of ADP and Top Heavy limits is increased, as other employees may only make a portion of the contributions they would make over a full year.
- In a short plan year, you have little time to ascertain that a plan is on course to be outside of IRS compliance limits, and undertake a timely remedy.
- If a plan is outside Top Heavy limits at the end of the the first year, it will be considered Top Heavy in both the first and second years. Often key employees will reduce contributions during an initial short plan year to avoid top heavy status.
Fluctuating or unpredictable income.
Owners and partners can participate in the 401(k) based on self employment income. When owners and partners take regular draws based on reasonable income estimates and make 401(k) deferrals on these draws, Guideline is able to project annual contributions and can assist in providing guidance around compliance testing. However, where income cannot be accurately projected or owners choose not to take regular draws, it is extremely difficult to create accurate projections for compliance purposes.
Similarly, some owners of C-corporations pay themselves large year-end bonuses based on estimated earnings. The use of such bonuses makes forward looking analysis of compliance testing much more difficult.
If your business is a passthrough entity and does not not pay regular draws or your business pays a large portion of compensation in year-end bonuses and owners or highly compensated employees wish to make significant 401(k) contributions you should seek to provide regular updated estimates of what that income will be or consider a safe harbor plan.
The best plan designs help employees save, coordinate matching and contributions, use vesting appropriately, and anticipate personnel changes.
Help your employees save. Use employer contributions to help your employees save for retirement in a meaningful way. Helping employees save can sometimes mean offering a seemingly less generous matching formulation.
Example: matching 100% of employee contributions up to 1% of compensation is generous but might lead some employees to contribute less to their 401(k) accounts than a match of 25% up to 4%. The cost is the same to the employer, but for an employee basing deferrals on the matching they receive, the total contributions would be only 2% in the former instance but 5% in the latter.
Coordinate automatic contribution and matching. Automatic contribution is a powerful tool that helps employees contribute to 401(k) by default without needing to go in and setup deferrals. The default automatic contributions rates have a big influence on what participants save and potentially on compliance results. If your plan offers matching it makes sense to coordinate your match with the default rate.
Example: if your company offers matching to 4% of compensation set the default deferral to 4%, otherwise only those who go into their accounts would gain full access access to matching.
Combine vesting and reduced service requirements. Allowing more employees to participate in the plan can help compliance results. At the same time, you may wish to use employer contributions as a reward for employee retention. To accomplish both consider a reduced service requirement and subject employer contributions to a vesting schedule. Employees who leave within a period of time forfeit some or all of the employee contributions they have received.
Anticipate personnel changes. If your company includes only owners, or relatives of owners, keep in mind that as soon as you hire non-owner employees your plans will likely to have compliance issues. If you have such a company and think you are likely to hire outside employees in the near future, consider instituting a Safe Harbor plan now.
Avoid High risk plan designs. Matching a low percentage of employee deferrals up to a high level of compensation invites compliance issues. Instead consider a modest match designed to encourage broad participation.
Safe Harbor provisions merit consideration.
While many 401(k) plans do not include safe harbor provisions and most pass compliance testing and do not require corrections, if owners and key employees want to be able to contribute without worrying about compliance limits or your plan includes one or more of the risk factors discussed in this article like small size, high proportion of owners, large wage discrepancies, or unpredictable earnings, a safe harbor plan will offer ease and predictability at a cost comparable to addressing corrections through employer contributions.
If you have you have questions about plan design or want to make make changes to your existing contact firstname.lastname@example.org.