How To Streamline Your Company’s 401(k) Annual Administration
Over the years, IIS Financial has helped design hundreds of 401(k) plans for small businesses. In our experience with plan design, we consistently advise employers to keep 401(k) features straightforward to ease the annual administration process. While adding complexity to these features might seemingly reduce costs initially, it often results in more challenges and expenses during administration.
During the plan design phase, employers need to clarify six key features: eligibility, compensation, contributions, vesting, distributions, and loans. Below are the options that can best streamline the management of those features.
Eligibility
All 401(k) plans need to specify the eligibility criteria for employees. Employers have the option to allow immediate enrollment for new hires or to establish minimum age and service requirements. They can also exclude certain employee categories, provided they pass the IRC section 410(b) coverage test.
The easiest approach to manage is to have no eligibility requirements, allowing all employees to enroll as soon as they are hired. This eliminates the need for employers to track future enrollment dates.
We suggest that employers consider stricter eligibility rules only if they need to exclude transient (short-term) employees or to ensure that employer contributions remain manageable.
Contributions
401(k) plans are generally classified into two main types: traditional and safe harbor. Traditional 401(k) plans must undergo annual ADP/ACP and top-heavy testing, whereas safe harbor plans can automatically meet these requirements by providing one of the following contributions to participants:
- A 4% matching contribution
- A 5% matching contribution (applicable only for Qualified Automatic Contribution Arrangement (QACA) safe harbor plans)
- A 3% nonelective contribution
In a recent study of plan design, it was discovered that approximately 75% of small business 401(k) plans opt for safe harbor contributions. These contributions are favored because many small business plans find it challenging to pass the ADP/ACP and top-heavy tests.
Safe harbor contributions greatly simplify the administration of 401(k) plans, allowing employers to avoid annual testing headaches while generally incurring costs similar to those of a traditional top-heavy plan. I recommend these contributions to all small businesses that are able to implement them.
Compensation
401(k) plans need to specify what constitutes "plan compensation" for allocating contributions to participants. Typically, employers determine plan compensation based on W-2 wages, adjusted for pre-tax salary deferrals.
Employers have the option to exclude certain types of compensation from this definition, provided that these exclusions do not unfairly disadvantage non-Highly Compensated Employees. Some exclusions are automatically deemed nondiscriminatory, such as compensation earned before joining the plan or fringe benefits. In contrast, other exclusions, like bonuses and overtime, require specific nondiscrimination testing.
The easiest approach to manage is to have no exclusions for compensation. Exclusions complicate the calculation of plan compensation and typically do not significantly reduce the costs associated with employer contributions.
401(k) plans need to specify what constitutes "plan compensation" for allocating contributions to participants. Typically, employers determine plan compensation based on W-2 wages, adjusted for pre-tax salary deferrals.
Employers have the option to exclude certain types of compensation from this definition, provided that these exclusions do not unfairly disadvantage non-Highly Compensated Employees. Some exclusions are automatically deemed nondiscriminatory, such as compensation earned before joining the plan or fringe benefits. In contrast, other exclusions, like bonuses and overtime, require specific nondiscrimination testing.
The easiest approach to manage is to have no exclusions for compensation. Exclusions complicate the calculation of plan compensation and, in my experience, do not significantly reduce the costs associated with employer contributions.
Vesting
401(k) participants are entitled only to the vested portion of their account. When they withdraw funds, any unvested amounts must be forfeited and returned to the plan. These forfeitures can be used to cover plan expenses or to offset future employer contributions. Elective deferrals and most safe harbor contributions are always fully vested, while other contributions may have vesting requirements, such as a 3-year cliff or a 6-year graded schedule.
The easiest approach to manage is to eliminate vesting requirements altogether. Vesting schedules necessitate that employers track employee service to ensure proper distribution of participant accounts. I recommend that employers steer clear of these schedules unless the potential forfeitures justify the added complexity.
Distributions
Withdrawals from 401(k) plans are referred to as distributions. Plans must outline the distribution options available to participants upon termination of employment. All plans permit a lump sum payment, which is a one-time disbursement of the participant's entire vested account balance, while some plans also offer installment and partial payment options.
Additionally, 401(k) plans may permit participants to take distributions while still employed. These "in-service" distributions can be available once participants reach a specific age or experience financial hardship.
To streamline the administration of distributions, employers should aim to limit the variety of optional distribution forms.
Loans
A 401(k) plan can either permit or disallow participant loans, which are frequently favored by employees but can complicate administration for employers. Employers typically need to approve loan requests and manage payroll deductions for repayments.
Administering participant loans can be one of the more challenging aspects of a 401(k) plan. For this reason, I advise employers to avoid offering them if possible. If they choose to allow loans, I recommend limiting each participant to having only one outstanding loan at any given time.
Read This Full Guide on Plan Fees and Expenses
401(k) Plan Design Matters!
Effective 401(k) plan design is crucial. Employers can often save significant amounts in plan expenses by selecting one design over another while still achieving their objectives. With assistance from a Financial Advisor, this process can take 30 minutes or less - an investment of time that I believe is worthwhile.
A well-thought-out plan design can also help employers minimize the time required for plan administration. Opting for simpler features can save employers numerous hours and help them avoid plan operational failures, which can be costly and time-consuming to rectify.
While the simplest 401(k) plan design options may not suit every employer, consider them as “defaults” or baseline options during the design process. This approach can facilitate the creation of a more straightforward plan without unnecessary complications. Click here to explore how we've assisted with employee retirement plans.
If you would like to discuss your company's 401(k) plan or have any questions please click here to schedule a call today!