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The DB and DC plans are more complicated to establish and more costly to administer than the SEP and SIMPLE plans. The 401(k) is the best-known DC plan (see Table 6.9).
Under Section 401(k) of the Internal Revenue Code, employees may choose to contribute up to 15 percent of annual pretax compensation up to a maximum $11,000 in 2002. In 2006, the maximum employee contribution increases to $15,000 of pretax pay. The maximum for employer and employee contributions combined is 25 percent of compensation up to a maximum of $40,000 in 2002. Similar plans for nonprofits are called “403 (b) plans.”
Table 6.9 Options Framework by Complexity and Cost of Administration
Easy/Inexpensive More Complicated/Costly Complex/Expensive
Bonus Defined contribution Stock options
SEP 401(k) Nonqualified plans
SIMPLE Defined benefit ESOP
What Are the Options?
It sounds like a win-win choice for employers and employees. Employees benefit by reducing current income taxes and receiving tax deferral on the earnings in the plan. The employer benefits because employees are funding their own retirement plans and the employer (and highly compensated employees) can put away up to $40,000 on a tax-deferred basis.
There is a catch: 401(k)s are costly to set up and administer.
Cost of Setup
Setting up a 401(k) is more difficult than starting a SEP or SIMPLE. You will need to work with a financial institution or advisor to establish a plan. You can sign up over the Internet, but carefully check out the company before you start sending in money. Working with a well-known institution is preferable, especially when you are dealing with retirement funds. Setup fees vary, but beware of “no fee” claims. You need to identify the cost because the fees may be hidden.
Complexity of Administration
Employee participation is a critical element in 401(k) plans. To ensure that they are not favoring highly compensated employees, the plans must meet nondiscrimination tests. You will need an actuary to determine whether you meet the complex test criteria. Discrimination testing is a costly annual process. If the tests show that lower-paid employee participation is not sufficient to justify contributions by highly compensated employees, the excess contributions have to be refunded to maintain plan compliance. This can be a big hassle for all involved.
A key challenge for business owners is getting lower-paid employees to participate in the 401(k) plan. Although employers
Part 2—More Complicated and Costly Plans
are not required to contribute to 401(k) plans for their employees, it may make sense. Employers can elect to make matching contributions up to a certain amount of employee contributions. Employer matches are discretionary and can be changed from year to year. Employer matching contributions encourage employee participation.
Safe Harbors—Employers Match Employee Contributions
Employers can avoid the discrimination testing process by complying with the “safe harbor” provisions. Employers can elect to:
• Match all employee contributions up to three percent of compensation.
• Contribute two percent on behalf of all eligible employees.
Employer match contributions can vest over time (graded vesting can be up to seven years depending on the plan). So, departing employees cannot walk away with employer contributions.
By electing to meet the safe harbor match requirements, owners and highly compensated individuals can contribute more to their own accounts and avoid the discrimination testing process (see Table 6.10).
Another aspect of 401(k) plans is the employer’s “fiduciary” responsibility to act “prudently.” Some plans allow participants to direct their own investments. Whether your plan is assigned to a company officer for management or participants
58 What Are the Options?
Table 6.10 Evaluating Whether a 401(k) Is a Good Choice
How many employees will participate?
How will you educate employees about the plan?
What investment choices (choice of funds) will you offer?
Will you match employee contributions to obtain safe harbor status? How much will it cost annually for administration, record keeping, and tax reporting?
manage their own investments, this is a risky area. Fiduciaries face a potential personal liability for investment decisions, especially in down markets. It is important to establish prudent investment policies and monitor investment choices and performance. This responsibility should not be casually assigned to an overworked member of your management team. It is safer to hire a firm qualified in administering 401(k) plans.
If you are 50 or older, the law now allows you to make “catchup” contributions. This means that you can increase the amount of pretax elective deferrals to 401(k) plans, SEP, or SIMPLE plans as shown in Table 6.11.
Table 6.11 Catch-Up Limits—Additional Contributions for Plan Participants Age 50 or Older
401(k) and SEP ($) SIMPLE ($)