Retirement plans are a popular way to save for retirement. Although many people participate in these plans, the flexibility allowed by plan provisions ensures each can be unique. Understanding the features and options available in a 401(k), 403(b) or 457(b) plan will help you design your plan so that it works best for you and your participants.
401(k), 403(b) and 457(b) refer to sections of the Internal Revenue Code that provide tax advantages for certain employer-sponsored retirement savings plans. These plans generally allow participants to have a portion of their pay contributed to the plan through payroll deductions. . Pre-tax contributions and earnings are taxed when withdrawn from the plan. This encourages automatic saving for retirement, with the added expectation that an individual’s tax rate may be lower during their retirement years.
A retirement plan sponsor can also choose to allow participant Roth contributions. Like the standard pre-tax salary deferrals, these are contributed to the plan and earmarked for retirement; the difference is that Roth contributions are taxed in the year they are withheld. The advantage to this is that earnings are tax-free so long as they meet the requirements of a qualified Roth distribution, which will account for most distributions taken by individuals of retirement age as long as the account was established at least five taxable years prior and the participant reaches age 59½. This option works best for participants who start deferring at an early age or whose tax rate is expected to be higher in retirement.
To participate in a retirement plan, an employee must generally meet the eligibility and entry requirements. Plan eligibility commonly incorporates a service requirement (based on hiring date and/or hours worked) and an age requirement, for example, eligibility upon hire for individuals age 21, or eligibility after working 1,000 hours in a 12-month period. The entry requirements define when the participant enters the plan after they become eligible; this could range from immediately to the next semi-annual entry date. These entry and eligibility criteria provide the plan sponsor with another avenue for plan customization, offering the ability to balance employee engagement and retention against costs and administrative responsibilities.
What happens after the participant meets the eligibility and entry requirements? Ideally, they will complete the enrollment paperwork, choose a deferral amount and select their investment options. However, many won’t engage with the plan in this way. To address this, a plan may include automatic enrollment provisions to enroll the participant at a preset deferral rate. At the same time, the plan can direct those contributions into a Qualified Default Investment Alternative (QDIA), allowing savings and investment to begin even without direct employee input.
Employers may also opt to contribute money to the plan on the participants’ behalf. This can be done in the form of a company match and/or non-elective contributions, the latter of which does not require an employee deferral. While optional, these types of contributions can fulfill certain safe harbor requirements, which may allow the plan to avoid most nondiscrimination testing that would otherwise be needed to ensure it isn’t discriminating against the non-highly compensated employees. If the safe harbor provision is added to the plan document, these types of contributions may be required.
Profit sharing is another option for more flexible employer contributions into a 401(k). A profit sharing provision can allow a plan sponsor, at their discretion, to make an additional contribution to the plan to reward the participants for a profitable year or to reduce the employer’s tax liability. The method for allocating these funds to participants is outlined in the plan document; several are available. These can be as simple as an equal salary percentage or a flat dollar amount, but more complex strategies are available as well, which might allocate more to higher-earning individuals or those nearer to retirement age. Some options may be more advantageous than others depending on the owner and staff demographics.
A combo plan is when two plan types are paired together, typically for the purpose of more favorable testing. For example, it’s common practice to pair a 401(k) plan with a cash balance defined benefit plan for the purpose of allowing higher contributions for older employees and owners.
One last option worth considering is a participant loan program. A plan sponsor may choose to offer this feature, allowing participants to borrow against their account balance. These loans can increase confidence and flexibility by giving participants access to their savings if a need arises.
Retirement plans are an important tool to meet your and your employees’ retirement goals. This is largely due to their adaptability. The options we’ve discussed are just some of the ways a retirement plan can be customized to balance the needs of participants with the needs of the company. If you are interested in exploring alternatives for your plan, please contact us for recommendations and advice.
