Establishing a 401(k) plan is a long-term commitment to your business and your employees.
Planning, building, and managing a 401(k) plan involves many choices that can directly impact your employees’ financial security and satisfaction with their job. Here are some commonly asked questions about sponsoring a 401(k) plan and some ideas on how to have active participation in your plan.
Q: How can I increase 401(k) plan participation?
A: Company-wide participation in your 401(k) is important. Not only does it mean your employees will be well cared-for in the future, which increases satisfaction, but it also means your company is more likely to pass certain necessary federal tests, and can earn your firm tax deductions. Getting employees on the program isn’t always easy, though. Some don’t understand the benefits, some may be experiencing financial stresses that make joining intimidating, and some simply can’t be bothered to plan for the future. However, there are a few ways to maximize your employee engagement.
- Make communications as clear and simple as possible. The less familiar the terms used to describe the plan, the more likely an employee is to put off making a decision. Explain the basics without over-explaining, and make yourself or another financial communicator available to answer questions, no matter how basic. Everyone has to start somewhere.
- Try auto-enrollment. The easiest way to get more employees in the plan is to start every employee out in the plan and let them opt out if desired. Companies that auto-enroll employees tend to retain 90% of them in the plan.
- Design your plan with a decent deferral rate. Some enrollment software starts new enrollees out at a nominal savings rate, like 3%. In most circumstances, a rate closer to 10% is a wiser choice, but research shows most employees tend to stick with whatever they start out with. Designing your onboarding process with a suggested rate of 6% or higher is better for your employees, and for you.
- Make making changes as quick and easy as possible. Investing in good web design and other benefits-management systems up front will pay dividends over the long run. For your employees the dividends can be literal, in the case of managing investment allocations or checking plan balances. If it can’t be done quickly, many employees will forget to take action at all. Send regular, clearly worded reminders, send updates and new information as soon as possible, and, in all your benefits emails as well as your company intranet, include a prominent link to your 401(k) provider’s login page. Encourage people to check out what’s going on with their plan and they’ll stay involved.
Q: How do I pass the nondiscrimination compliance tests for 401(k) plans?
A: There are two major compliance tests, both designed to determine if your company’s 401(k) plans benefit all employees, or if they’re a better deal for top-level executives who have more money to invest, also known as “Highly Compensated Employees” or HCEs. Now, the easiest way to pass nondiscrimination tests is by setting up a Safe Harbor 401(k), because they’re exempt from testing. No tests, no problem! But if that’s not an option, then your plan faces two main challenges: the Actual Deferral Percentage (ADP) test, and the Actual Contribution Percentage (ACP) test.
The ADP is calculated by dividing the amount an employee defers by their total W-2 income. It measures, by percentage, how much income HCEs and non-HCEs each contribute to their 401(k).
The ACP, on the other hand, is calculated by dividing the company’s contribution to an employee by his or her W-2 income. It compares how much, on average, an employer contributes to HCEs versus non-HCEs.
So, in other words, passing both tests will depend largely on three factors: how many employees defer a portion of their income to contribute to a plan, how much those employees choose to defer, and at what level the company contributes to the plan.
The numbers for deferring employees can depend on how many feel they have enough income to set a little aside, but it can also depend on whether they’re aware of the benefits a 401(k) offers, or even how to get involved. Whatever the reasons, if there’s low participation overall yet a high proportion of HCEs participating, then there could be trouble. (See the above Q&A for some good ideas for increasing participation.)
Employer contributions can be either matching contributions – based on how much an employee defers – or nonelective contributions – which happen regardless of an employee’s deferrals. Either kind of contribution helps keep employees happy and counts as a tax-deductible business expense … and either kind can help your company avoid nondiscrimination issues.
Think you might be at risk? The government formula for determining a passing score is detailed in the IRS 401(k) Plan Fix-It Guide.
Q: Can employees make after-tax contributions to my 401(k)?
A: While our 401(k) prototypes allow for after-tax contributions, this can be problematic for many plan sponsors. Here’s why: While after-tax is included in ACP testing (counted like a match), it doesn’t get same the relief from ACP testing as traditional safe-harbor provisions. And generally, highly compensated employees (HCEs) will be interested in contributing above the 401(k) deferral limits, which can cause ACP testing issues for most plan sponsors.
So, what types of employers might consider an after-tax contribution option a good idea?
* Plan sponsors who have either no HCEs or no non-HCEs. Since ACP testing relies on a comparison of HCEs to non-HCEs, this obstacle to after-tax contributions is eliminated with the absence of one or the other category of employees.
* Owner-only plans where there are no non-HCEs to test against. Particularly, look for an owner-only employer that also sponsors a defined-benefit plan and has limited employer contributions in the 401(k) profit sharing plan (so there’s plenty of room for large after-tax contributions) – or, consider owner-only clients who want to contribute the defined contribution maximums but run against the 25% employer-deduction limit.
* Employers with a high concentration of high earners (above the 130k HCE compensation definition) who are using the top 20% election for the HCE definition. In this circumstance, as far as ACP testing is concerned, you have highly paid employees counted as non-HCEs.
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* Participation: https://blog.forusall.com/5-tips-boost-401k-participation/
* Nondiscrimination tests: https://www.guideline.com/blog/nondiscrimination-test-401k-compliance/.