Employers have traditionally used a mix of salary and employee benefits to attract and retain those employees who are critical to their firms’ success. One of the most appealing and effective employee benefits that employers offer is the qualified retirement plan. And the 401(k) salary deferral plan is a qualified plan that has become extraordinarily popular among employers throughout the country. And with good reason. Employers like them because they can be very cost effective since employees share in the cost of retirement savings and any contributions made by the employer are tax deductible. Moreover, 401(k) plans are very flexible and may be designed to meet a wide variety of business, tax, and personal objectives. Employees, for their part, are excited about the opportunity to be actively involved in saving for retirement and selecting their own investments.

If you have ever given any thought to utilizing a 401(k) plan in your business, but were put off by its apparent complexity, expense, and administrative requirements, read on.

A 401(k) Plan Offers Unparalleled flexibility

Employers and employees enjoy several attractive benefits as a result of participating in a 401(k) plan. The primary benefit for employers is the high degree of flexibility inherent in the structure and operation of a 401(k) plan. An employer may have the ability to not only provide a cost-effective employee benefit but also, at the same time, maximize benefits for the owners and other highly compensated individuals.

• Employer Match: You can choose to match a percentage of your employees’ contributions if you wish - or not. The match is typically used as an incentive to encourage contributions by employees.
  
  
• Profit Combination: A 401(k) profit-sharing plan combines two of the most popular retirement plan options available. With a profit-sharing plan, you, as the employer, make contributions, which are generally (though they do not have to be) based on the profits of your business. You can contribute and deduct up to 25% of eligible employees’ payroll to the plan. If your company realizes little or no profits in a particular year, you do not have to make contributions to the plan since profit sharing and matching contributions are typically discretionary. Contributions may be adjusted, depending on your own determination of your business’s ability to make contributions. The 401(k) profit-sharing plan allows you to deduct all contributions up to the tax law’s limits in the year they are placed in the plan.
  
  
• Loan Option: You can offer a plan loan option if you wish. Loans are not taxable to employees as long as they are repaid on time.
  
  
• Hardship Distribution Option: A 401(k) plan may allow participants to take distributions in the event of financial “hardship.” A hardship might include an event such as buying a principal residence or paying for medical expenses or a child’s college tuition. Hardship distributions are taxable to employees and may be subject to a 10% excise tax if the employee is under age 59-1/2.
  
  
• Flexible Vesting Arrangements: You have some flexibility in deciding on how long you require employees to work for your business before they become fully entitled to (or vested in) employer contributions (matching and profit-sharing contributions). However, tax law limits apply. It is not uncommon to provide full entitlement over six years.
  
  
• Choice in Number of Investment Options: You can choose the investment options your plan will offer. Employers that want to satisfy the protection-from-liability provisions of ERISA Section 404(c) must provide a “broad range of investment alternatives” - generally at least three core investment choices. Each must be diversified and have materially different risk and return characteristics, among other requirements.
  
  
• Choice of Administrative Structure: You have a number of choices when it comes to the administration of your plan. One-stop shopping for all plan services is not the only way to go, nor is it necessarily the best way. Many employers choose an independent plan administrator to design a plan that meets their specific objectives and to handle the numerous details of plan administration and consulting.

The Basic Requirements

There are participation and special nondiscrimination rules that 401(k) plans must meet if they are to retain their tax-qualified status.

• You must provide a written plan, which specifies who may participate and how contributions will be allocated among employees.
  
  
• You cannot deny participation to eligible employees age 21 or over who have at least one year of service.
  
  
• Employee contributions are always 100% vested.
  
  
• Your plan may not discriminate in favor of highly compensated employees (HCEs). An HCE is an employee who: (1) was a 5% owner of the employer at any time during the current year or preceding year or (2) had compensation of more than $90,000 for the preceding year (indexed for inflation) and, if the employer should so elect, was in the top 20% of employees by compensation for the year.

Safe Harbor Design

The law offers employers methods that can help them more easily satisfy the nondiscrimination requirements. The Small Business Job Protection Act of 1996 simplifies plan administration by giving the employer the choice of performing the special 401(k) nondiscrimination tests using data for NHCEs for the preceding or current year. Formerly, only current year data could be used. This resulted in a plan having to be regularly tested during the year to ensure compliance with the rules. With the use of data from the preceding year, compliance may be easier.

In addition, the law also provides special ‘safe harbor” methods for satisfying the nondiscrimination rules. Plans that use a safe harbor need not otherwise pass the special tests. By adopting a safe harbor design, an employer can allow HCEs to contribute the maximum deferral (currently $12,000, or $14,000 for individuals age 50 or older) without regard to how much the NHCEs contribute.

Essentially, to qualify under the safe harbor, the employer must make: (1) a nonforfeitable profit-sharing contribution equal to 30 of pay or (2) a nonforfeitable matching contribution for each NHCE equal to 100% of the first 3% of the compensation deferred and 50% of the next 2% of compensation deferred. Several other rules apply. If you are already making a matching or profit- sharing contribution, it may be advisable to consider a safe harbor design.

Another type of safe harbor provision permits an employer to apply the ADP/ACP tests by ignoring NHCEs who are eligible but who have not completed a year of service or reached age 21. Since these NHCEs will have no impact on the amount HCEs can contribute, it is becoming more common for plans to allow employees to start contributing immediately upon beginning work. The immediate participation is a more attractive employee benefit that will not necessarily increase employer costs since the one-year wait and age 21 requirement may remain in place for purposes of matching and profit sharing contributions.

The Importance of Link-Ups

Participants are more sophisticated now than ever before. They want easier access to plan information. They want to be able to check plan balances and make changes in their investment accounts at any time.

This participant insistence on more comprehensive options and capabilities puts pressure on plan sponsors to find an administrator who can deliver these services - and more. Traditionally, plan sponsors have turned to one service provider for all their plan-related services. However, many plan sponsors have found that a one-size-fits-all, turnkey approach is not always the best strategy. For example, a plan sponsor may be satisfied with the investment management skills of its plan provider but be less than happy with the provider’s ability to provide meaningful consulting and deliver superior administrative services. Unfortunately, the plan sponsor who receives a bundled package of plan services has to take the good with the bad.

As a plan sponsor, the question you have to ask is whether an investment company or another financial institution is the best place to secure the kind of ongoing pension and tax advice you require to keep your plan on the right track and out of costly compliance trouble.

Many plan sponsors have found that it makes sense to choose the strongest provider in each area of plan services. Thus, an investment manager is chosen to manage plan investments and a separate third-party administrator is selected to handle the full range of administrative services.

It makes sense to work with a plan administrator who will delve into the details of the tax and pension laws and of your specific situation to uncover the strategies that make the most sense for your business. Moreover, you want your plan administrator to have the experience and the technical know-how to ensure cutting-edge services, regular - and easy - access to plan information, and compliance with the complexities of the pension and tax laws.

Conclusion

Introducing a 401(k) plan into your workplace is a serious undertaking. It requires effort and a great deal of thought in order to meet specific business objectives. Margolis & Company can help you with with the following services: Plan Design; Plan Administration; the Development of Investment Strategies and Money Management*.

Leon Dutkiewicz, CPA, CRSP, is a member of Margolis & Company’s Tax Advisory Services Group and is the firm’s expert on retirement planning. Fore more information, please call Leon at (610) 667-6250, ext. #136 or contact him at ldutkiewicz@marg.com.

*All securities transactions will be cleared through Raymond James & Associates, a New York Stock Exchange member firm and affiliate of RJFS.