The Department of Labor released a new rule to make it easier for small businesses to band together to create joint 401(k) retirement plans for workers. The new rule will take effect on September 30th of this year.
Under the rule, companies in different industries—for example, a salon and pizza parlor—could create a joint plan as long as they are located in the same state or metropolitan area. The rule also would clarify that similar companies—for example, two grocery stores—located in different regions of the country could join together.
This ruling could be a game-changer for small business owners. Roughly 38 million employees of small and midsize businesses do not have a workplace retirement plan, according to the Department of Labor. In 2018, 47% of workers at companies with fewer than 100 workers did not have access to one, compared to only 15% of workers at larger companies.
Quite frankly, the retirement saving options for small business owners stink. Most small business owners said their main reasons for not offering plans are costs and administrative oversight. While most worries about administrative oversight can be addressed by a good plan provider, the costs of having a plan can be significant. Along with the costs, small business owners typically get caught up in a tangled mess of rules that preclude them from taking full advantage themselves of such a plan.
The Current Tangled Mess
Most participants in a 401(k) retirement plan are able to contribute up to $19,000 in 2019 to their plan. If they are over 50, the can contribute an additional $6,000. Employers can contribute too, but there is a $56,000 limit on total contributions (more if you are over 50).
To put this in perspective, let’s look at the other primary option. A SIMPLE IRA allows an owner to save up to $13,000 each year (for the sake of this article, know that you can save more if you are older than 50 for most of these options). However, any employer match is calculated as a percentage of compensation. While this makes sense, and the tax-savvy owner (who most likely is organized as an LLC or S-Corp) is also setting their salary based the minimum amount needed to reduce their payroll tax liability. As a result, the 3% limit on compensation can severely curb what an owner can put away each year. Also, employer contributions are mandatory, meaning each employee, every year gets a contribution. There is not a lot of flexibility in these plans, compared to 401(k).
I won’t go through a SEP IRA or Self-Employed 401(k) plan, because this article assumes you have employees.
So, based on just this analysis, the 401(k) plan appears to be the better option. Hold on though…..this is where things get tricky with a 401(k) plan.
For regular 401(k) plans, there are limits placed on highly compensated employees. You are considered a “highly compensated employee” for 401(k) plan purposes if you earn $125,000 or more per year or own more than 5% of the company. While the salary stipulation may not get to you (especially if you are tax planning with your pay), the 5% threshold certainly will. Even if you get tricky and give 96% of the company to your spouse, they still get included in the calculation (along with your kids, parents, and grandchildren). Each year the plan is required to do non-discrimination testing to make sure the plan doesn’t favor highly compensated employees over the rest of the company. To pass the test, the group of highly compensated employees can’t make more than 2% over the average contributions to the plan. So, if the average contribution is 4% of your employees’ salaries to the plan, the highly compensated individuals can’t be more then 6% of their salary.
So, let’s break this down in a non-accounting/legal language example. As the owner of the company, you decide that you are going to contribute $15,000 of your total $50,000 salary to your 401(k) plan. This contribution represents 30% of your salary. However, you have 4 other employees in the plan whose average pay is $40,000 and they all average contribution of only $4,000 each, or 10% of their salary. This means the maximum you can contribute to the plan is 12% of your total pay, or only $6,000. That means you need to pay taxes on the $9,000 of contributions your plan will be required to distribute back to you.
There has to be a better way….and there is…kind of. What most employers do is choose to design their plan so it will be a safe harbor 401(k) plan. These plans automatically pass annual top-heavy testing and allow business owners to make salary deferrals up to the legal limit without the risk of corrective refunds or contributions. This is great you may say, and for the most part, it is. However, there is a catch. These plans must make matching contributions (i.e the Company must pay these contributions). There are certain rules on what these contributions must be. Essentially, you must match 3-4% of total compensation for employees who are participating in the plan (there is more to it, but we’ll leave it at that for this article).
In our example above, you can now leave your entire $15,000 in the plan. However, you will need to match contributions. You will match 4% of your personal salary deferrals, or $2,000. You will also need to match your employee’s deferrals. In this scenario, they made $16,000 of total deferrals, which means that your total employee match for that group will be $6,400 (just trust that the math is right).
You might look at this and be fine with it. After all, one of the best mistakes you can make is to overpay for good employees who are vital to your business. There are additional provisions in which a company can make profit sharing or other employer contributions which can also increase your individual (and employees) contributions.
Now that we have discussed what type of 401(k) plan may make the most sense, let’s discuss the second piece of the math formula to see if the total costs make sense for your business.
401(k) Plan Costs and the Total Cost Formula
Wouldn’t it be a great world we could all live in if 401(k) providers did all of their administrative duties out of just the kindness of their heart? As you can guess, they don’t. Providers that are in the small business 401(k) space such as Fidelity, Employee Fiduciary, Betterment and ShareBuilder make their money two ways: plan asset fees (revenue sharing) and plan fees.
When a small business owner sets up there plan, they are often given a list of investments to choose from that will be offered to plan participants. All of those investments come with a certain “fee” that is paid based on the balance held within that investment. For instance, as a participant, you may choose to invest in the Fidelity Contrafund investment. This fund comes with an expense ratio, typically between 0.8% and 1.1% (the actual fee depends on many factors which we won’t cover). This means that if your average balance in the fund is $5,000 and your plan has a fee related to that investment of 1%, you will pay fees of $50 on that investment for the year. This fee is paid directly by the participants in the plan.
The second fee can be grouped together as plan fees. These include fees related to recordkeeping, administration, and asset advisory services. For a typical small plan, fees will generally run between $1,000 – $2,000 per year. These fees are typically paid by the employer (AKA the small business owner).
Now that we have all of our data, let’s see if a 401(k) plan makes sense for our fictitious company that we have been using in this article. Let’s first recap what we know.
- The owner of this company has $50,000 in salary in which they are contributing $15,000 to their 401(k) plan. This reduces their taxable salary to $35,000.
- The company has 4 employees who contributed a total of $16,000 of their wages.
- Because this is a safe harbor plan, the company is making matching contributions of $2,000 to the owner and $6,400 to the other employees.
- Let’s also assume a tax rate of 25% for our owner.
- Plan fees are $1,500 each year
The owner of this company will save $3,750 of taxes related to their personal contributions made ($15,000 of contributions multiplied by 25% tax rate). The owner will also create an additional $8,800 in expenses in their company, which will lead to a total tax savings of $2,200. Total tax savings to the owner of this business will be $5,950.
The plan will create additional costs of $1,500 of plan provider fees and $6,400 in employer contributions. We don’t count the $2,000 of employer matching contributions to the owner because this is money that is going to the owner. Total expenses are $7,900.
In this case, the small business owner will lose $2,000 by implementing this plan. This may very well be worth it. The owner might experience higher employee retention rates or appreciate the fact he has a retirement plan for himself. Of course, this math will be specified in each situation. Any of the factors in the above calculation will most likely be different based on each company’s individual circumstances.
How Owning Two Businesses Doesn’t Help
I have seen many small business owners have a second business or a side gig. The common reaction to all of this is they will just do a 401(k) plan in the second business that has no employees. Not so fast my friend. Under the IRS’ controlled group rules, two or more employers with common ownership are considered a single employer for purposes of 401(k) nondiscrimination testing. These rules often obligate all members of a controlled group to cover their employees with the same 401(k) plan in order to pass annual coverage testing.
The controlled group rules exist to prevent employers from dividing their businesses into separate companies – one company employing highly compensated employees and another employing non-highly compensated employees – in order to test each company independently for nondiscrimination.
However, the rule also means that if you have two businesses you own more than 5% of (in most cases), employees of both must have the ability to join and participate in the same 401(k) plan.
How Much Work Is a Plan for a Small Business?
I have both administered and audited 401(k) plans. Based on this experience, I can tell you that there is much less involved than initially thought in a 401(k) plan for small business owners. Where most get in trouble is not submitting contributions to the plan provider on a timely basis. However, in terms of oversight and administration, if an employer has good systems setup and a strong plan provider in place, the work is minimal.
How Does the New Law Effect Everything We Just Talked About?
Let’s come full circle. The new rules are potentially exciting for small business owners. While there has been a continued race to the bottom from a few providers in terms of fees, most fees are still too high for many small business providers. Even the fees quoted in this article assume that you go with one of the low-cost providers (other provider’s fees will be double or more). On top of that, these new rules will most likely open better investment options that may have not been available to smaller plans.
One of the best benefits around 401(k) plans that we only briefly touched about is the flexibility of their design. This flexibility can give owners the ability to contribute even more to their 401(k) plans using special allocation rules (which is a whole other topic). I am curious to see how these new, multi-employer plans address special allocation and employer matching rules.
While this news is exciting, it will be interesting to learn more about the implementation and specific rules over the next 60 days. It will also be exciting to see how plan providers take advantage of the new rules and offerings they might come up with. For instance, will Fidelity offer a “restaurant only plan” that might be designed and cater to only restaurants?
There could be more changes on the way. Federal retirement legislation known as the Secure Act, which cleared the House in May but has stalled in the Senate, includes a provision to allow companies to team up regardless of their membership in a professional organization or their industry. In other words, their only commonality would be their participation in a shared 401(k) for their workers.
Regardless of the new rules, the equation discussed stays mostly the same. As a business owner, having a savvy accounting and financial consultant to aid your business will enable you to make the best decision for you and your employees.
Krieger Analytics is a unique accounting practice that is looking to provide financial clarity for the business owner so they can accomplish their goals. We aren’t the typical accountant as we want to provide a high, more comprehensive level of service to you. We help you understand your past results and plan more for the future. Unlike most accountants, I am also a small business owner so I understand the issues you are dealing with. If you would like to discuss your business and see if we may be the right solution, contact us now.