Small business owners: Is your retirement plan working for you?

401k

Many small employers offer 401-k retirement plans as an employee benefit.  These plans offer a method for individuals to save and invest for their own retirement security and reward them with tax benefits and often some form of employer contribution.  For most employees, their 401-k plan is the most effective wealth building and retirement planning tool in their financial planning toolkit.  For the employer, it is a tool to recruit, reward, and retain the best employees and to be competitive in the labor marketplace.

However, the owners of small firms are usually employees too.  They have their own unique set of retirement, tax, and investment goals.  In the financial planning/investment management world, we often speak of proper diversification as a tool to reduce risk when managing a portfolio.  But the prototypical highly-focused and hardworking entrepreneur often concentrates the majority of their resources (time, effort, and money) into one asset; their business equity.   The ability to extract equity in a tax efficient manner and diversify among safer, more predictable investments that are not exposed to the harsh realities of small business can be an important consideration to their overall financial wellbeing.

For business owners and other highly compensated employees, traditional 401(k) plans can be frustrating.   Their own personal contributions may be limited based on certain non-discrimination regulations found within ERISA (Employee Retirement Income Security Act). Qualified retirement plans are governed by ERISA and much of the law is designed to make sure that employers don’t discriminate against their employees when making contributions to the plan. In addition, given the complexity of the ERISA requirements, a fair amount of administration and reporting accompanies these plans.

It has been our experience that small business owners may short change themselves by deciding to have no plan or by choosing a plan design that does not fit their unique objectives.

But there is good news!  There are alternatives to the traditional 401-k plan design; business owners may be well served by researching them periodically in light of their own financial objectives with the help of a financial planner and retirement plan consultant.

The most common and simple alternative is the 401-k plan with a safe harbor provision.  In exchange for a relatively small but mandatory employer contribution, and a more liberal vesting schedule, the plan becomes much more friendly to the business owner(s) and highly compensated employees (HCEs).   Most nondiscrimination testing is automatically satisfied and all employees have a greater opportunity to maximize their contributions (salary deferrals).

Here is a summary of the key requirements:

  • Mandatory employer contributions: A choice of either a 3% non-elective contribution for all eligible participants regardless of their contribution or a matching arrangement of 100% of the first 3% of employee deferrals and an additional 50% of the next 2% of employee deferrals (for a maximum total of 4%).
  • Vesting: All safe harbor contributions are immediately 100% vested.

By and large, if these basic requirements are met and communicated in a timely manner, the plan is deemed to have satisfied the nondiscrimination testing requirements and all employees may defer up to the normal contribution limits:

2017 Employee Deferral Limits: 

$18,000 per year

$24,000 per year if age 50 or above

But don’t stop here:   There are other retirement plan alternatives in addition to the Safe Harbor Provision which may also fit given the right set of circumstances, especially for the business owner-employee who is highly compensated or closer to retirement age.  Under the right set of circumstances, they offer the opportunity to contribute much larger amounts than the 401-k option alone.

We’ll discuss these options in my next blog post!

Winfred Jacob, CFP®
Senior Financial Advisor

Winfred Jacob