Planning Your Small
Business 401(k)
If you
are a small business owner enticed by the sudden new availability of
401(k) plans that have no setup or operating costs, you may be ready to
jump at this new opportunity. The new online-administered 401(k) plans can
now be started for free within 45 minutes and self-administered at no cost
with only a few hours of employer’s time each year. There is simply no
good reason why a business would not offer employees an opportunity to
defer some of their earning in top-quality 401(k) plan. But there are a
few planning issues you should consider in advance that will make starting
your 401(k) plan easier.
Know
Your Purpose Like any new business project, it makes sense to start with
the end goal in mind. Small businesses utilizing proven straightforward
benefit plan designs are more likely to be successful in achieving their
stated goals than those trying to reinvent the wheel with overly
complicated benefit plans designs. The most popular successful reasons for
starting a small business 401(k) plan are: 1) To recruit and retain
employees. 401(k) plans are the 2nd most popular type of employee benefit
in a small business, trailing only behind health insurance. 2) To defer
income taxes. 3) To make savings easier by automatically deducting a small
amount from each paycheck. 4) To help make employees more financially
stable, reduce their financial stress, and improve productivity on the job
by enabling employees to adapt an improved attitude about their financial
status.
Motivations for starting a 401(k) that are more likely to fail are: 1) To
give a tax-deduction primarily to the business owner. 2) To enable
employees to become active investors or investment “traders”. 3) To
“strong arm” employees into saving a portion of their paychecks.
Are you
Ready for Online Finance? Only a few short years ago the majority of us
were skeptical about online banking and online securities brokerage. Now
these are as commonplace and routine as any other type of transaction.
Currently only larger employers use online 401(k) management systems. If
you work for an employer with more than 500 employees, chances are that
all of your employee benefits tasks are handled entirely through a
computer terminal. But small businesses are still unfamiliar with online
enrollment and account management systems. Using an online 401(k) system
will save you thousands of dollars over the years but only if your plan
participants will actually use it. Some factors to consider: 1) Do
employees have access to an Internet-connected PC at home or in the
office? 2) If the employees only have access to a PC at work, is there
enough office time available for all employees to use it? What about
employees in remote locations or different shifts? 3) Does the office
environment provide enough privacy to allow employees to enroll for
personal employee benefits comfortably? 4) Is there anyone in your company
so fearful of online finance that this system may present a barrier to
participation in your employee benefit plans?
Have
Your Data Ready Before you start a 401(k) plan, you will need to have the
same data available as would be needed to set up a payroll system. This
includes the employer’s information (name, address and tax ID number) and
the personal information on each eligible employee (name, address, date of
birth, earnings, and social security number). Earnings or salary can be
estimated but the rest of the information must be precise or you will wind
up spending more time correcting it later.
Serving
as the Plan Trustee One of the principal ways that small businesses save
money on a 401(k) plan is serving as their own retirement plan trustee
rather than paying an annual fee of $1000 or more to a financial service
firm. The law requires that in this case the 401(k) plan trustee (often
the business owner) obtain a fidelity bond in order to fulfill this
obligation. A bond for a small business plan will cost about $100 per
year. Your own commercial insurance broker can add this to your business
insurance package or your 401(k) plan adviser can help you obtain this
coverage at the time you set up your 401(k) plan.
Should
the Employer Pay? The new 401(k) plans have no mandatory costs for an
employer. There are no setup or administrative fees and there are no
required employer contributions into the employees’ accounts. But the
employer may wish to contribute to employee accounts for three reasons: 1)
Most small business plans without employer contributions eventually fail
due to lack of interest from the employees. It is really the employer’s
matching contribution that entices most employees to participate. Without
an employer matching, many financial advisers will steer employees away
from a 401(k) because there are less restrictive options available outside
of 401(k) plan. 2) If the employer does not make matching contributions
then the business owners will likely be restricted in their contributions
due to tax law known as the “top heavy rules”. 3) Administration and
planning is easier if the employer makes minimal matching contributions or
3% or 4% of payroll. These are called the “safe harbor” rules. The best
advice we give most small employers starting a new 401(k) plan is to say
to employees “instead of a basic pay raise this year, our company will be
making matching contributions into the 401(k) up to 4% of pay”. The
matching contribution does not need to be dollar-for-dollar. A common
formula in a small business 401(k) plans is $.50 matching contribution per
dollar of employee contribution up to 4% of pay. In any event, we suggest
that the business owner should be aware of the “safe harbor” rules and
what they may mean to your 401(k).
Who
Should Participate? Some of the first questions your new plan
administrator will ask you are those related to eligibility in your new
plan. Will it be for all your employees? Full time only? Part time?
Minimum length of employment? Minimum age? The business owner has a large
amount of latitude in this area. The significance of these questions is
that they will affect the employer’s contribution discussed above. For
example, let’s consider an ice cream shop that sets up a 401(k) plan with
generous employer matching. The business has only two full time
owner/employees and the other employees are seasonal/part-time high school
students. If the plan excludes the part timers, then 100% of the employer
contribution goes to the owners. If the 401(k) plan includes the
part-timers, the business might find themselves setting up dozens of tiny
investment accounts for employees that really don’t care much about saving
for retirement. The cost of making inappropriate eligibility choices could
be significant.
Investment Choices While an unlimited number of investment choices are
actually available within a 401(k) plan, it usually makes sense to limit
the choices in order to obtain a reduction in investment account costs.
The most popular low-cost 401(k) plans offer about 80 different investment
choices from about 10 independent “name brand” investment companies. The
unlimited investment choice option falls into the same “low cost” category
only if your account balance is more than about $2 million dollars. If you
absolutely need to have an unlimited section in a smaller 401(k) plan
account then this is possible but the cost will be significantly higher
than what you will find available in a personal discount brokerage
account. We suggest that if investment choice is a more important issue
than low investment costs, then you should explore investment plan options
outside of a 401(k) plan.
Skip the
Exotic Investment Strategies The newspapers lately are loaded with stories
of 401(k) plan investors suffering from losses in restricted employer
stock, stock options and crashes in high-flying investments. To add
further insult to this injury is the fact that their 401(k) plans paid
steep administrative fees for the option of allowing the plan participants
to select these questionable investments. President Bush proposed
restrictions that would prevent these types of problems for 401(k) plans
in the future. We suggest that you implement a better strategy right now.
The
lowest cost 401(k) plans are those that limit investments to a few dozen
of the nation’s most popular name-brand mutual funds. The reality is that
all of the fancy investment schemes won’t produce long-term returns higher
than these very “ordinary” mutual funds. In fact, there is substantial
evidence that an investor who picks a handful of well-established mutual
funds and leaves their money alone with the funds for 20 or 30 years will
outperform almost all investors who used any other more active money
management strategies.
Understand Investment Charges Neither the 401(k) plan itself nor the firms
or advisers servicing the 401(k) plan charge investment fees, commissions
or account fees. All investment fees are set by the specific investment
company that each plan participants select. The investment fees are
exactly the same as they would be if an investor owned the investment in
another account outside of the 401(k) plan. The best source of information
about an investment’s fees is the investment prospectus, that is available
online on in print. The 401(k) plan administrator and the adviser receive
a portion of the investment fees, regardless of the source or the amount.
Skip the
Loan Feature One of the most attractive features of a 401(k) plan is the
ability to borrow your own funds tax-free from your account as long as you
pay it back with interest just like a bank loan. But when starting a
401(k) plan, there really is not much to borrow anyway. The cost of
administering a loan re-payment program is often more than the savings you
may receive by borrowing from 401(k) funds. And in a small business 401(k)
the business owner is placed in the awkward duel role of being both
employer (the need to maintain good relations with the employee) as well
as the 401(k) plan trustee (the need to enforce loan collection or face
still tax penalties). We recommend that small businesses just skip the
loan feature in their 401(k). It is much easier to help plan participants
obtain loans outside of the 401(k) plan. Also remember that today’s
liberal IRA rules allow an employee to terminate a 401(k) plan, roll the
funds over into an IRA and then withdrawal funds without paying early
withdrawal penalties for a wide range of reasons. The allowable reasons
include buying a home, paying medical expenses, and paying education
expenses.
Add
Financial Planning In order to get maximum value from the 401(k) plan, the
plan participants should have access to advisory services that can address
a wide range of financial planning issues not restricted to the 401(k)
plan. While the advisory service for the 401(k) plan is free, it makes
sense to purchase an option for broad-based comprehensive financial
planning for all of the plan participants. This may be priced in the range
of $100 per participant per year if all of the participants are included.
This also helps the employer reduce liability by delegating responsibility
for retirement plan advice to an outside professional. If this extra
planning is feasible for your company, at least obtain some of the free
financial planning tools available today from your 401(k) adviser, like a
retirement planning calculator.
What
about the Tax Return? A 401(k) plan requires an annual tax return called a
“Form 5500” to be prepared and submitted on an annual basis in addition to
your business tax return. Make sure that your free 401(k) administration
package includes the preparation of a signature-ready Form 5500 at no
additional charge. Your accountant will probably appreciate this, since
most are often not completely comfortable completing this type of the tax
return without close communication and a substantial amount of information
from the retirement plan administrator.
Use The
Enrollment Adviser A 401(k) specialist typically has far more specialized
experience in setting up a plan and handling the enrollment than a typical
small business accountant or financial adviser. Use the advisers that are
available online or toll-free telephone to get quick answers to your
questions.
Be Ready
for Fast Action With the new 401(k) plans, your plan is often up and
running within hours after you give the go-ahead. Since all of the
administrative tasks are handled by computer at no charge, there is no lag
time in setting up a plan. Of course, you may change or terminate your
selections at any time without penalty. Gone are the preparatory
interviews, plan comparisons, and committee meetings that typically
accompany the selection of a 401(k) plan. This fast pace catches most
small business owners by surprise, given the historically slow pace of the
financial services industry.
Tony Novak, MBA, MT, is an accountant, writer and financial adviser
based in the Philadelphia area specializing in financia coaching for life
transitions. He provides tax and financial planning consultations
nationwide by telephone on an hourly basis in conjunction with
accountants, attorneys, financial advisers and individuals not represented
by another professional through OnlineAdviserTM service. Over the past 20
years he has responded to tens of thousands of questions posed by
telephone, e-mail and on the radio. Hundreds of his columns and articles
on financial planning topics are published in dozens of publications
throughout the U. S. Tony Novak may be contacted at
http://www.tonynovak.com
taxplanner@tonynovak.com
