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August 23, 2019

401(k): Employee Benefit or Employer Benefit?

While retirement savings plans can help employees prepare for their future, it’s also worthwhile to understand important 401(k) benefits for employers and how to best design 401(k) offerings to maximize the owner’s savings.

There are three big reasons employers offer a 401(k):

Employees ask for it
Employers need the plan to be competitive in their industry
The owners want to reduce their taxes and save for retirement

Offering 401(k) options for employees can be both an employee benefit plan and help the owner with their taxes and savings goal. However, we find that many owners are not satisfied with the amount they can put into the 401(k) plan because of the non-discrimination test that limits their contributions. Another factor is that 401(k) plans may not help the owner save much for retirement if the employees aren’t utilizing the plan.

Why aren’t employees utilizing their 401(k) plan benefits?

The reason employees may not be utilizing or saving money in the plan can be for many reasons. Most common is their cost of living is such that that they don’t have the money to put into the plan. Another reason is that no one is explaining to them the benefits. But, in over 3 decades of advising, our experienced professionals at BEI have never spoken to anyone who regretted saving money in a 401(k) plan.

Non-Discrimination Test That Limits Contributions

The U.S. government has a compliance test that may limit the savings available to employers, if they are an owner or executive earning $125,000 or more. Technically it’s known as the “non-discrimination test or ADP/ACP Test.”

Let’s take a closer look at the example below to better understand the non-discrimination test:

A business owner 52 years old with ten employees wants to save $25,000 and this is the 2019 limit for 401(k) plans.

For this example, the government non-discrimination test tells us that this owner can only save $8,000.

This is because the staff isn’t saving very much in the plan. However, with a plan design known as “Safe Harbor” 401(k) the owner can save $25,000.

What is a “Safe Harbor” 401(k)?

To effectively design this type of retirement plan, it requires an analysis of all the employee’s wages.

One of the primary things we consider at BEI when consulting on plan design, is how much can an owner offer his employees and still come out ahead. In other words, an employer could choose to give the money you would otherwise have paid in taxes to your employees.

To elaborate on the example above, let’s consider a company with ten employees. We make the calculation and owner can put away $25,000, instead of the $8,000, if the company puts $9,000 into the plan for their employees. We generally get stopped right here and hear from our clients “Whoa – did you say $9,000?” And our response back to them is if they do not choose to put $25,000 into the 401(k) you will pay approximately $10,000 in taxes.

What is more cost effective? Giving the government $10,000 of your money or giving your employees $9,000? At first blush you might say “why bother?” But another way to look at this is the owner is getting 74% of the money the company puts into the plan. If the company owner takes the money home and pays taxes, what are they left with in the end? Not 74% of the money! Also remember, the money goes in every year and earns interest along the way.

To determine the cost for employees, we need to know how much all the employees earn and how much money the employees want to save in the plan. At BEI, we have observed plans where the owner receives less than half of the money to receiving more than 90%.

The Benefits of Profit Sharing

Okay, but want if $25,000 isn’t going to get the business owner to their retirement goal? They can turn on the profit sharing part of the 401(k) that will increase the $25,000 401(k) limit.

When combining both 401(k) and profit sharing, employers can put away a total of $62,000 if they are 50 or older. If they are less than 50 years old the maximum is $56,000. To get to this larger number they will put $18,000 (using this example) into the plan for employees.

Again, consider this. Take $62,000 into income and pay taxes on that amount at 40% tax rate (federal and state) that amounts to $25,000? Or the company can contribute $18,000 to the plan on behalf of their employees and everyone wins?

To do a study requires developing a master list of all employees working for the employer with their name, date of birth, date of hire and W-2 wages. Our expert team at Benefit Equity Inc. can assist you with this task, since we’ve created a simple, formatted excel worksheet that our clients quickly complete. We will do an illustration at no charge to see if the “safe harbor” 401k/profit sharing design works for you. For successful businesses that want to create value that is cost effective, this is a way to do it. Call us today at 800-899-9141 to learn more.

Author: Robert Gorelick, APA, Founder Benefit Equity Inc.

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