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Put your company’s 401(k) plan on ‘cruise control’

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in Small Business Tax

As a small business owner, your company's 401(k) plan is one of the best deals around. You can salt away part of your salary tax-free within generous limits, while the company matches all or part of your deferral.

But one potential downside exists: Because of strict "nondiscrimination" rules, if the gap is too great between how much highly paid employees contribute to the 401(k) plan and how much lower-paid employees contribute, your personal benefit from the plan will be limited.

Set up an "automatic enrollment" 401(k) plan. With such an arrangement, your employees will be automatically enrolled in the company's 401(k) plan, unless they choose to opt out. (In contrast, most 401(k) plans currently require employees to opt into their plans.) The IRS has said automatic enrollment is kosher.

Why do you want more employees to contribute? When a higher percentage of rank-and-file workers contribute to the 401(k) plan, you can overcome the nondiscrimination rules and, therefore, maximize your own personal 401(k) contributions.

Here's the whole story: In 2005, you can defer on a pretax basis up to $14,000 in salary to the plan. That number increases to $15,000 next year (see at right). Plus, you're entitled to defer an extra $4,000 if you're age 50 or over ($5,000 in 2006).

Those contributions grow over time without any tax erosion. And your company can provide matching contributions (e.g., 50 cents on the dollar) that also grow tax-deferred.

To qualify for these tax benefits, your plan must satisfy testing requirements to ensure it doesn't discriminate in favor of highly compensated employees.

The plan must comply with participation and vesting rules that apply to all qualified plans. In addition, a 401(k) plan must pass two complex tests: the actual deferral percentage (ADP) tests and the actual contribution percentage (ACP) tests.

If your 401(k) plan doesn't make the grade—say, the disparity between the average contributions of highly paid employees and other employees is too great—the company typically is forced to kick in contributions of 3 percent of compensation for lower-paid staff.

Fast solution: An automatic enrollment plan eliminates a lot of the hassle. Due to human nature, participation is significantly greater with auto-enrollment plans than with traditional opt-in plans. The automatic plan may even provide for annual increases in the deferral percentage.

Also, an automatic plan often benefits workers who otherwise might not participate in a 401(k) plan. Due to this "forced saving," they can begin building a nest egg for retirement.

Some states have laws restricting the use of automatic-enrollment plans. Consult with your tax pro.

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