Why Business Owners Should Try to Boost Participation in Their Retirement Plans
So one of your clients has decided to start a retirement plan for her business and offer it to her employees. Both she and her employees will soon start reaping the benefits, but only if she gets employees to participate, and then—if it’s a 401(k) plan—to increase their deferrals to a meaningful level as their means permit. Why should she care how much her employees save? Increased plan participation may lead to larger tax deductions, streamlined compliance testing, and improved productivity. And while you should avoid giving clients tax advice, you can provide good customer service by suggesting that your clients become more familiar with the benefits of increased plan participation, perhaps in consultation with their tax advisors.
Plan Design Options for Increasing Participation
A 401(k) plan normally must satisfy special nondiscrimination tests, including 1) the actual deferral percentage (ADP) test for elective deferrals; and 2) the actual contribution percentage (ACP) test for matching and employee after-tax contributions. These tests help ensure that the highly compensated employees (HCEs)—those who meet certain ownership or compensation thresholds—do not receive disproportionately more benefits than those received by lower paid rank-and-file employees, commonly called non-highly compensated employees (non-HCEs).
Safe Harbor Plan Design
An employer sponsoring a “safe harbor” 401(k) plan can avoid the contribution limitations imposed by the ADP and ACP tests by satisfying certain safe harbor provisions—which include committing to making a limited contribution each year. This employer contribution may encourage more employees to participate in the plan. Safe harbor 401(k) plans are also attractive to employers who want their employees to have a secure retirement, but don’t want to face the challenge of passing nondiscrimination testing each year.
NonSafe Harbor Plan Design
A nonsafe harbor 401(k) plan may benefit those employers who want to offer a retirement plan, but are undecided about committing to making a required contribution each year. Although nonsafe harbor 401(k) plans must pass nondiscrimination tests each year, employers still can—but aren’t required to—make a contribution to the plan.
Benefits of Increasing Plan Participation
Larger Tax Deductions
Most employers know that offering a retirement plan and making contributions benefits their employees. After all, Americans need all the help they can get when saving for retirement. But don’t forget to remind business owner clients that they can deduct contributions made by the business on their employees’ behalf—up to 25 percent of aggregate employee compensation earned during the business tax year. This could lead to a significant tax savings for the employer.
Easier Compliance Testing
As previously mentioned, nonsafe harbor 401(k) plans must pass annual nondiscrimination testing to ensure that HCEs do not receive disproportionately more benefits compared to the non-HCEs. This nondiscrimination testing can be complex. Hiring someone to perform the testing may help, but your client’s retirement plan can still fail. If it does, the HCEs may be required to take distributions from the plan. This can lead to administrative headaches and added expenses, not to mention unhappy employees.
The more non-HCEs who participate and make their own contributions, the less likely the plan will fail compliance testing, causing the employer to take corrective action. In other words, increasing participation helps avoid potential compliance testing failures—or at least helps lessen the blow.
Consider the ADP test. To pass this compliance test, the average HCE deferral rate must fall within a certain range compared to non-HCEs. For example, if non-HCEs are deferring at an average rate of 6 percent, the HCEs’ average deferral rate cannot exceed 8 percent. If the HCE rate exceeds the allowable percentage, the HCEs may be required to take distributions to lower their average rate, or the employer may have to make an additional contribution to the non-HCEs to raise their average deferral rate.
By increasing the number of non-HCE employees participating in a retirement plan, employers may be able to raise the average deferral rate for non-HCEs and possibly eliminate testing failures. Or if not, then reduce the amount that HCEs need to distribute due to a testing failure, or that non-HCEs need to receive in additional employer contributions in order to pass the test.
Increasing plan participation may also make employees feel more financially secure. Although it is difficult to show a direct correlation between retirement plan participation and greater employee satisfaction, survey data has shown that employees who are struggling financially have lower engagement levels and are less productive than peers without financial worries. Actively saving for retirement can go a long way toward reducing potential financial stress among employees.
So What Now?
Now that you know why employers should try to increase plan participation, you should also know that just offering a retirement plan is not enough; your clients should take additional steps to ensure their employees are participating and saving as much as possible. Your clients may be wondering, How do I do that? What are the steps I can take? Fortunately, it doesn’t have to mean a lot more work. Watch for other articles that will highlight simple, meaningful ways (e.g., implementing an employee communications program or an auto-enrollment feature) that your clients can increase participation among their employees.