When small business owners decide to set up a retirement plan, they’re often surprised by how many types there are, and can have trouble finding the right fit for their business. Learning the overall ins and outs of each type of 401(k) is a good place to start.
There are three core 401(k) plan types to consider: a Safe Harbor 401(k), a Traditional 401(k), and a Tiered Profit Sharing 401(k). Here’s the scoop on each. Note, if you’re self-employed, you’ll want to consider a Solo 401(k) plan.
The Safe Harbor 401(k)
The Safe Harbor 401(k) is a popular choice for businesses with less than 15 employees – and for good reason. These plans allow business owners to contribute the maximum deferral amount to their own account ($20,500 in 2022 or $27,000 for those 50 years of age and over). Plus, they’ll satisfy IRS non-discrimination testing – a governmental check and balance that ensures plans serve all employees and not just a few at the top.
The business must provide a relatively small “safe harbor” match or contribution – an amount the employer puts into an employee’s 401(k) account as a percent of an employee’s compensation – so that any employee, including the owner, can contribute the maximum to the plan and receive the match, too. The employer contribution is what helps the business automatically pass government discrimination testing. It’s tax deductible for the business and is also what gives owners and highly compensated employees the ability to maximize tax-deferred contributions without the restrictions, which can be an issue with Traditional 401(k) plans (see below).
It’s important to note that the annual government deadline for starting a Safe Harbor 401(k) is October 1, but most providers have internal deadlines a few days to a month earlier to allow time for set-up. If you’re looking to get the most savings and tax protection out of your plan this year, the earlier you start the better.
The Traditional 401(k)
A Traditional 401(k) enables small business owners to customize their plan. This typically comes down to how the business prefers to reward employees. The company may not be in the position to offer a match at all. Or the business may have highly seasonal income or employees, so offering a regular matching contribution wouldn’t be a good option. Some businesses experience high employee turnover and prefer to use a multi-year vesting schedule for employer matching contributions to encourage loyalty and better manage contribution monies. Others are better off only providing an employer contribution if the business hits its goals. These firms typically reward employees annually with a 401(k) profit share contribution.
Traditional plans are typically a good fit for businesses that are highly seasonal or their employees are expected to contribute 7% or more of their salaries. In a Traditional 401(k) plan, employers and highly compensated employees (those making at least $135K in 2022) can contribute 2% more of their salary than the average percent of salary contributed by non-highly compensated employees. So, if the average employee in the business contributes 7% of their salary, the owner will be restricted to contribute no more than 9% of his salary.
The 411 on Matching in a Traditional 401(k)
It’s important to note that matching is not required with a traditional plan. But when an owner does decide to provide a match, they can choose the percentage and whether to use a vesting schedule. With vesting schedules, the business owner chooses a period of time that a percentage of the employer contributions will officially become the employee’s. For example, an owner could elect to match 3% of contributions made by eligible employees, but it will vest over a three-year period. The owner might also allow for 50% matching contributions to become the employee’s in year one, 25% in year two, and the remaining 25% in year three. In this scenario, 100% of matches are fully vested after three full years. Know that if an employee leaves before fully vested, the unvested amounts are returned to the plan to use for future matching contributions. This is pretty different from Safe Harbor 401(k)s. With a Safe Harbor plan, a 3-4% match is typically required and employer matching contributions are vested immediately, which means it becomes the employee’s money the moment it hits their account.
The Tiered Profit Sharing 401(k)
And last, but definitely not least, is the preferred plan design for businesses with strong profits and fewer than 50 employees. Sometimes called an Advanced Profit Sharing 401(k) Plan, a Tiered Profit Sharing 401(k) rewards employees based on unique employee groups within a company.
For example, let’s say a legal firm has three main groups: partners who own the business, front-line attorneys who work on cases, and support staff that handles administrative tasks. Each group is distinct, has differing compensation levels, and is essential to the firm’s success. A different percent of salary can be provided as a profit share to each group as a reward based on their role and performance.
This type of 401(k) can be great for firms with this structure and a savvy way for a firm to manage the cost of sharing profits. It’s common for these plan types to also provide a safe harbor employer contribution to pass government tests.
So, there you have it – the three most common 401(k) plan types. These options offer great flexibility in aligning a plan with what your business is looking to achieve.
This material is intended only as general information for your convenience and should not in any way be construed as investment or tax advice by ShareBuilder 401k. The owner/participant should consult with their tax advisor regarding any specific tax strategies.