How to start a small business 401(k) plan

by Tony Novak, CPA, MBA, MT¹
last updated on 2/15/2013

This article covers the planning steps required to help ensure a successful small business 401(k) plan.

Planning

First, consider whether you really want a 401(k) plan. It seems that every small business likes the idea of a 401(k) plan until they fully consider the cost and administrative requirements. Often a less expensive and easier-to-manage alternate type of savings plan offers the same advantages. Consider, for example, some of the other options known as SIMPLE retirement plans, Simplified Employee Pensions, employer-paid IRAs, or deferred compensation arrangements. These other options have minimal administrative cost and typically offer the employer more flexibility in operating the plan.

Once you resolve to launch the 401(k) plan, the next step is to select a financial institution to help you establish and run the plan. While it is possible to set up a "do-it-yourself" 401(k) plan, few small business use that approach. Alost all small business 401(k) plans are operated with professional help from a bank or other retail financial service firm.

The key, of course, is to find a service provider that offers a high level of service at a reasonable cost. The problem is that numerous published reports show that most customers do not understand the details and fees bundled with their 401(k) plans. An independent fee-only adviser (like us) can play a useful role in selecting the right 401(k) service provider.

Setup

Four specific steps are necessary to start the 401(k) plan:
1) Adopt a written plan,
2) Establish a trust account for the plan’s assets,
3) Establish a recordkeeping system, and
4) Provide the plan information to the eligible employees.

Details of each step are discussed below.

Adopt a written plan

401(k) plans begin with a written document that serves as the foundation for day-to-day plan operations. If you have hired someone to help with your plan, that firm will likely provide the plan document. Freedom Benefits provides prototype plan documents at no charge to advisory clients but does not advise this approach for 401(k) plans.

 The document is drafted around one of three allowable types of 401(k) plan designs: a traditional 401(k), a safe harbor 401(k), or a SIMPLE 401(k) plan.

A traditional 401(k) plan offers the maximum flexibility of the three types of plans. Employers have discretion to make contributions on behalf of all participants, to match employees’ deferrals, or do both. These contributions can be subject to a vesting schedule (which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time). In addition, a traditional 401(k) allows participants to make pre-tax contributions through payroll deductions. Annual testing ensures that benefits for rank and file employees are proportional to benefits for owners/managers.

A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, must provide for employer contributions that are fully vested when made. However, the safe harbor 401(k) is not subject to many of the complex tax rules that are associated with a traditional 401(k) plan, including annual nondiscrimination testing.

Both the traditional and safe harbor plans are for employers of any size and can be combined with other retirement plans.

A SIMPLE 401(k) plan was created so that small businesses could have an effective cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to the traditional plans. Similar to a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5000 in compensation from the employer for the preceding calendar year. In addition, employees that are covered by a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.

Once your have decided on the type of plan for your company, you will have flexibility in choosing some of the plan’s features - such as which employees can contribute to the plan and how much. Other features written into the plan are required by law. For instance, the plan document must describe how certain key functions are carried out, such as how contributions are deposited in the plan.

Establish a trust fund for the plan’s assets

A plan’s assets ("assets" used in the context of a benefit plan is just another term for "investments") must be held in trust to assure that assets are used solely to benefit the participants and their beneficiaries. The trust must have at least one trustee to handle contributions, plan investments, and distributions to and from the 401(k) plan. Since the financial integrity of the plan depends on the trustee, this is one of the most important decisions you will make in establishing a 401(k) plan. If you set up your plan through insurance contracts, the contracts do not need to be held in trust. Freedom Benefits recommends Ameritrade or Vanguard for this service but any other bank or investment company may also be used.

Establish a recordkeeping system

An accurate recordkeeping system helps track the flow of money – contributions, earnings and losses in participants’ accounts, plan investments, expenses, and benefit distributions. If you have a contract administrator or financial institution assist in managing the plan, that entity typically will help in keeping the required records. In addition, a recordkeeping system will help you, your plan administrator, or financial provider prepare the plan’s annual return/report that must be filed with the Federal government.

Payroll accounting software systems integrate with 401(k) plan recordkeeping systems. Proper setup is crucial. If you use a payroll company, discuss the setup with your service provider.

Provide plan information to eligible employees

As you put your 401(k) plan in place, you must notify employees who are eligible to participate in the plan about your plan’s benefits and requirements. A "Summary Plan Description", also known as the SPD, is the primary vehicle to inform participants and beneficiaries about the plan and how it operates. The SPD typically is created with the plan document. You will need to send it to all plan participants. The employer typically distributes a written copy with payroll communications and the plan adviser sends an electronic copy to each participant by email.

In addition, you may want to provide your employees with information that emphasizes the advantages of joining your 401(k) plan. Employee perks – such as pre-tax contributions to a 401(k) plan, employer contributions (if you choose to make them), and compounded tax-deferred earnings – help highlight the advantages of participating in the plan.

Finally, make sure that employees have access to additional help about the plan and investments form a registered investment adviser who is independent from the employer. This shifts legal responsibility for future investment performance away from the employer and further reinforces that a 401(k) plan is truly a self-directed investment plan.

A followup article titled "How to Improve Small Business 401(k) Plans" was revised February 18, 2013.

 ¹Tony Novak offers affordable small business benefit plan advice through Freedom Benefits to help small firms start their own 401(k) plans without sales pressure or commissioned product sales.