As a business owner, there are few tax advantages greater than a good retirement plan. What makes a retirement plan good or bad? In short, Plan Design. If your plan design doesn't match your companies needs, it will always feel like meh! In our first post in the series, we broke down profit sharing plans. As we found out, there can be limitations for business owners. To help resolve some of these issues, a plan sponsor could add the 401(k) feature. Today we'll breakdown 401(k)s to see if this option would be the best for your company.
The 401(k) plan is typically used when a company seeks to offer an employee-funded benefit. As we mentioned in part one, all plan options are built on the platform of a profit sharing plan. When a company turns on the 401(k) feature, the biggest change from profit sharing plans, is employees can start saving their own money for retirement. Employees can fund their own 401(k), up to $19,500 in 2021. If a business would like to make matching contributions, they may do so, but it must be uniformed(same percentage) across all employees. Employer-matching contributions are available up to $58,000 or $64,500 if over age 50 in 2021, but are not required. This number includes employee contributions and employer contributions. And just like profit sharing plans, plan sponsors can subject employees to a vesting schedule.
Below is an example of business owners who want to maximize their deferral. Lets start with 401(k) contributions for owners and employees. In this example, employees contributed 5% of their eligible compensation for $10,000 and both owners reached their plan limits of $45,500, for a total of $55,500.
Because these owners want to max out their contributions for the year, they are going also going to do a employer contribution as well. Owner one is able to add $38,500 in employer contributions to reach the 2021 plan limits. $38,500 equates to 13.27% of owner 1's compensation. 13.27% is now what the business needs to contribute for everyone's eligible compensation. In this example, the company contributes $94,908, of which $68,370 went towards the 2 owners.
With the $113,870 the owners were able to defer, this is already better than the profit sharing plan option. We show employees saving 5% of their own money and receiving the match. The business was able to lower the employer contributions from $40,000 to $26,538. Even with lower employer contributions, employees still would have an increase in overall savings versus the profit sharing option. In the real world, owners and employees would still have the ability to adjust their contributions to match their financial situation.
Obviously not every company is going to max out contributions every year. But businesses do have not make employer contributions every year. Even without employer contributions, owners and employees would still have the ability to save up to the plan limits every year for themselves. Giving businesses and employees the flexibility to build their retirement for their needs.
401(k) plans is one of the most popular options in the defined contributions space and for good reason. But one of things that can limit owners contributions is ADP testing. In our next plan design post I will cover the safe harbor 401(k) option. The safe harbor option eliminates the ADP problem.
Questions about your plan design? Let's chat.
The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.