Time to Evaluate Discretionary 401(k) ContributionsSubmitted by Mission Financial Planning on February 28th, 2013
This is the time of year that small business owners are reviewing their options for making extra 401(k) contributions and evaluating discretionary matches or profit sharing contributions based on last year’s numbers. They are to be congratulated for having a 401(k) plan, and for planning well enough to have the funds to consider going the “extra mile” with contributions.
For the owner who wants to maximize the benefits of having a 401(k)/profit sharing plan, the first thing to fund is his own (and if applicable, a spouse’s) salary deferrals. Maximizing one’s salary deferrals does not change the staff expense of having a 401(k) (for the purposes of this article a Safe Harbor plan is assumed), so deferrals are the most cost effective of contributions.
The Safe Harbor contributions (3% fixed or up to 4% match) are optimally funded at the same time as payroll; these contributions are immediately vested and will help the plan avoid discrimination testing.
Once deferrals and Safe Harbor contributions are funded, the owner is allowed some flexibility on additional funding.
Mission Financial Planning works with each client’s Third Party Administrator as they calculate the most advantageous way to allocate these additional contributions.
To get to the best recommendations, the company should provide several pieces of information as quickly as possible after year-end:
⇒ an estimate of the additional contributions the company has the capacity to make
⇒ an employee “census” form, reporting employees’ compensation, hours worked, years with the company, age, and turnover
⇒ notes on particular employees the owner hopes to reward with higher contributions.
With that information the Third Party Administrator (TPA) will run multiple calculations of the various ways to structure contributions so they are as advantageous as they can be for the owner and, to the extent possible, particular employees. Cross-testing (also called new comparability) and age-weighted testing may allow a larger share of a company’s contribution on behalf of those employees to whom the owner wishes to provide more significant benefits, including himself, assuming non-discrimination requirements are met.
For the owner to qualify for extra contributions beyond his deferrals and Safe Harbor, he must make similar contributions for his employees. There are a number of benefits to making staff contributions, including obvious reasons such as providing incentives to employees and reducing the company’s tax liability. But at the end of the day, the reason most small business owners make these discretionary contributions is to increase the amount they can add to their own 401(k) accounts. Contributing year-end profits to a 401(k) plan is tax efficient for both the company and the owner, and the associated staff expense is likely to be less expensive than taxes would have been if profits were taken outright.
A longer-term “benefit” to these discretionary contributions is that they are subject to a vesting schedule, so through employee attrition will skew toward rewarding longer term employees and/or the owner.