The embattled 401(k)

Businesses can still find value in this employee benefit

Today’s employees may be more concerned than ever about building up retirement savings, and they’ll be looking to their employers to help them meet this goal via a 401(k) plan. Even if you’re not worried about attracting and retaining workers now, doing so will likely soon become a challenge as the economy recovers and more baby boomers retire. So if you don’t already have a plan in place, you’ll want to look at your 401(k) options.

A traditional 401(k) plan

The most common 401(k) is, not surprisingly, the traditional one. It allows employees to save for retirement on a pretax basis with the employer matching all or a percentage of their contributions if it so chooses.

In 2010, employees can defer a total amount of $16,500 through salary reductions. (Employees age 50 and over by year end can make an additional contribution of $5,500.) The 2010 combined employer-employee contribution limit is the lesser of 100% of compensation or $49,000 — $54,500 for those age 50 or over. (Typically these limits increase annually but, because of low and in some cases even negative inflation rates, these amounts all remain the same as they were for 2009.)

One detriment to a traditional 401(k) plan is that it’s subject to rigorous testing requirements to make sure the plan is offered equitably to employees. More specifically, benefits for rank-and-file workers must meet certain proportionality tests in relation to those for owners or other highly compensated employees (HCEs).

A Roth 401(k)

A recent variation that’s garnered a lot of attention is the Roth 401(k). Unlike a traditional plan, wherein employees contribute pretax dollars and face income taxes upon withdrawals, the Roth version allows employees to contribute after-tax dollars but take tax-free withdrawals (subject to certain limitations).

Employer contributions, however, can go into only traditional 401(k) accounts. And many employees will still want to use the traditional plan for their contributions to take advantage of the current tax savings. So most employers don’t forgo offering a traditional 401(k) but rather provide a Roth 401(k) as an additional option that employees can elect. Generally, employees who expect their marginal tax rates to remain almost as high or be higher in retirement are better off with a Roth 401(k). Conversely, those who expect their tax rates to decrease significantly will do better with a traditional plan.

Some employees may like having the opportunity to hedge their bets and split their contributions between the two types of accounts. Employees whose incomes are too high for them to be eligible to make Roth IRA contributions may particularly appreciate the Roth 401(k) option, because no such limits apply to the Roth 401(k).

This year, participants can make combined contributions to traditional and Roth 401(k) accounts of up to $16,500 ($22,000 for those age 50 or over).

Alternate 401(k) versions

As mentioned earlier, federal rules require a traditional 401(k) plan to benefit rank-and-file workers and HCEs proportionally. This means that, if rank-and-file workers don’t contribute enough, HCEs may not be able to contribute the maximum — and may get a portion of their contribution returned to them.

If your company can’t easily meet these rules, you have the option of a Safe Harbor 401(k). Under this plan, employers must make certain contributions, but owners and HCEs can maximize their contributions without worrying about the above-mentioned testing rules.

To qualify for the safe harbor election, the employer needs to either contribute 3% of compensation for all eligible employees, even those who don’t make their own contributions, or match 100% of the first 3% of worker deferrals and 50% of the next 2% of deferrals. The required contributions can make a Safe Harbor 401(k) a substantial investment for the company. Plus, employer safe harbor contributions vest immediately, which could be costly if your staff turns over quickly.

If your business has 100 or fewer employees, you might consider the Savings Incentive Match Plan for Employees (SIMPLE) 401(k). Like a Safe Harbor 401(k), the employer must make fully vested contributions, and there’s also no rigorous testing (though the IRS does require an annual filing).

Under a SIMPLE 401(k), eligible participants can defer a smaller amount: only up to $11,500 in 2010 ($14,000 for those 50 and over). As the employer, you generally need to match contributions up to 3% of employees’ pay or make nonelective contributions of 2% of all employees’ pay regardless of whether they contribute. So required contributions are a little lower than with a Safe Harbor 401(k).

A new era for the 401(k)

Although losses in many 401(k) plans have left some employees jaded, those challenges have helped many others learn to better manage their accounts. So you may be able to attract and retain a savvier type of worker by offering a carefully chosen and implemented 401(k) plan.

Self-employed? Maybe a Solo 401(k) is for you

For many years, being self-employed meant forgoing any hope of saving for retirement via a 401(k). But today’s earn-it-yourselfers can contribute up to 100% of the first $16,500 of 2010 compensation or self-employment income ($22,000 if you’ll be 50 or older by year end). If you’re a sole proprietor, you also can make an “employer” contribution, generally of up to 25% of compensation, or 20% of your self-employment income.

The maximum combined 2010 contribution is $49,000 ($54,500 if you’re 50 or older). If necessary, you may vary your yearly contributions or contribute nothing at all. You must, however, establish your plan by Dec. 31, 2010, if you want to claim a 2010 tax deduction for plan contributions. Fortunately, you have plenty of time.

If you would like to discuss these matters further or if you would like to learn how we can help your company set up a plan, please contact Feeley & Driscoll's forensic accountants by Email or call 1 (888) 875-9770 to learn more.

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