When choosing a plan type, one of the biggest considerations is how you want to prepare for annual nondiscrimination testing that’s designed to make sure plans are just as accessible to entry-level employees — or those with lower compensation levels — as they are to executives.
Plans that require employers to make contributions to employees’ 401(k) accounts tend to have an easier time passing the tests, and may even be exempt from testing if they’re designed properly. Plans that don’t require employer contributions cost your company less, but may be at risk of plan failure.
Here are three popular plan types, along with some pros and cons:
- Traditional 401(k): Employers can choose between not contributing, making outright contributions, or matching a portion of the wages employees defer. An employer can also set up contributions that are subject to a vesting period. While all this flexibility is useful, a traditional plan must pass nondiscrimination testing each year.
- Safe Harbor 401(k): This plan type is similar to a traditional plan and companies of any size can offer it, but it requires employers to make contributions above and beyond what their participants choose to defer. The contributions you offer must be of a certain amount (at least 3% of an employee’s taxable wages) and vest immediately. By committing to making these contributions, a plan is exempt from nondiscrimination testing.
- SIMPLE: SIMPLE, or Savings Incentive Match Plan for Employees, is for businesses with fewer than 100 employees. Like Safe Harbor plans, SIMPLE plans require employers to make contributions to their participants’ 401(k) accounts that vest immediately and are exempt from nondiscrimination testing.
There are very specific rules about how contributions are structured in these plans. It’s all spelled out in our Safe Harbor 401(k) guide if you want to learn more.
Once you’ve selected a plan type, you need to adopt a written document that — according to the IRS — “serves as the foundation for day-to-day plan operations.” That language may sound a little intimidating, but your 401(k) plan administrator usually handles this paperwork for you.
A plan’s assets must be held in trust to ensure that they’re used solely to benefit plan participants and their beneficiaries. In other words, all those employee and employer contributions need to be kept in a safe place and monitored by a designated trustee. This trustee is responsible for collecting the contributions, investing them, and issuing distributions.
It’s important to maintain a reliable accounting of plan activity. This step helps you keep track of contributions, earnings and losses, plan investments, expenses, and benefit distributions from participants’ accounts. If you have a plan administrator, they typically help you take care of recordkeeping. Doing a good job makes the preparation of the plan’s annual reports and business tax returns easy.
As a plan sponsor, you are required to notify all eligible employees and beneficiaries about the 401(k) plan, in addition to any updates to it. Most often, this is accomplished via a summary plan description that’s circulated on a recurring basis, detailing information about your plan and its benefits, along with other documents related to fees.