Why Professional Service Firms Should Sponsor a 401(k) Plan

Why Professional Service Firms Should Sponsor a 401(k) Plan

I work as a retirement plan financial advisor  to professional service organizations such as legal practices, physician groups and dentists. A big reason for these firms to sponsor a plan is that it is a huge employee benefit. More importantly for the plan sponsor, it is a key component used to recruit and retain top-level employees and highly compensated partners and talent. These organizations must constantly be evaluating recruitment and retention because it is the lifeblood of their growth.

Compared to health insurance premiums that seem to increase 20% or more annually, the costs of administering a retirement plan are far more forecastable. The value to partners and staff of building future wealth through a qualified retirement plan can far outweigh health benefits provided through a Cadillac health plan.

For this reason, the dominant plan of choice for professional service organizations is the 401(k). Despite what you may have heard otherwise, 401(k) plans are only bad if they are run poorly or administered by incompetent providers. When it comes to retirement plans, a well-designed 401(k) is the gold standard for professional service firms. This article will tell you why.

Pension Plans have become as rare as the slide projector!

Vintage Slide Projector

Prior to the broad acceptance of personal computers in the 80’s, the slide projector was the presentation tool of choice. In similar fashion, prior to the introduction of 401(k) plans in the early 80’s, the retirement plan of choice was the good old-fashioned defined benefit plan. These plans are far less popular now, primarily because 401(k) plans are far cheaper for employers to maintain. The bulk of savings in the average 401(k) is funded by the employee through salary deferrals, while pension plans, which seek to fund a future benefit at retirement, are almost entirely funded by employers. 

Pension vs 401(k)

This higher cost of pension plans to the employer, combined with soaring premiums for employer funded health insurance benefits, made it inevitable that defined benefit pension plans were going to be a casualty. Fortunately, lower cost 401(k) plans became an increasingly attractive alternative for employers who could now largely shift the cost and liabilities incurred with pension plans to the employees. 

Pension plans are still a great tool for sole proprietors and small, family businesses. For many professional service organizations, certain “hybrid” defined benefit plans such as cash balance plans have flourished in recent years as a way to allow the most highly compensated owners and partners to substantially increase their pre-tax contributions and tax savings when paired with a traditional 401(k) plan.

For many legal, physician, dental and accounting practices with highly compensated employees, these newer defined benefit plans, paired with a traditional 401(k) defined contribution plan, are still something that you should consider. But fundamental to this strategy is a well designed 401(k).

SEP’s and SIMPLE IRA plans are very efficient… unless you have employees!

Clearly there are some company sponsored retirement vehicles that are cheaper to manage and free of the compliance requirements of a 401(k) plan. These plans have virtually no administrative cost, are easy to set up and maintain, and have minimal filing requirements (no Form 5500). The two most popular are the SEP- IRA (Simplified Employee Pension) or the SIMPLE-IRA (Savings Incentive Match Plan for Employees). The limitations of these two options are flexibility and that total employer costs are directly related to headcount.

SEP-IRA plans allow only employer contributions.

The good news with the SEP is that it has virtually no administration cost  and it allows employers to make discretionary, pre-tax contributions up to 25% of compensation without administrative or compliance duties of a more complex qualified plan. Under the SEP, employers make contributions to eligible employees through a traditional retirement arrangement called a SEP-IRA. The employee owns and controls the account and the employer makes the contributions to the financial institution where the assets are maintained.

Employees cannot make contributions to a SEP meaning that 100% of the contributions are made by the employer. SEP plans get very expensive because all employer contributions are made pro-rata. This means that the same percentage of compensation is applied to all employees. In a SEP, there is no flexibility to favor certain employee groups of higher paid employees, partners or owners.

SIMPLE IRA’s have lower contribution limits and less flexibility.

The SIMPLE IRA is similar to the SEP in the sense that it is an IRA-type arrangement, but there are three major differences:

  1. A SIMPLE-IRA allows participant contributions up to $13,500 or up to $16,500 if they are older than 50. Contrast this with $19,500 and $26,000 limits for 401(k) in 2020.
  2. Certain minimum employer contributions must be made each year, regardless of whether the business is profitable. Employers must make these contributions either in the form of a dollar-for-dollar match up to 3% of the employee’s compensation or a flat 2% for each employee. Adding to this employer expense, every employee making more than $5,000 annually is eligible. In comparison, the employer match with 401(k) is discretionary and can be adjusted annually. Eligibility can be restricted to full time employees, age 21 or older, with a service requirement up to 12 months from hire date.
  3. SIMPLE plans are only available to employers with fewer than 100 employees. 

When it comes to retirement plans for legal, medical and other professional service organizations, the 401(k) plan is the “gold standard”!

Highly compensated employees cannot save enough in a SEP or SIMPLE to fund retirement.

Highly compensated individuals are severely limited by the lower contribution limits of SEP and SIMPLE plans. In contrast, annual participant deferral limits for 401(k) allow $19,500 or $26,000 if they are over age 50.  Optional employer contributions in the form of discretionary match and profit-sharing contributions allow total annual contributions up to $57,000 annually for 401(k) participants who meet the income requirements.

 When you factor that these additional investment savings compound free of tax for 30 years to retirement age, just do the math!

There is no flexibility in contributions for a SEP or a SIMPLE. 

A SIMPLE requires a contribution every year. Both SEP and SIMPLE plans require pro-rata employer contributions. This means that if you are an owner and want to give yourself a 25% contribution, under a SEP, you must give the same pro-rata contribution to all of your eligible employees. That requirement becomes expensive very quickly for a plan sponsor. With a SIMPLE, there is no profit sharing feature and simply limited to a 3% match.

The flexibility of 401(k) plan design allows the option of both a flexible match and an additional profit sharing contribution. For those employees that are eligible yet choose not to contribute to the plan, the plan may be designed so that no match from the employer is required. 

401(k) allows legal discrimination through profit sharing contributions to key employees.

In organizations where some highly compensated employees make over the Social Security Wage Base ($137,700 in 2020) or where higher compensated employees in general are older than lesser paid employees, 401(k) designs allow flexibility to make much higher allocations for these employees through profit sharing allocation features. An allocation formula arrived by cross-testing/new comparability may produce the same result.  

Employee Groups

So unlike in a SEP where you would be forced to give every eligible employee a pro-rata 25% contribution, these profit sharing allocation formulas allow certain employee groups up to 25% of compensation while only 5-7% of compensation would be required to lower paid staff. 

The after-tax benefits of a well-designed 401(k) plan often exceed the total annual costs of the plan.

In most plans, the bulk of the contributions are made by the participants. Because of this, it’s safe to say that with respect to employer contributions, the 401(k) is the most cost effective plan for organizations with more than a handful of employees. 

Thanks to competition and recent fee disclosure, 401(k) plans have seen considerable fee compression in recent years. Despite of the lack of administrative costs for SEP and SIMPLE plans, these plans lack the flexibility to achieve higher contributions for your highly compensated employees.

Law Firm

If your firm has highly compensated owners, partners and key employees and you have a SEP or SIMPLE, you have the wrong plan.

For certain professional organizations that I work with, a 401(k) can be combined with a “hybrid” cash balance plan that may allow older, more highly compensated partners to legally contribute up to $250,000 in annual tax-deferred contributions in some cases without proportionate increases to the rank and file. While this requires some additional administrative costs to the organization, there simply is no other plan design that comes anywhere close to providing this level of annual pre-tax deferral and tax savings for both the organization and these highly compensated individuals. 

An experienced 401(k) advisor is usually available to help 401(k) participants.

Employers who sponsor 401(k) plans are required to provide education to employees with regard to their investment options and decisions. This is one of many reasons that informed plan sponsors should hire a financial advisor both to select and monitor plan investment options and to provide guidance to employees

With SEP’s and Simple’s, most employees make these decisions without the help or guidance of a financial advisor. This is a serious disadvantage for most employees who are not investment savvy. In most cases, SEP or SIMPLE plans are funded with higher cost mutual fund share classes, further reducing future returns. I recently reviewed a SIMPLE IRA for a client that offered A shares with a 5% load fee in addition to annual expenses of nearly 0.75%. She thought the plan was free. 

Technology provides limited liability to employers for participant direction of investments.

The booming stock market and technology advances in the late 90’s converged to produce a boom in the creation of 401(k) plans by mutual fund companies. Online daily valuation coupled with participant direction through custom website portals simplified the administrative process for plan sponsors. 

Employers who followed the rules established in ERISA 404c could also now rely on a layer of protection against liability for participant investment decisions. As long as you did the work of selecting and monitoring investment options and educating participants, you would not be held liable for plan losses incurred by participants. Lower liability for investment returns became a significant advantage not possible with defined benefit plans..

A well designed 401(k) is not an expense. It is a valuable business asset.

The additional flexibility in 401(k) employer contributions allow both savings to the employer and significant tax saving benefits to talented employees who have started saving for retirement in their 40’s. Proper 401(k) plan design allows your key talent to build wealth much faster than other plans.

Asset vs Expense

In most cases, the after tax benefits of a well-designed 401(k) plan far exceed the additional costs. When the ability to recruit and retain talent is added to the equation, the decision to sponsor 401(k) retirement plan becomes a no-brainer for the firm’s growth.

The 401(k) market is loaded with talent.

Because 401(k) is the dominant plan in the marketplace, it is loaded with talented providers that can assist you with your fiduciary duties. With most other plans, you probably will to get no help. If you are overwhelmed with the process of establishing and managing a 401(k) plan for your firm, there are excellent providers who can walk you through everything without a lot of stress.

It’s a 401(k) world!

If you are a professional organization such as a legal or CPA firm, a physician group or dental practice, you will quickly outgrow less sophisticated plans. Rather than convert an inferior plan after only a few years, it is far preferrable to design a 401(k) plan that complements your current business revenue growth and is flexible as you grow the business. For you, it’s a 401(k) world!

Brian C. Rall

President – Strategic Retirement Partners, LLC

February 27, 2020

Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.

Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.

401(k) Profit Sharing: What Are the Best Options for My Plan?

401(k) Profit Sharing: What Are the Best Options for My Plan?

One of the strongest features of a well-designed 401(k) plan is the ability of participants with higher levels of compensation to make significant contributions to a qualified retirement plan (up to $56,000 annually plus an additional “catch-up” deferral of $6,000 for those over the age of 50). This provides both meaningful tax benefits and allows the investment returns on these contributions to cumulate tax-free while they remain in the plan. The result is annual tax savings and significantly larger balances for employees at retirement.

One of the strategic ways where highly compensated employees can reach these maximum thresholds is through a discretionary profit sharing feature. The IRS rules allow employers to decide both whether a contribution will be made for a given year up and the amount, allowing them flexibility year to year based on their business results.

Profit Sharing Contributions: The Basics

Flexible Vesting

401(k) profit sharing contributions, in addition to being discretionary, are considered a type of “non-elective” employer contributions. This means that employees who may not be deferring into the plan are still eligible to receive contributions made to profit sharing. Profit sharing contributions also have added flexibility for the employer as they can be made subject to a vesting schedule – up to a 3-year cliff or 6-year graded. For organizations which may have short-tenured employees, this can involve forfeiture of these benefits upon termination, further lowering the overall cost to owners for utilizing a profit sharing feature.

When to Choose Profit Sharing

Because of the discretionary nature of profit sharing contributions, they can be a great choice for startups, companies with erratic profitability or those who frequently make corporate acquisitions.For professional organizations such as medical practices and certain law firms with stable or increasing cash flows, profit sharing contributions can be pivotal in achieving certain plan goals, including the following:

  • Allowing certain HCE’s to increase total annual contributions up to the legal limits (described above).
  • Giving your lower paid staff and administrative employees (whose loyalty greatly benefits the organization) a base retirement benefit.
  • Attracting and recruiting top employee talent through a generous retirement benefit.

To be clear, profit sharing contributions are not always good choice for every 401(k) plan. Matching contributions may be a more effective way to go for those plans whose primary goal is to incentivize a high percentage of employees to participate in salary deferrals. 

Further, not all employers will qualify for the most flexible allocation methods due to IRS nondiscrimination testing limits and the demographic makeup of its workforce. But for many professional service firms, profit sharing contributions can be an extremely valuable tool to achieve plan goals.

Profit Sharing Allocation Methods

For professional firms such as legal and medical practices, achieving these upper limits of participant contributions for the highly compensated employees (HCE’s) of the practice without unfairly discriminating against those designated by ERISA as non-highly compensated (NHCE’s) involves choosing among a variety of methods by which to allocate the total annual profit sharing contribution. By comparing the resulting impact of each method and then combining it with other 401(k) features such as matching contributions, an overall plan design can be customized to best achieve plan goals.

When employers choose to “turn-on” the profit sharing feature of their plan, they can allocate these contributions using one of the following methods:

Option #1: Pro-Rata or Salary Proportional

This formula is the most basic and serves as the default allocation for many 401(k) plans. With pro-rata allocation, each participant receives an allocation equal to a uniform percentage of his or her compensation. This salary proportional method is a good choice given that the  employer wishes to provide an easy to understand retirement floor for employees. It’s obvious drawback is that it may be significantly more expensive formula for those companies which want their highly compensated partners to max-out their retirement contributions.

Option #2: Permitted Disparity / Social Security Integrated

Unlike easier to understand methods such as pro-rata, permitted disparity allocation formulas are a bit more complex. This option is also referred to as Social Security Integration in that it recognizes that Social Security retirement benefits are provided only up to compensation at or below the Social Security Wage Base ($132,900 for 2019; $137,700 for 2020). This formula specifically allows additional plan contributions for employees whose annual compensation may exceed that level (termed “Excess Compensation”).

There are two steps to determining the contribution using Permitted Disparity or Social Security Integration:

  • Step 1 – A uniform percentage of total base pay, referred to as the “base percentage”, is allocated to all eligible participants. This would include those eligible but not actively deferring a portion of their own wages into the plan.
  • Step 2 – A uniform percentage of Excess Compensation is allocated to those eligible participants whose compensation exceeds the Social Security Taxable Wage Base (SSTWB) in effect for that year. This excess percentage cannot exceed the lesser of the base percentage or 5.7%.

For example, Curtis is a partner of ABC Law and earns $200,000 in 2019. Curtis would have excess compensation of $67,100 in that year ($200,000 – $132,900). If the base percentage set for the plan were 10%, Curtis would receive a profit sharing contribution of $23,825based on the formula as follows:

Total Compensation X 10%  ($200,000 X .10) = $20,000

+Excess Comp X 5.7%              ($67,100 X .057)=  $3,825

                                                          Total Contribution $23,825

It should be noted that it is also possible to integrate the allocation at a level below the SSTWB. Doing so, however, would result in a reduction of the maximum excess contribution percentage.

This permitted disparity allocation formula should be considered for plans wishing to increase contributions for high income employees while insuring that the plan will also pass IRS nondiscrimination testing.

Option #3: New Comparability

The new comparability method uses the time value of money as a basis to allocate larger contributions to older participants who are closer to retirement. It is also the most flexible type of profit sharing allocation formula in that it allows employers to allocate contributions at multiple rates to different employee groups. This added flexibility allows employers to allocate larger contributions to business owners or other highly compensated employees (HCE’s).

The first step for determining the allocation for a given year involves dividing eligible participants into employee groups referred to as “allocation groups”. Participants are placed into various groups to maximize flexibility and employers are permitted to determine the amount of the total profit sharing contribution to allocate to each group.

NHCE’s are required to receive a minimum “gateway” contribution that is the lesser of the following:

  • 5% of compensation
  • One third of the highest percentage allocated to any HCE

The next step is to project these contributions as a benefit at the plan’s normal retirement age (usually age 65) and cross-tested to confirm that the future benefits to be received by HCE’s is not disproportionately higher than the future benefits to be received by the NHCE’s on a percentage basis. This cross-testing can make a 15% contribution to a 55 year old employee with 10 years to retirement as relatively valuable as a 5% contribution to a 30 year old with 35 years to retirement.  If the HCE benefits fall outside of the acceptable range, the company can correct by increasing the contributions for NHCE’s, reduce the contributions for HCE’s, or a combination of both.

Importantly, the effectiveness of new comparability is highly sensitive to the demographic composition of a company’s workforce. However, if one of your primary plan goals is maximizing business owner contributions at the lowest total cost, a new comparability formula may be a great option. 

Due to the “cross-testing” required for determining new comparability allocations, companies with older business owners are often the best candidates for new comparability. A spread of 10 years between owners and NHCE’s often allows these employers to maximize owner contributions while limiting NHCE contributions to the “gateway minimum”. Often the annual tax saving to owners utilizing this method exceeds the additional non-elective contributions made on behalf of lower paid staff.

Changing Methods: What You Need to Know

Allocation formulas may be changed from year to year based on changing company demographics or profitability. However, it is important that the plan document specify the allocation method to be used for any particular plan year. The general guideline for making an allocation change is by the end of the year for which the contribution will be made. If you are considering making a profit sharing contribution this year, you should have SRP run an illustration of how the various methods would work for you and amend your plan document accordingly prior to December 31, 2019 (or the last day of your current plan year). Amending your plan’s profit sharing method will in not commit you to electing profit sharing contribution for the current year. 

Call Us for a Customized Illustration

Profit sharing contributions are flexible and allow plan sponsors meet a variety of plan goals. You should understand your options in order to decide whether to implement them for your plan. Give us a call and we can provide you with an illustration tailored to your company.

Brian C. Rall

President- Strategic Retirement Partners, LLC

Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.

Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.

Audit Proof Your Company’s 401(k) Plan!

It is highly probable that your company’s 401(k) plan will be subjected to audits conducted by the DOL and the Internal Revenue Service at some point in the future. If you are not 100% certain what documents you will need, download this free copy of our “Fiduciary Audit File Checklist” and be sure!