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:
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.
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.
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.
I regularly get calls from legal firms, medical and dental practices and CPA’s looking to set up a company sponsored retirement plan. Not surprisingly, they usually want a plan that is simple to administrate and is low cost. Congress has established several types of retirement plans in addition to 401(k) that are intended to be easy for small businesses to implement and maintain. This article will attempt to highlight the similarities and differences between 401(k), Simplified Employee Pension (“SEP”) and Savings Incentive Match Plan for Employees (SIMPLE).
Although both SEP and SIMPLE plans require minimal documentation, no annual testing and limited government filings, each imposes some additional limitations that often lead to a regular 401(k) plan being a more cost effective solution.
The Size and Goals for Your Plan
Employers of any size are allowed to implement 401(k) and SEPs. SIMPLE plans are limited to companies of 100 or fewer employees with a minimum of $5000 compensation during the immediately preceding year. It is also important to determine whether the plan goals are to benefit more highly compensated partners and owners, or primarily to help rank and file employees save for retirement.
Exclusive Plans
A SIMPLE plan must be the only plan maintained by an employer in a given calendar year. This is important when transitioning a SIMPLE to a 401(k) plan in that the earliest a 401(k) can be established is January 1 of the subsequent year given that adequate notice of termination is provided to employees (not less than 60 days prior to year-end).
401(k) and SEP plans are not subject to this exclusivity restriction, allowing employers more flexibility to maintain multiple plans or to transition from one plan to another.
Eligibility
Flexibility in regard to eligibility requirements is a key feature of 401(k) plans, with employers allowed to restrict up to age 21 and completion of one year of service. A year of service is further defined as a twelve consecutive month period in which the employee works a minimum of 1000 hours.
In a SIMPLE or a SEP, this flexibility is lost. SIMPLE plans are able to limit eligibility to employees who have earned at least $5000 in compensation in the prior two years and are reasonably expected to do the same in the current year. There are no service eligibility exclusions. SEPs can limit plan coverage only to those employees who have earned at least $550 in compensation in at least three of the past five years. Importantly, there is no ability to exclude short-term or part-time employees if they meet this requirement. This often makes these plans more, not less, expensive for employers than a traditional or safe harbor 401(k).
Employee Contributions
Salary deferrals are not allowed in SEP plans unless they were established prior to 1997. While both 401(k) and SIMPLE plans allow employee deferrals, there are some critical differences.
The first is in regard to the limits to total annual deferral limits. A 401(k) participant is allowed to defer up to $25,000 per year ($19,000 plus an additional “catch-up” deferral for those age 50 or older). SIMPLE participants are capped at $16,000 ($13,000 plus $3000), a whopping $10,000 less than 401(k). Do the math! For business owners or partners in higher tax brackets, the tax savings alone often offset the additional cost of a 401(k) plan not to mention hundreds of thousands of additional retirement benefits at retirement age.
Employer Matching
Employer contributions are mandatory for SIMPLE plans, with the option of a match or profit sharing contribution. The match option is limited to 100% of the first 3% deferred by the employee. There are no additional matching contributions available.
401(k) plan sponsors, however, may elect a discretionary match, giving them flexibility from year to year whether to make a match and if so, how much. Employers who elect safe harbor provisions avoid certain non-discrimination testing restrictions by agreeing to a matching formula of 100% up to the first 3% deferred by participants, plus 50% of the next 2% deferred. This match is typically made each payroll, although some plans make a one-time match in the quarter immediately following year end.
Since SEP plans do not allow employee deferrals, matching options are eliminated by design.
Employer Profit Sharing
Employers with SIMPLE plans can elect a mandatory profit sharing contribution of 2% of compensation for each eligible employee rather than making the required matching employee contributions. This makes it easier for many employers to estimate the total employer contributions required.
Both SEPs and 401(k) plans allow discretionary profit sharing contributions of up to 25% of compensation, limited to the lesser of 100% or $56,000 in 2019. As an alternative to the tiered safe harbor match for 401(k) plans, a non-elective safe harbor profit sharing of 3% may be made on behalf of all eligible employees.
SEP contributions must be uniform, or pro-rata, for all eligible employees. An employer or owner contributing 10% of pay for himself or other key employees must also contribute 10% to each eligible employee. 401(k) plans on the other hand allow owners much greater flexibility to discriminate higher profit sharing allocations to those who earn more than the taxable wage base or target contributions based on job classification. These allocation options include age weighted, Social Security integration and new comparability. These profit sharing options make 401(k) a much more popular option for attorneys, physicians and dentists who benefit from the ability to maximize deferrals and tax savings.
Additional Tax Savings for Partners & Owners
In addition, a separate “cash balance” added to a traditional or safe harbor 401(k) plan may be established in organizations with strong and predictable cash flow and where owners, partners and other highly compensated employees wish to increase their annual pre-tax contributions. These plans enable certain targeted participants the ability to contribute up to a total of $280,000 annually, depending on age and annual compensation. I plan to discuss these plans in greater detail in future articles so stay tuned to the blog or give me a call for further details.
Vesting Considerations for Employer Contributions
A 401(k) plan can impose a vesting schedule of up to 6 years on employer contributions other than those which are designated as safe harbor. (All safe harbor employer contributions are immediately vested.) This can be an advantage to a plan sponsor who has higher turnover among its lower paid employees.
There is no such vesting flexibility with SIMPLE or SEP plans, making them less effective than 401(k) in regard to retaining key employees.
Loans and In-Service Withdrawals
401(k) plans are the only employer sponsored retirement plans that offer participant loans.
A participant taking an in-service withdrawal from 401(k) prior to age 59 ½ are subject to regular income tax plus a 10% early withdrawal penalty. SEP distributions in most cases are treated similarly. Withdrawals or rollovers from a SIMPLE, if made within the first two years of participation, are subject to a 25% penalty. This potential negative impact should be factored in both to decision and timing of terminating a SIMPLE.
Plan Documents
All of these plan types require some form of documentation. For plans that that can be standardized (i.e. no creative plan design, controlled or complex ownership) the IRS has forms available that you can adopt:
Form 5305 – SEP
Form 5304 – SIMPLE: This allows each employee the option of selecting his own custodian and financial institution. This means that a company of 10 employees may have to send contributions to 10 different custodians each pay period. This is clearly not simple!
Form 5305 – SIMPLE: Employer selects a single financial institution for all plan contributions.
Plans such as 401(k) or more customized SEP/SIMPLE plans typically adopt a pre-approved prototype format or an individually customized plan document. Many providers offer prototype plan documents that can appear to be straight-forward, but given the importance of the plan document, we recommend working with an advisor with expertise in plan design.
Annual Discrimination Tests
Both SEP and SIMPLE plans are exempt from most annual compliance testing, with the exception of minimum coverage requirements for SIMPLE plans. This is one of the reasons that administrative costs are lower for these plans.
A traditional 401(k) plan which has not adopted safe harbor matching or profit sharing provisions must comply with a series of compliance tests that ensure that employer contributions and the percentage overall invested assets associated with lower paid, rank and file employees are adequate. Although testing adds to administrative expense and complexity, the trade-offs for a well designed 401(k) plan may more than pay for this additional cost. Such trade offs include higher annual contribution limits and tax saving, employer profit sharing and lower investment fees.
Government Reporting
401(k) plans of all sizes must file an annual Form 5500 report with the DOL each year. In addition, most plans with more than 100 employees are required to perform an annual audit of the plan, adding to administrative costs. Those plan sponsors with terminated employees which continue to maintain a balance in the plan must also file form 8955-SSA.
Neither SEP or SIMPLE plan sponsors are subject to these filing requirements. However, plan sponsors must monitor and comply with participant reporting requirements related to required minimum distributions at age 70 ½ and other in-service withdrawals. Because monitoring participant accounts with multiple custodians is next to impossible, compliance is a real headache for plan sponsors of SIMPLE plans.
Plan Investments
Although there a few exceptions, financial providers of SIMPLE plans often offer mutual funds with front end or deferred sales loads that may range as high as 5%. In many cases, they offer proprietary funds that are subject to revenue sharing arrangements that offer them additional hidden compensation. In short, participants are treated as retail accounts and therefore the quality of financial advice to participants is subject to the lesser standard of suitability. In contrast, the fiduciary standard for an experienced, fee-based 401(k) advisor is a much higher level of prudence. Finally, fee disclosure requirements for SIMPLE plans are not uniform and transparency can vary significantly depending on the provider.
SEP plans are often invested in individual financial instruments subject to the restrictions of the plan document itself or the investment policies of the account. In most cases, participants do not self-direct their individual investment accounts or are offered standardized investment allocations with limited options to change during the plan year. As is the case with SIMPLE plans, fee disclosure transparency is often a huge downside.
Depending on the provider that you choose, 401K typically offers greater flexibility with regard to investment options. Although some bundled providers such as mutual fund companies or insurance companies offer more expensive mutual fund share classes or high-cost variable annuity products as turn-key solutions, there are many terrific, low-cost providers today who offer flexible “open-architecture” investment platforms. These designs permit lower cost, institutional share class funds and include both actively managed as well as passive index fund options that are superior to most of those offered through SIMPLE platforms. In general, plan sponsors should use only those providers that they understand and who are transparent about their fees.
Transitioning to 401(k) can offer significant investment cost savings both immediately and over longer time periods. Working with an experienced 401(k) advisor acting as a plan fiduciary is highly recommended to achieve both positive participant outcomes and a well-documented investment process.
What Plan is Right for My Practice?
There is no question that a company sponsored retirement plan offers significant benefits including individual tax saving, employee recruitment and retention of key employees. For most law firms, physician and dental groups, a well designed 401(k) offers these important employee benefits and pays for itself through tax savings at a fairly modest level of owner participation.
For established firms or practices with highly compensated owners or partners who wish to contribute more of their compensation pre-tax for retirement, the addition of a defined-benefit cash balance plan can offer huge benefits and more than pay for the additional administrative expense.
However, if your retirement plan goal is to offer a payroll savings plan which primarily motivates lower paid employees to save for retirement, a SIMPLE may be your best option, despite it’s clear limitations. On the other hand, if you are considering transitioning from a SIMPLE to a 401(k), you should understand the steps necessary to be compliant and attempt to avoid possible distribution penalties and rollover restrictions.
If you are shopping for a plan, give us a call. We can help you put the pieces together that will result in the best plan for you and your employees!
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.
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!
