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A well-executed 401(k) plan can be a tool for recruiting and retaining talented employees. It also can benefit the employer, and small business owners and professionals in practice for themselves should understand the full tax benefits these plans offer.

For firms that already offer a 401(k) plan, chances are it was set up years ago. Since then, there have been legislative changes, the demographics of the employees have likely changed and even the employer’s objectives may have changed.
Fall is here and year’s end is around the corner—the season for wrapping up the fiscal year, thinking about ways to minimize the tax bite and arranging business affairs for the coming year. It’s a good time as well to review the plan to make sure it is still providing maximum benefits to the business or professional practice.

There are many reasons to have a compliance review, but one thing can be virtually guaranteed: If the plan was set up by a payroll company, mutual fund company or is any form of a “bundled” plan, a custom design likely can save the employer tens of thousands of dollars in employee costs. It also will save a good deal of effort. Many bundled plans require the plan sponsor to prepare its own Form 5500 and perform other administrative duties; a full-service administration firm, on the other hand, performs all those tasks for the plan sponsor.

The custom design beats the cookie cutter every time, and by a significant margin. But there are other reasons to review the plan.

The Employee Retirement Income Security Act of 1974 (ERISA) imposes certain requirements on employers. Ignoring or neglecting the rules can lead to plan disqualification, fines and other unpleasant consequences.

The most common areas of trouble include:
  • Plan design—The first thing to realize about a plan is the tax benefits.
    • Contributions are income tax-deductible
    • Growth is tax-deferred
    • Plan assets are protected from the claim of judgment creditors
    • One’s account balance is, generally speaking, eligible for an IRA rollover when one separates from the plan

Those benefits are favorable for the owner of the business or professional practice, but another task a review can perform is to determine whether the plan has maximized those benefits for the plan’s sponsor.

No one is advocating taking away from the participating employees, but if there is a way to amend the plan to put away more for the favored group, without increasing costs for the others, would it not make sense to do so?

There are many ways to do this through the custom design.
  • Fees:  Fees must be “reasonable.” What is reasonable is not defined, but one way to measure is to compare the fees paid by the plan to the actual cost of the funds themselves if purchased retail—a benchmark. Is the difference reasonable for the services provided?
  • Fee Disclosure: Under the new ERISA Regulation 404(a)(5), fees and costs must be disclosed to all participants. Most investment houses are sending the disclosures to the plan sponsor, requiring the sponsor to make the disclosure to the participants. This is new and must be complied with.
  • Employee Meeting: Is the plan administrator’s representative meeting with participants at least semiannually (preferably quarterly) to revisit the plan’s benefits and merits and investment performance?
  • Investment Offerings: The plan sponsor is responsible for the fund lineup and how the offerings compare to benchmarks. Do the investment choices get rearranged when laggards are discovered? How were the funds chosen to begin with? What are the default options? Are the offerings diverse?
  • Highly Compensated Employees (HCE): Defined as those who made more than $115,000 last year, those who own more than 5 percent of the business or practice or, under rules of attribution, spouses and lineal descendants and ascendants of HCEs. Many believe there are limits on how much HCEs can defer. If a plan participant complains, “I don’t understand why I send contributions to my 401(k) plan and they keep sending them back,” the plan’s design is likely a cookie cutter, not set up to enable the HCEs to maximize the available tax benefits.
  • Eligible Employees: The plan’s document defines who is eligible. If the plan does not offer automatic enrollment, the employer should make sure to retain evidence of all employee notifications of eligibility to enroll in the plan.
  • Notices: Every participant must receive a Summary Plan Description (SPD) when entering the plan. This is a “plain English” explanation of the plan. Annually thereafter, a Summary Annual Report (SAR) is necessary.
  • EIN (tax identification number): Every plan is a tax-exempt trust. It is also a separate legal entity and should have its own, separate EIN or Taxpayer Identification Number. Sponsors using bundled plans frequently have not obtained this EIN, and that is a mistake. One illustration of why this is important: A participant who leaves a plan receives a 1099-R. The payor’s EIN must be shown on the Form 1099-R. That payor is the plan. This is but one example.
  • Documentation: The plan sponsor has the duty to show it acted reasonably and prudently on behalf of the plan participants. This requires documentation. Examples of things to document:
    • How and when plan investment choices were reviewed and compared to the benchmarks
    • How and when laggards were removed and replaced with similar funds with better track records
    • How fees of investment choices were reviewed and date of review
    • How investment choices were in fact chosen, what criterion, what measure was used

  • Plan Contributions: Plans with less than 100 participants must have salary deferrals transferred to the plan no later than the seventh day following the day of withholding. The plan must have a fiduciary responsible for ensuring monies are successfully transferred.

The compliance review thus should cover disclosure compliance and fiduciary compliance under new regulations, but it also offers an opportunity to revisit the plan’s design and structure to ensure it is being maximized for all parties involved.


This discussion is not intended as tax advice. The determination of how the tax laws affect a taxpayer is dependent on the taxpayer’s particular situation. A taxpayer may be affected by exceptions to the general rules and by other laws not discussed here. Taxpayers are encouraged to seek help from a competent tax professional for advice about the proper application of the laws to their situation.

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