401K Plans You Can Learn To Love

New rules let you reward top talent--and still be fair to all

Want to get more out of your 401(k) plan for yourself and key employees? Until this year, it was almost impossible, because of tough federal standards designed to protect the rights of your lower-paid workers. But new rules that took effect on Jan. 1 let you legally sidestep that barrier. The result could be a shower of extra benefits for entrepreneurs and their top managers.

Sound selfish? Not really. If you set up a new "safe-harbor" plan the right way, everyone in your company can come out ahead.

Offering better benefits is crucial for attracting top talent in this tight labor market (Enterprise--Dec. 7). But small companies have been hobbled by annual antidiscrimination tests required by the Internal Revenue Service. The formula is fearsomely complex, but in practice your plan will flunk the test if the lower-paid people don't participate or contribute enough. And you don't want to fail: The prescribed remedy is reducing or returning some of the 401(k) contributions of your top earners.

Unfortunately, nearly half of all 401(k) plans failed these tests in 1997, in part because low-paid workers can't afford to set very much money aside for retirement. As a result, contributions from senior staffers typically are held to far less than the $10,000 annual maximum.

What's more, running the tests can cost $1,000 or more each year, not to mention the agita: "You test the plan all year, working yourself silly to make it come out right," says Joan H. Vines, a partner at tax accountants Grant Thornton in Washington. Perhaps that explains why only 30% of workers at small companies are covered by a 401(k) plan.

But now, two "safe-harbor" options let you dodge the tests. Under the first option--let's call it "the matching plan"--you must match employee contributions dollar for dollar on the first 3% of pay, plus 50 cents on the dollar for the next 2%. That's more than many 401(k) plans pay these days, and your employees must be vested immediately in the match instead of waiting for up to five years. The cost: Anywhere from nothing to 4% of payroll, depending on how much your workers participate.

The appeal of this option is obvious: Since many lower-paid workers can't afford to put money aside, they won't sign up--saving you lots of money. But think twice about such a cynical strategy. Federal rules require you to promote the plan to employees. If you guess too low about participation, you will blow a hole in your budget. Besides, squeezing your weakest employees to give yourself a raise could poison the atmosphere in your workplace.

PREDICTABLE. Far more appealing--and potentially lucrative--is the second safe-harbor option, which we'll call the 3% plan. You simply put aside 3% of pay for all eligible employees, regardless of whether they contribute. Clearly, workers who can't afford to save are better off with this plan, and so are you: Your budget is predictable. You are automatically exempt from the annual antidiscrimination tests plus an additional test that imposes more costs on your plan if more than 60% of total assets are held by the top brass. Then comes the kicker: Since you have adopted the 3% plan, you automatically become eligible to boost retirement-plan payments to older workers--a group that usually includes owners and key employees--using an existing method called cross-testing.

Cross-testing turns the idea of fairness on its head. Instead of focusing on how much workers get now, it focuses on how much they will get when they retire. The goal: to make sure everyone's retirement payment is equal. Thus, you could set aside 3% of salary for a 35-year-old and 10% of salary for a 55-year-old if it would bring the same monthly benefit at 65. The upshot: Key employees can receive as much as $30,000 or 25% of salary in total retirement contributions each year, whichever is less.

What's more, company contributions aren't salary and are thus free of FICA and Medicare payroll taxes, notes Glenn Rossman of Buck Consultants Inc. in St. Louis. On top of all that, says Dennis Coleman of PricewaterhouseCoopers Kwasha, the 3% safe-harbor contribution helps you pass antidiscrimination tests if you also offer an old-fashioned, defined-benefit pension plan.

"This is a really exciting opportunity," says Marilyn R. Bergen of Capital Management Consulting, a Portland (Ore.) financial planner. She's considering a safe-harbor not just for clients but also for her own company. Currently, she says, her firm doesn't offer a 401(k) plan because preliminary surveys showed that lower-level employees wouldn't use it enough, drastically limiting benefits for the partners. The new rules, she says, can make the idea much more viable.

This safe-harbor/cross-testing combination was strung together by consultants at Pioneer Group Inc. in Boston, who dubbed it a DASH 401(k) plan, or double advantage safe harbor. But there's nothing to prevent anyone from setting up similar plans. As for signing up, you must give employees 30 days' notice about which safe-harbor option you have chosen for the coming year. In 1999, though, you get a break: Businesses have until Mar. 1 to notify workers, and until Dec. 31 to amend the plan. You can switch options each year.

The price? After setup costs of about $1,000 and annual fees of $1,000 more, the big expense is the immediate vesting. This means workers own the 3% contribution immediately, regardless of how long they stick around afterward, instead of waiting for up to five years under current law.

But in practice, the difference is negligible if you already contribute close to 3% of payroll and your employees usually stay long enough to vest. "For most small businesses, I don't think it's a significant issue in terms of dollars," says Wil Heupel, a principal at Accredited Investors in Minneapolis. Instead, think of it this way: Here's a chance to do what you have to do anyway to attract good employees--and give something extra to the ones you need most.

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