Why A Safe Harbor 401(k) May Be The Best Tax Savings Idea A Small Business Can Implement

Let’s face it - none of us like paying more than we need to in taxes. If you’re self-employed and you’ve started having some financial success, you’ve most likely been hit with a tax bill that made your toes curl (and not in a good way). For those of us unaware of how basic taxes work, let’s look at typical taxes a small business pays:

1. Federal Taxes - typically around 22%-32% - but it can be as high as 37%
2. State Taxes - According to US News the average American paid 8.9% of their income to state taxes
3. Social Security Tax - 12.4% (A small business is responsible for both halves of the 6.2% tax unless they incorporate via something like an LLC with the S-Corporation Election)
4. Medicare Tax - 2.9% (A small business is responsible for both halves of the 1.45% tax unless they incorporate via something like an LLC with the S-Corporation Election)
   

When we add this up, even if we stick to the low end of the scale, we end up with nearly 40% of our income GONE to cover taxes…and this doesn’t include things such as Unemployment Insurance or Workers Compensation! Is it any wonder small business professionals are constantly looking for as many tax deductions as possible?

While there are many tax saving avenues that exist, one of the best options is to utilize a 401(k) plan. These plans allow small business owners to contribute up to $66,000 in 2023 with an additional $7,500 available if they’re over the age of 50. While these limits are not as high as setting up a cash balance plan, for many small business owners, this can be a huge savings opportunity - both for retirement and for taxes.

Yet there are often misconceptions about how 401(k) plans should be designed. Today we’re going to cover the highlights regarding plan design options in the attempt of bringing clarity to an often convoluted conversation.

401(k) Contributions:

Let’s start with how one even gets to the point where they can get to the $66,000 401(k) contribution limits. This number is the combination of a couple of different things:

1. Personal contribution limits - As an individual, a person can contribute up to 100% of their earned income to a maximum of $22,500 into their 401(k).
2. Company Match - A company can match up to 6% of an employee’s salary
3. Non-Elective, Non-Safe Harbor Contributions (also known as a “profit share”) - a company has the option of doing a discretionary “profit share” each year. This can be a set percentage to each employee (i.e. 5% of everyone’s salary) or can follow what’s known as “New Comparability” rules which allow employees to have their share of the profit based on their age and income. This option can make up whatever’s left after personal contributions and company match to get to the maximum allowed contribution.
   

Let’s look at an example:

Assume a business owner earns $300,000 per year, is 45 years old, has no employees, and is in a 35% marginal tax bracket. Let’s also assume she offers herself a 6% match and annual profit share. Here’s what it would look like if she were to max out her 401(k).

In addition to the savings on her federal income taxes, this also lowers out her total payroll which means it reduces her social security and medicare taxes. Assuming she had not incorporated and was paid as 1099 Independent Contractor she would save the 15.3% Payroll taxes that would otherwise need to be paid. As seen, putting away a total of $66k for her retirement saves her over $33k dollars in taxes!

What About Employees?

Now, if an individual is a high earning professional and has no other employees on her payroll, all this is pretty simple. But what happens when other employees work for her? Now we have to pay attention to the 401(k)’s plan design and ensure that it is the best fit for the organization as a whole.

Fiduciary Responsibility

It’s important to start any conversation about 401(k) plan design with a reminder that ERISA Law is very clear that if a 401(k) is offered, decisions regarding the 401(k) need to be made with the exclusive purpose of benefiting plan participants and their beneficiaries. ERISA Law also makes it clear that what matters most is the “process” and not necessarily the outcome - meaning that if one documents their process clearly on why they made specific decisions they believed were in the best interest of participants, that should fulfill their fiduciary obligations. However, one should always consult with their financial advisor and/or ERISA attorney before making any major decisions regarding their 401(k).

Plan Design Options:

Employers have 5 main plan design options when they offer a 401(k). None of these options are best in every situation and decisions regarding which to use should be made carefully and based on each organization’s specific needs. The reason for this is that ERISA, the Department of Labor, and the IRS have very specific rules in place to ensure that employers don’t use 401(k)s solely for their own benefit. If a corporation is going to offer a plan, it has to be built so that all employees are fairly represented by it. If a plan fails certain requirements, it can lead to major issues and fines for an organization and defeat the entire purpose of offering the plan in the first place. An employer can avoid the majority of these issues by offering what’s known as a Safe Harbor 401(k) Plan.

A Safe Harbor 401(k) automatically passes 401(k) discrimination rules and ensures that highly compensated individuals are not getting preferential treatment over other employees in the plan. If all this sounds confusing, don’t worry - we can help you figure out which option fits you best if you email us at questions@letswinwithmoney.com.

Option 1 - Traditional Plan (NOT a Safe Harbor plan)

Traditional Plans are the most flexible type of plan for a small business. These plans can be great as a benefit for employees but are not usually the best fit for owners looking to cut their tax bill if they have employees on their payroll.

This plan type is not a safe harbor plan and thus is subject to all IRS nondiscrimination testing. If owners (any person owning more than 5% of the company) or highly compensated employees (any person paid more than $130,000) choose to participate it could result in the plan failing nondiscrimination testing.

Plan Highlights:

• This is the most flexible plan and allows the company to contribute any percentage, or not at all, to employee accounts
• This plan type has the most vesting options on employer contributions (if you choose to contribute)
• Automatic enrollment is optional (although highly encouraged) for this type of plan

Things to Consider:

• This plan is not a safe harbor plan.
• If any owners or highly compensated employees put money into their account it is likely to fail IRS testing.
• Failing the IRS testing can result in the company being required to put money in their employees accounts and can be expensive.

If as an owner, you’re setting up a plan to help reduce taxes, it’s strongly recommended you select a safe-harbor plan that exempt you from IRS testing.

Option 2 - Basic Safe Harbor Plan

Basic Safe harbor Plans exempt the company from ADP and ACP testing requirements. This plan design requires a company match of 100% on the first 3% of employee's deferred compensation and a 50% match on the next 2% of an employee's deferred compensation. For an employee to earn the full 4% match they must defer 5% of their pay.

Plan Highlights:

• This plan design is a Safe Harbor plan and protects your company from IRS nondiscrimination testing
• Employees are 100% vested in all contributions to their account
• The company matches 100% of an employee's deferral up to 3% of their pay along with a 50% match for contributions between 3% and 5% (for a total match of up to 4% of an employee's pay)

Things to Consider:

• This plan requires a 100% match on the first 3% of an employee's deferred compensation and a 50% match on the next 2% of deferred compensation for a total match of up to 4%.

Option 3: Enhanced Safe Harbor Plan:

As a safe harbor plan this plan exempts the company from ADP and ACP testing requirements. This plan requires a company match of 100% on the first 4%, 5%, or 6% (your choice) of employee's deferred compensation. This is one of the most benefit rich style plans and is great for employers looking to offer a top tier benefit to their employees.

Plan Highlights:

• This is a Safe Harbor plan and protects your company from IRS nondiscrimination testing
• Employees are 100% vested in all contributions to their account
• The company matches 100% of an employee's deferral up to 4%, 5%, or 6% (your choice) of their pay

Things to Consider:

• This plan requires you to match your employee's deferrals up to 4%, 5%, or 6% of their compensation
• This plan type can be one of the most expensive for employers

Option 4: Qualified Automatic Contribution Arrangement (QACA) Safe Harbor Plan:

The Qualified Automatic Contribution Arrangement Plan (QACA) is the best plan to encourage employee participation. Employees are automatically enrolled in the plan. This means they will have deferrals sent to their 401(k) account from their paycheck unless they opt-out. This simple step of having employees automatically enrolled significantly increases participation rates and is encouraged by the IRS (they offer additional tax credits for having automatic enrollment on your plan). The automatic deferral amount is then increased by 1% each year as long as the employee doesn't make an alternate deferral election.

As a safe harbor plan this plan exempts the company from ADP and ACP testing requirements. This plan requires a company match of 100% on the first 1% of employee's deferred compensation and a 50% match on the next 5% of an employee's deferred compensation. For an employee to earn the full 3.5% match they must defer 6% of their pay.

Plan Highlights:

• This is a Safe Harbor plan and protects your company from IRS nondiscrimination testing
• Employees are automatically enrolled
• The company matches 100% of an employee's deferral up to 1% of their pay along with a 50% match for contributions between 1% and 6% (for a total match of up to 3.5% of an employee's pay)

Things to Consider:

• This plan requires an automatic enrollment of 3, 4, 5, or 6 percent.
• This plan requires a 100% match on the first 1% of an employee's deferred compensation and a 50% match on the next 5% of deferred compensation for a total match of up to 3.5%.

Option 5 Guaranteed Contributions Safe Harbor Non-Elective Plan

As a safe harbor plan this plan exempts the company from ADP and ACP testing requirements. This plan requires the company to contribute 3% of each employee's pay to their 401(k) account. Employers can also choose a deferral amount higher than 3% if they desire.

All employees are entitled to the 3% company contribution regardless if they are participating in the plan by deferring some of their pay or not.

Plan Highlights:

• This is a Safe Harbor plan and protects your company from IRS nondiscrimination testing
• Employees are 100% vested in all contributions to their account
• The company contributes 3% of each employee's pay to their 401(k) account

Things To Consider:

• This plan requires a non-elective contribution meaning the company will contribute to all employees regardless of their participation. You selected to use a matching contribution that requires participation to receive a company contribution.
  

As seen, there are numerous options to consider when looking at one’s plan design. Working with a qualified advisor to make sure you get this area right can help ensure that you stay compliant with IRS and DOL regulations while also offering significant tax savings as a business owner. If you’d like to learn more about which plan type would best fit your organization’s needs or to discuss 401(k) plans in general, send us an email at questions@letswinwithmoney.com.