Understanding your 401(k) Plan Document
Betterment will draft your 401(k) plan document, but it’s important that you understand what it includes and that you follow it as written.
What exactly is a Plan Document?
A 401(k) plan is considered a qualified retirement plan by the Internal Revenue Service (IRS), and as such, must meet certain requirements to take advantage of significant tax benefits. Every 401(k) retirement plan is required to have a plan document that outlines how the plan is to be operated.
The plan document should reflect your organization’s objectives in sponsoring the 401(k) plan, including information such as plan eligibility requirements, contribution formulas, vesting requirements, loan provisions, and distribution requirements. As regulations change or your organization changes plan features and/or rules, the plan document will need to be amended.
Your provider will likely draft your plan’s document, but because of your fiduciary duty, it is important that you as plan sponsor review your plan document, understand it, and refer to it if questions arise. Whether you are a small business or a large corporation, failure to operate the plan in a manner consistent with the document as written can result in penalties from the IRS and/or the Department of Labor (DOL).
Understanding Your Fiduciary Responsibilities
Although a given 401(k) plan may have multiple (and multiple types of) fiduciaries based on specific plan functions, the plan document identifies the plan’s “Named Fiduciary” who holds the ultimate authority over the plan and is responsible for the plan’s operations, administration and investments. Typically the employer as plan sponsor is the Named Fiduciary.
The employer is also the “plan administrator” with responsibility for overall plan governance. While certain fiduciary responsibilities may be delegated to third parties, fiduciary responsibility can never be fully eliminated or transferred.
All fiduciaries are subject to the five cornerstone rules of ERISA (Employee Retirement Income Security Act) when managing the plan’s investments and making decisions regarding plan operations:
- Acting solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them;
- Carrying out their duties prudently;
- Following the plan documents (unless inconsistent with ERISA);
- Diversifying plan investments; and
- Paying only reasonable plan expenses.
One of the best ways to demonstrate that you have fulfilled your fiduciary responsibilities is to document your decision-making processes. Many plan sponsors establish a formal 401(k) plan committee to help ensure that decisions are appropriately discussed and documented.
Which Type of 401(k) Plan is Best for Your Organization?
The plan document will identify the basic plan type, which usually falls into one of two categories. Both types allow employees to make contributions via payroll deduction.
- Traditional 401(k) plans provide maximum flexibility with respect to employer contributions and associated vesting schedules (defining when those contributions become owned by the employee). However, these plans are subject to annual nondiscrimination testing to ensure that the plan benefits all employees—not just business owners or highly compensated employees (HCEs).
- Safe Harbor 401(k) plans are deemed to pass certain nondiscrimination tests but require employers to contribute to the plan on behalf of employees. This mandatory employer contribution must vest immediately—rather than on a graded or cliff vesting schedule. The 2019 SECURE Act relaxed certain safe harbor requirements.
Profit-sharing 401(k) plans include an additional component that allows employers to make more significant contributions to their employee accounts. Besides helping to attract and retain talent, small businesses can find this feature especially helpful In highly profitable years, since it reduces taxable income.
There is no one plan type that is better than another, but this flexibility allows you to determine which type makes the most sense for your organization.
Eligibility Requirements to Meet Your Needs
Although the IRS mandates that employees age 21 or older with at least 1 year of service are eligible to make employee deferrals, employers do have considerable flexibility in setting 401(k) plan eligibility:
- Age -- employers often choose to adopt a minimum age of 18
- Service -- employers can establish requirements on elapsed time or hours
- Entry date -- employers may allow employees to participate in the plan immediately upon hiring but often require some waiting period. For example, employees may have to wait until the first of the month or quarter following their hire date.
This flexibility allows employers to adopt eligibility requirements appropriate to their business needs. For instance, a company with high turnover or lots of seasonal workers may institute a waiting period to reduce the number of small balance accounts and the associated administrative costs.
As a result of the SECURE Act, beginning in 2021, plans must provide access for part-time workers who haven’t met 1,000 hours in one year, but have worked for over 500 hours for an employer for at least three years.
Automatic Enrollment may be the Way to Go
Enrollment in a 401(k) plan can either be voluntary or automatic. As retirement savings has become ever more essential for workers, employers are increasingly choosing to adopt automatic enrollment, whereby a set percentage is automatically deferred from employee paychecks and contributed to the plan, unless an employee explicitly elects to “opt out” or not contribute.
The benefit of automatic enrollment is that human inertia means most employees take no action and start saving for their future. In fact, according to research by The Pew Charitable Trusts, automatic enrollment 401(k) plans have participation rates greater than 90% compared to the roughly 50% participation rate for plans with voluntary enrollment.
Employee Contribution Flexibility Provides Valuable Flexibility
The plan document will specify the types of contributions (or “elective deferrals”) that eligible employees can make to the plan via payroll deduction. Typically these will be either pre-tax contributions or Roth (made with after-tax dollars) contributions. Allowing plan participants to decide when to pay the taxes on their contributions can provide meaningful flexibility and tax diversification benefits.
Elective deferrals are often expressed as either a flat dollar amount or as a percentage of compensation. Employee contribution limits are determined each year by the IRS. The plan document must specify whether the plan will allow catch-up contributions for those age 50 and older.
Able and/or Willing to Contribute to Employee Accounts?
The plan document will also include provisions regarding employer contributions, which can be made on either a matching or non-matching basis. Matching contributions are often used to incentivize employees to participate in the plan. For example, an employer may match 50% of every $1 an employee contributes, up to a maximum of 6% of compensation.
For traditional 401(k) plans, matching contributions can be discretionary so that the employer can determine not only how much to contribute in any given year but whether or not to contribute at all. As stated above, matching employer contributions are required for Safe Harbor 401(k) plans.
The plan document may also permit the employer to make contributions other than matching contributions. These so-called “nonelective” contributions would be made on behalf of all employees who are considered plan participants, regardless of whether they are actively contributing.
Vesting Schedules and Employee Retention
Vesting simply means ownership. Employees own, or are fully vested, in their own
contributions at all times. Employers with traditional 401(k) plans, however, often impose a vesting schedule on company contributions to encourage employee retention. Although there are a wide variety of approaches to vesting, one of the most common is to use a graded vesting schedule. For instance, an employee would vest in the employer contribution at a rate of 25% each year and be 100% vested after 4 years.
Employer contributions as part of Safe Harbor 401(k) plans are vested immediately.
Let Betterment help you create a 401(k) that works for you and your employees
As a full-service provider, Betterment aims to make life easy for you. We will draft your plan document based on your preferences and our industry expertise of best practices. We will work to keep your plan in compliance at all times and can prepare amendments based on your changing needs.
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