Hi Reader,

Hope your week has been going well.

Last week, I gave you an introduction to understanding the confusing world of retirement plans: aptly named Retirement Plans 101 (read the details here, if you missed it).

This week, we're going to move into Retirement Plans 102. We're going to go a bit deeper into the basics of retirement plans. This slightly deeper dive will be essential to understand if you have employees in your practice (or are thinking of starting a group practice in the future).

Read below my signature for all the fun details of Retirement Plan 102. 👇

Estimated Tax Payment due June 15th!

And don't forget that the second estimated tax payment is due next week! June 15th to be precise.

​Here's a video I recorded last June if you'd like a little explainer of what these estimated tax payments are all about.​

And as always, if you have questions about what's covered in this email (or anything else happening in your financial world), HIT REPLY and let me know. I read and reply to every email!

Best,
Dave

Retirement Plans 102: When you have Employees

If you already have employees and are looking to establish a retirement plan, there are a few more important details you’ll need to understand. Specifically we need to talk more about discrimination provisions and employer contributions. We’ll wrap things up by talking about newer “safe harbor” type plans which make all this simpler, easier and - in most cases - less expensive for small business owners.

Retirement Plan Discrimination Testing

The government wants to make sure retirement plans aren’t operating primarily for the benefit of business owners and other highly compensated employees. For that reason, the discrimination testing provisions exist.

Specifically, the discrimination calculations ensure that the plan fairly benefits non-Highly Compensated Employees (HCEs). HCE’s are generally those employees in the top 20% of compensation and anyone who owns more than 5% of the sponsoring employer. Both the full definition of an HCE and the exact nature of this discrimination testing is way beyond the scope of this article, and better left to the accountants and attorneys. Best of luck to them.

Guess what? It’s super common for small business to fail these discrimination tests. What happens then? You can fix (or “cure”) the test failure by making an employer contribution to each non-Highly Compensated Employee’s plan account.

And that brings us to the next topic we need to discuss a bit more: employer contributions.

Matching Contributions versus Nonelective Contributions

To make matters a bit more confusing, there are two different types of employER contributions. For many (not all) employer-sponsored retirement plans, the employer can choose to make contributions on behalf of employees as either matching contributions or nonelective contributions.

1. Matching contributions are just that - the employer matches the percent of compensation that the employee elects to contribute to the retirement plan. Let’s say the plan rules stipulate that the employer matches employee contributions up to 3%. If an employee contributes 3% of their compensation, the employer will contribute an equal amount. If an employee contributes 5%, the employer still contributes only 3% - the match is only up to 3%. And if an employee contributes less than 3%, the employer only matches that lower amount. If the employee elects to contribute nothing - the employer will match that nothing and not contribute anything on behalf of that employee.
2. Nonelective contributions are different. A nonelective contribution takes place regardless of whether the employee contributes anything. Let’s say the plan rules stipulate that the employer makes a nonelective contribution of 2% for all eligible employees. In this case, the employer contributes that 2% regardless of how much the employee contributes. Indeed, the employer must contribute 2% even if the employee decides not to contribute anything.

Remember how many small business retirement plans fail those discrimination tests? The easiest way to fix that failure is to make a nonelective contribution to the accounts of all non-Highly Compensated Employees. But what if there were a simpler way to pass the discrimination test? Good news - there is!

Safe Harbor Plans to the Rescue

Recognizing that all this is testing and after-the-fact employer contributions to fix failing those tests is a lot of rigamarole (technical term), legislatures introduced “safe harbor” retirement plans. The two most relevant for small business owners are SIMPLE IRA’s and Safe Harbor 401(k)’s.

These “safe harbor” plans allow you to skip all the complex testing if you follow the rules they put in place. The two most important rules are mandatory employer contributions and immediate vesting in employer contributions.

These safe harbor plans require annual employer contributions. These contributions can be either matching or nonelective, but the percentage of compensation is specified and must be paid on behalf of all employees annually.

Safe harbor plans also require that employees are immediately vested in all employer contributions deposited in their accounts. More complex, non-safe harbor retirement plans allow multi-year vesting schedules before employees fully own the employer contributions in their account. (Note that employees are always fully vested in their own employee contributions because this was always their money - they simply chose to direct some of it into the company retirement plan.)

One final characteristic of these safe harbor plans: they generally require most - and in many cases all - employees are included. More complex, non-safe harbor retirement plans allow more (though not much) flexibility in excluding certain classes of employees.

That's a Wrap 🎬

Alright - so that's it! I mean - I know it wasn't a small amount of information.

If anything's still unclear or confusing, please hit reply and let me know!