Retirement plans such as 401(k)’s and profit-sharing plans are an excellent way for small business owners and their employees to save for retirement. As with any type of service, there are costs associated with providing a retirement plan. These costs, or a large portion of these costs, are normally paid as a percentage of a participant’s account balance. This discussion will examine the traditional way small businesses have paid for retirement plan expenses, explore some alternative methods, and analyze the long-term impact the differing fee structures may have on retirement accounts.

Case Study

• Small Business with two owners and eight employees
• Company is filing taxes as an S-corporation
• The business has a steady cash flow and has been profitable
• The owners want to maximize their retirement contribution while providing an excellent benefit for the employees
• The owners are interested in ways to reduce taxes as they fall into the 35% tax rate
• A 401(k) and profit-sharing plan is currently in place with $2,000,000 in plan assets
• The two owners of the business have account balances of $750,000 each or $1,500,000 total
• The eight employees’ balances are a combined $500,000
• Common Plan Expenses Itemized:
  • Record Keeping: $4,000 or 0.2%
  • Third-Party Administrator: $1,000
  • Fiduciary Services 3(38): $2,000 or 0.1%
  • Investment Advisor: $10,000 or 0.5%
  • Average Internal Mutual Fund Costs: $4,000 or 0.2%
  • Total Annual Plan Expense: $21,000 or approximately 1.05%

Now consider the different options you have to pay these plan expenses.

Option 1: Paying the Expenses with Plan Assets

Paying plan expenses by deducting them from plan assets is the most common way small businesses pay for the company’s retirement plan. The 1.05% annual plan expense is paid quarterly at a rate of 0.26% of a participants account balance.

Cost breakdown:

• Owners: $15,750 or 1.05% of $1,500,000 account balances
• Participants: $5,250 or 1.05% of $500,000 remaining account balances

Thus the owners pay 75% of all plan expenses because that is the prorated portion of their account balances in this plan. Small business plans like this example typically have the majority of the plan assets in the owners’ or partners’ accounts. A common misconception is that as a business owner, you don’t pay any retirement plan fees because you don’t “write a check” for them. The costs to administer a retirement plan will vary, but there are always costs associated with it.

Option 2: Business Pays the Expenses

Paying plan expenses through the business can offer a significant advantage to the business owners and to the participants of the retirement plan. As a business owner, you have the ability to pay all of these plan costs, except internal fund costs, outside the plan as a tax-deductible business expense.

Cost Breakdown:

• Business Expense: $17,000 ($21,000 minus $4,000 in fund costs)
• Owners: $3,000 or 0.2% of the $1,500,000 account balance for internal mutual fund costs
• Participants: $1,000 or 0.2% of the $500,000 account balance for internal mutual fund costs

In this case, the company would be paying approximately 81%, or $17,000, of the retirement plan fees as a business expense. Assuming a 35% tax rate, this saves the company or owners $5,950 in taxes. So while the business is still paying $17,000 in plan expenses, it's able to deduct the $5,950. The owners are now paying $11,050 in plan administrative expenses versus the $12,750 when paid by plan assets. By having the company pay the retirement plan expenses, it saves the business owners $1,700 in annual costs and the employees $4,250 in annual fees.

Long-Term Impact of Retirement Accounts

The greatest impact of having the business pay retirement plan expenses will be realized in the long-term growth of the owner's and participant's retirement accounts. The two scenarios below will illustrate that impact.

The first calculation will take into account the impact on an owner’s account balance. Assuming a 7 percent rate of return, maxing out the 401(k) and profit-sharing contributions at $54,000 annually for a 45-year-old in 2017, and saving that amount for 20 years, the potential impact is $603,139. The current account balance of $750,000 would grow to $4,961,678 versus $4,358,539 if the fees are paid pro-rata from the owners’ account balance. However, this difference doesn’t take into account the owner’s ability to invest the $11,050 they are now paying for plan expenses outside the retirement plan. This would dilute the impact to the owners over the 20 years.

The second calculation analyzes the potential impact on a 30-year-old employee’s account over 35 years. Starting with an account balance of $50,000 and saving $5,000 per year, the difference in fees would have an impact of $232,459 or a retirement account balance of $1,161,747 versus $929,288.

Keys to Success

• Itemized Plan Expenses:
  • Review your current plan to make sure the fees you are paying are itemized according to the service being provided as they are in the above case study. If they are not itemized, you may have a plan that is “bundled” or “wrapped” into one “asset fee” by your provider.  This is where the record keeper, Third Party Administrator, plan advisor, and fiduciary service fees may all be combined into one fee, referred to as an “asset charge.” This type of arrangement not only makes it difficult to determine what you are paying for each service but can also be difficult to fully separate it from the cost of the investments.
  • Having the fees itemized also allows business owners the flexibility to choose which expenses are paid by the business versus those that are passed onto the employees.
• Flexible Service Providers:
  • Business can change from year to year. Make sure your service providers are able to change the way fees are charged to the plan if the situation requires it.
  • The flexibility of your providers can also benefit a company that wants to pay a set amount of expenses through the business and the rest through participant account balances.
• Institutional Low-Cost Mutual Funds:
  • Review the share class of your plan’s investment options. Make sure the mutual funds are the lowest expense share class available and don’t have any 12b-1 fees or revenue sharing. Those fees increase the internal expenses of the mutual fund.
  • Consider passive investment options, as they will have lower fund expenses than their actively managed counterparts.

If structured properly, the fees of maintaining a 401(k) and profit-sharing plan can provide short-term tax benefits for business owners and a significant long-term impact on the retirement accounts of the business owners and their employees. It’s important to not only review the fees you are paying for your plan but to also explore the company’s options in how those fees are paid.

IMPORTANT DISCLOSURE INFORMATION