Small business plans stand tall in latest report

Crystal Hardie Langston, Head of Vanguard Retirement Plan Access

Although our team has been working on the Small Business edition of our How America Saves 2015 report for many months, I could hardly wait for the finished product. In the past year that I’ve had the privilege of leading Vanguard Retirement Plan Access™ (VRPA), I’ve observed first-hand the efforts small businesses are making to help their employees meet their retirement goals. It’s gratifying to see how well their defined contribution (DC) plans are doing. And with this report it’s pretty powerful to see the success of those plans in aggregate. You might expect plan design and participant behavior to differ between large and small firms, but we’re tracking encouraging trends across the board and the data are remarkably similar.

For example, 69% of eligible employees at larger companies contribute to their plans compared to 65% at small companies represented by VRPA. Participants at large and small companies also take advantage of Roth contributions, catch-up contributions, and “max out” their contributions at a similar rate.

Interestingly, smaller plans are even doing better than larger plans in these areas:

• State-of-the-art offer. Most plan sponsors don’t actively ensure that their DC offer is “state-of-the-art” on a regular basis. However, if the plan moves to another provider, they usually do an evaluation. Because VRPA plans either converted within the last three years or were new start-ups, they are likely to have state-of-the-art offers.
• Target-date funds. Nearly all VRPA plans offer TDFs, which translates to a higher allocation of assets and contributions to these funds.
• Balanced portfolios. More than half of VRPA plan participants hold a single TDF, which contributes to the data showing nearly 80% of VRPA plan participants hold balanced portfolios.
• Reenrollment strategy. 70% of VRPA plans used a reenrollment strategy at conversion and 95% reenrolled into a TDF.

Of course, these numbers aren’t really a surprise to those of us who work with VRPA clients. A few years ago when Vanguard took a closer look at this marketplace, it was clear that small businesses were being underserved and overcharged. It’s the reason we launched VRPA in 2011. As a leading retirement plan provider with deep expertise, we felt we could make a difference by supporting and partnering with plan sponsors and their financial advisors to create better retirement outcomes.

We love the opportunity to work with new plan sponsors who are eager to set their employees up for success. One of the first small businesses we partnered with was a boutique investment firm with a highly sophisticated workforce. Their management team was eager to move their plan to Vanguard because of our low costs and investment philosophy. While their employees certainly had the investment expertise to design their own portfolios, our team recommended a best-practice approach to design a state-of-the-art program by implementing reenrollment into target-date funds. This would help keep costs low and portfolios diversified, and would satisfy the QDIA requirements to gain fiduciary relief. Their plan is now among the many offering target-date funds as a way of helping their participants maintain balanced portfolios over time.

Although VRPA plans are doing well overall, it is engrained in our culture here at Vanguard to constantly look for ways to improve. Based on the data from our report, there are several ways small business plans can improve their employees’ retirement outcomes:

• Adopt automatic enrollment with higher initial contribution rates.
• Implement automatic annual increases with a total participant contribution cap of at least 10%.
• Default employee contributions at a level that maximizes the employer match and increases their deferral rate until individuals are saving at least 10% of their pay.

How America Saves, Small business edition is a great research tool for plan sponsors and advisors. This year’s report shows a number of positive trends and highlights what small businesses are doing to provide essential retirement benefits for their employees. VRPA is making a difference, and that’s definitely good news for small plans and their participants.

How does your plan shape up?

Notes:

• Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a target-date fund is not guaranteed at any time, including on or after the target date.
• All investing is subject to risk, including the possible loss of the money you invest.

About Crystal Hardie Langston

Crystal Hardie Langston is an officer and head of Vanguard Institutional Sales’ Small Market Department. Her department is responsible for Vanguard Retirement Plan Access™, a comprehensive suite of 401(k) retirement plan services for small businesses. Before her current position, Mrs. Langston was an officer in Vanguard Corporate Strategy. Her previous Vanguard roles include leading the relationship management team and internal sales organization in Vanguard Financial Advisor Services™ and serving as chief of staff for the institutional division. Mrs. Langston started her Vanguard career as a relationship manager. Before Vanguard, she was an analyst with Banc of America Securities debt capital markets department. Mrs. Langston earned a B.S. from the University of Virginia and an M.B.A. at Duke University’s Fuqua School of Business. Mrs. Langston is a cofounder and leader of the Vanguard Black Professional Network. She is also board chair for Urban Tree Connection, an organization focused on community-based urban greening in Philadelphia.

Correcting missed required minimum distributions

Federal tax law requires every qualified plan to provide required minimum distributions (RMDs) as soon as a participant reaches his or her required beginning date (RBD). Generally, the RBD is April 1 of the year after the participant reaches age 70½, though it may be later if the participant owns 5% or less of the employer and continues to work for the employer beyond age 70½.

If an individual worked at seven jobs during his or her career and left money in seven different qualified plans, each plan is required to distribute an RMD to the individual. In the event of a participant’s death, the plan is required to follow the minimum distribution requirements for beneficiaries.

Failure to distribute an RMD may result in plan disqualification and/or the imposition of a 50% excise tax on the participant or beneficiary. This article explains the correction process that is available when a qualified plan fails to timely distribute an RMD.

Missed RMDs from qualified plans
Mistakes can result in one or more missed RMDs. For example, an employee’s date of birth may be incorrectly provided to the recordkeeper or third party administrator, inadvertently causing the employer and plan administrator to be unaware of the year that the employee attained age 70½. Or, an employee’s data may have been lost in a merger or acquisition.

Upon discovery of a missed RMD, all appropriate steps should be taken to remedy the situation as soon as possible. Specifically, the RMD should be immediately distributed along with calculated earnings. If the employer files under the IRS’s Voluntary Correction Program (VCP), the employer may request that the IRS waive the excise tax imposed on the missed RMD.

Excise tax
As noted, a participant or beneficiary who does not receive a full RMD for a distribution calendar year is subject to a federal excise tax of 50% of the underpayment. For example, assume an RMD is $3,200 for 2015, but the participant received only $2,000. The underpayment of $1,200 is subject to the 50% excise tax of $600. The $1,200 still has to be withdrawn. The participant files IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with his or her federal income-tax return for the year in which the error occurred.

Waiver of the 50% penalty due to reasonable cause
If the employer does not request waiver of the excise tax under VCP, the participant or beneficiary may be granted a waiver for the excise tax when they file Form 5329 if there was a reasonable cause for the failure to take the RMD and steps are taken to remedy the shortfall. The IRS will review the information provided and decide whether to grant the request for the waiver.

Automatic waiver for certain beneficiaries
An automatic waiver may be available in situations where the participant dies before reaching his or her RBD and an individual is the sole beneficiary of a participant’s benefit or of a separate share of the participant’s benefit. If the amounts are payable under the life expectancy method and a payment is missed during the first five years, the excise taxes are waived if the total death benefit or separate share is paid under the five-year rule.

Correcting RMD failures using the Employee Plans Compliance Resolution System (EPCRS)
The EPCRS provides a streamlined procedure for correcting missed RMDs under the VCP using Form 14568-H, Appendix C Part II Schedule 8, Failure to Pay Required Minimum Distributions Timely under §401(a)(9). As part of the VCP submission, the employer is able to request the waiver of the participant level excise tax imposed under IRC Sec. 4974.

Fee schedule for RMD failures
IRS Revenue Procedure 2015-27 recently updated the VCP fee for missed RMDs, amending it to $500 for missed RMDs involving 150 or fewer participants. The compliance fee is $1,500 when 151 to 300 participants are involved. If more than 300 participants failed to receive RMDs, the IRS’s general fee schedule, which is based on the number of participants in the plan, will be used.

Correction includes distribution of missed RMDs plus earnings
In a defined contribution plan, the permitted correction method under EPCRS is to distribute the missed RMDs with earnings from the date of the failure to the date of the distribution. If more than one year’s RMD has been missed, the amount required to be distributed is the RMD for each year, starting with the year in which the initial failure occurred. Amounts are determined by dividing the adjusted account balance on the applicable valuation date by the applicable distribution period and then calculating the earnings for each missed RMD.

Example: A defined contribution plan missed a participant’s RMDs for 2013, 2014, and 2015. The participant was born in 1941.

The missed RMD for 2013 would be calculated as follows:

• December 31, 2012, fair market value (FMV) $100,000 ÷ 25.6 (age 72) = $3,906.25*

The missed RMD for 2014 would be calculated as follows:

• December 31, 2013, FMV $108,000 – $3,906.25 ÷ 24.7 (age 73) = $4,214.32*

The missed RMD for 2015 would be calculated as follows:

• December 31, 2014, FMV $115,000 – $3,906.25 – $4,214.32 ÷ 23.8 (age 74) = $4,490.73*

*Gains/losses are calculated on each RMD from the date the RMD should have been distributed until the actual distribution date.


Copyright © 2016 by NPI and McKay Hochman.

2016 contribution limits

The IRS announced the 2016 cost-of-living adjustments (COLAs) to applicable dollar limitations for retirement plans.

Retirement Plan Limitation	Contribution Limit
402(g)(1) salary deferral limit	$18,000
Catch-up contribution	$6,000
415(c)(1)(A) annual additions limit (defined contribution plans)	$53,000
415(b)(1)(A) annual benefit limit (defined benefit plans)	$210,000
Key Employee Officer amount*	$170,000
Highly Compensated Employee (HCE)*	$120,000
SIMPLE plan salary deferral limit	$12,500
SIMPLE plan catch-up contribution	$3,000
Annual compensation cap	$265,000
Social Security taxable wage base	$118,500
SEP plan minimum compensation amount	$600

How much Roth can employees contribute in 2016?

If your plan allows for Roth 401(k) deferrals, your employees should be mindful of how these deferrals apply toward the maximum 402(g) limit. 

First, employees need to know that the maximum deferral limit is $18,000 in 2016. If employees are eligible for catch-up contributions, they can contribute an additional $6,000 above that. 

Deferrals—which include pre-tax 401(k) and Roth 401(k) contributions that employees request to have deducted from their pay—are combined and applied to the maximum deferral limit. For example, if employees wish to max out on their deferrals in 2016, they can contribute $10,000 in pre-tax and $8,000 in Roth. 

If employees are eligible for catch-up, either pre-tax or Roth can be deferred and combined toward the additional $6,000 limit. 

Also, be aware that the pre-tax and Roth deferrals are combined to calculate the Average Deferral Ratio for each employee if your plan is subject to ADP/ACP testing.

The ADP test

Congress has devised several types of nondiscrimination tests designed to prevent qualified retirement plans from favoring highly compensated employees (HCEs) disproportionately. One such test is the average deferral percentage (ADP) test. The ADP test is required to be performed annually and entails the use of mathematical formulas to compare the elective deferral rates of HCEs and non-HCEs (NHCEs) and to determine whether the plan is discriminating in favor of the HCEs.

Who is an HCE? 

Generally, an HCE is an employee who is either:

• A more-than-5% owner of the business (also known as a 5% owner) in the year of testing or the prior year, or 
• Someone who earned more than $80,000 in compensation in the prior year, as adjusted annually for cost-of-living increases. For 2015, the cost-of-living adjusted limit is $120,000.

It is possible to further limit the number of HCEs to those in the top 20% of employees when ranked by pay (which can be a particularly effective tactic for small employers, such as law firms and physicians). 

All in the family

The 5%-owner rule requires careful review of the ownership attribution rules for families. Based on their relationship, an individual is deemed to own the stock of a corporation owned by other family members. The family members taken into consideration for purposes of determining attribution of ownership include spouses, parents, children (including adopted children) regardless of age, and grandchildren. An individual can also be deemed to own the stock held by partnerships, corporations, estates, and trusts. 

Here’s an example of how the family attribution rules work: If a husband and wife each work for a firm and the husband is actually the sole owner, the wife would also be considered a 100% owner of the business and, thus, an HCE. 

Performing the test

To perform the ADP test, first determine all of the employees who were eligible to make elective deferrals during the plan year. It does not matter if an employee actually made an elective deferral but only whether the employee was eligible. Divide the eligible employees into HCEs and NHCEs. 

Then, starting with the NHCEs, determine each employee’s actual deferral ratio (ADR) by dividing the employee’s elective deferrals for the plan year by the employee’s compensation. Employees who were eligible but did not defer are included in this calculation at 0%. Once each NHCE’s ADR is determined, the ADRs are averaged to arrive at the ADP for all NHCEs. Here’s an illustration:

NHCE	Compensation	Deferral	ADR
1	$70,000	$4,000	5.71%
2	$28,000	$0	0%
3	$30,000	$800	2.67%
4	$10,000	$0	0%
5	$47,000	$2,000	4.26%

NHCE ADP (5.71% + 0% + 2.67% + 0% + 4.26%) =12.64 ÷ 5 = 2.53% 

The same process is used to arrive at the ADP for all HCEs. 

For a plan to pass the ADP test, the amount by which the HCE ADP exceeds the NHCE ADP is limited. The limits may be summarized as follows:

NHCE ADP	Maximum HCE limit
0 to 2%	NHCE limit × 2
2% to 8%	NHCE limit + 2
> 8%	NHCE limit × 1.25

For the plan to pass the ADP test, the HCE ADP is limited to 4.53% (NHCE ADP) plus 2%. 

Timing the test

A failed ADP test must be corrected within 12 months after the end of the plan year to avoid disqualification of the plan. To avoid a 10% excise tax on an excess contribution, either the excess contribution (and the applicable earnings) must be refunded within two and a half months (six months for an eligible automatic contribution arrangement) following the end of the plan year, or additional contributions must be made to the plan. 

Other factors 

This is the big picture of how the ADP test is performed. There is a variety of additional factors to be taken into consideration to optimize the test results.

Copyright © 2016 by NPI and McKay Hochman.