The 5 Most Popular Small Business 401(k) Plan Features

Tens of thousands of dollars are on the line. 

This might sound a bit sensational, but when it comes to choosing the right type of 401(k) plan, this is true a lot more often than many small business owners realize. 

Over the years, our firm has helped thousands of business owners design a 401(k) plan for their company. During these consultations, I can’t tell you how many times we’ve seen a business save thousands in annual contribution expenses by choosing one type of 401(k) plan over another, while still meeting their plan goals.

And it’s not just money that’s at stake.

Choosing the wrong type of 401(k) plan can result in failed nondiscrimination testing, countless hours of administrative hassle, and can ultimately make it more difficult for the plan to achieve its goals.

So it goes without saying that choosing the right plan is important. The problem? 401(k) plans are complex, and it can be really difficult to know which type of 401(k) plan is best for you. 

Our goal today is to make it easy.

Using data gathered in our study of 3,975 small businesses, we’ll break down the 5 most popular “types” of 401(k) plans. We’ll explain how they work and why they’re so popular, helping you come to the quickest decision as to which type is best for you.

Before we dive in though, there’s a common misconception we’ll need to clear up...

There Aren’t Exactly “Types” of 401(k) Plans

The notion that there are different types of 401(k) plans that are distinct from one another is not technically accurate.

You see, 401(k) plans are highly-customizable. What you might think of as different plan “types” (safe harbor, Roth, profit sharing, etc…) are in fact different contribution “features” that can be added to a plan in various combinations.

We’ll now discuss your feature options and how to decide whether each is right for your plan or not.

The 5 Most Popular 401(k) Contribution Features 

Small business owners can have dramatically different goals for their 401(k) plan. While some want to maximize their personal contributions, others want to incentivize contributions from employees across the organization. The process of matching a small business’s goals to available 401(k) features is called plan design. 

The five most popular contribution features that small businesses add to a 401(k) during the plan design process are:

1. Safe harbor – allows a 401(k) plan to automatically pass the ADP/ACP and top-heavy nondiscrimination tests. To achieve safe harbor status, a small business must make a qualifying nonelective contribution or match to plan participants. 
2. Roth – allows plan participants to make salary deferrals on an after-tax basis.
3. Automatic enrollment – allows a small business to automatically enroll plan-eligible employees that fail to make an affirmative salary deferral election themselves.
4. Profit sharing – allows a small business to allocate a contribution to any plan participant, regardless of whether they make pre-tax or Roth salary deferrals themselves or not.
5. Discretionary match – allows a small business to match a percentage of the pre-tax or Roth salary deferrals made by plan participants.

Last year, we studied the plan designs of 3,975 small business 401(k) plans. Below is the adoption rate we found for each feature: 

We’ll now walk you through each of these features and why you might want them.

69% of Small Businesses Add Safe Harbor Contributions

Safe harbor 401(k) plans are very popular with small businesses. Unlike a traditional (non-safe harbor) 401(k) plan, they automatically pass the ADP/ACP and top heavy nondiscrimination tests when mandatory contribution and participant disclosure requirements are met. This benefit is well worth the cost for many business owners, who often bear the brunt of the consequences when nondiscrimination tests fail. 

Reasons to add a safe harbor 401(k) feature

• You expect your plan to be top heavy. A top heavy 401(k) plan must generally make a 3% minimum contribution to non-owners. That means adding a safe harbor contribution to a top heavy 401(k) plan may add little to no cost. A safe harbor match might even lower the cost of your plan if participants defer at low rates.
• You expect your plan to fail ADP/ACP testing. A safe harbor plan allows HCEs to maximize annual contributions without the risk of corrective refunds due to failed testing.
• You want to offer a generous retirement benefit to employees.

Reasons to avoid

• You plan will have no trouble passing the ADP/ACP and top heavy tests.
• You may not be able to afford the feature’s mandatory contribution requirement
• You want to incentivize long-term employment by adding allocation conditions (e.g., 1,000 hours, employment on last day of plan year) and/or vesting schedule to employer contributions.
• You want to use a “stretch” match formula (e.g., 25% of salary deferrals up to 10% of compensation) to incentivize plan participants to make bigger salary deferrals. 

71% of Small Businesses Add Roth Contributions

Roth contributions allow plan participants to build a tax-free nest egg for retirement. To do so, however, they must pay taxes on these contributions in the year they are made — at personal income tax rates. This differs from traditional 401(k) salary deferrals, which are tax-deductible in the year they are made - and taxed in retirement. 

With Roth IRAs growing in popularity, having this as a feature in your 401(k) may be popular with your employees as well, as people really like the idea of tax-free income during retirement. It’s especially popular among younger, lower-earning employees who are early in their careers and expect to be in a higher tax bracket by the time they retire. 

Essentially, if employees expect to be making a lot more money down the line, it might make sense to pay income taxes on their employee contributions now while they’re in a lower tax bracket.

There’s Little Reason Not to Offer Roth

Honestly, there’s little reason not to offer this contribution feature. It requires a little extra work when setting up your payroll for contributions, but this isn’t terribly time-consuming or complex. If you’ve yet to set up your plan or are thinking of changing it, this is an excellent box to check. 

Only 9.53% of Businesses Add Automatic Enrollment

Automatic enrollment allows a small business to automatically enroll eligible employees that fail to make an affirmative salary deferral election themselves. For plans that struggle to pass nondiscrimination testing, automatic enrollment can be a way to increase in employee participation.

Reasons to add an automatic enrollment feature

• For plans that struggle to pass nondiscrimination testing, automatic enrollment can be a way to increase in employee participation – which often improves increases the amount HCEs can contribute annually with no testing issues. 
• Following the passage of the SECURE Act, small businesses can earn a $500 tax credit by adding an automatic enrollment feature to a new or existing 401(k) plan. The credit is available for each of the first three years the feature is effective.
• A Qualified Automatic Contribution Arrangement (QACA) can reduce the cost of a safe harbor plan. The QACA match is less costly than other safe harbor matches (3.5% of compensation vs. 4%) and QACA contributions can be subject to a vesting schedule.

Reasons to avoid

• In general, the feature adds administrative complexity to a plan and a failure to properly enroll employees automatically can be a costly mistake to fix.
• Employees may not like having their take-home pay reduced without their explicit consent.
• Automatic enrollment can actually lower salary deferral rates when participants see a low default deferral rate as a de facto recommendation - making plan nondiscrimination testing harder to pass. 

84.81% of Small Businesses Add Profit Sharing

Bar none, profit sharing contributions are the most flexible type of employer contribution a small business can make to their 401(k) plan. These contributions are not only discretionary, but they can be made to any eligible plan participant – even if the participant does not make salary deferrals themselves. They can also be allocated using dramatically different formulas – allowing employers to meet a broad range of 401(k) plan goals with them. 

Reasons to add a profit sharing feature

• A “new comparability” or “integrated” formula can be the cheapest way to get business owner contributions up to the IRS legal limit ($73,500 for 2023 with catch-up contributions).
• Profit sharing contributions are discretionary. If your business is a startup, has erratic profitability, or frequently acquires other companies, you may not be in a position to make an employer contribution every year. This isn’t a problem with profit sharing contributions. At the end of each year, you have control over whether to contribute, and if so, how much.
• Because profit sharing contributions are usually made in good years only, the feature can help incentivize employees to care more about your bottom line. 
• Profit sharing contributions can be flexible enough for you to target individual employees for more generous contributions. 
• Unlike an employer match, employees are not obligated to contribute salary deferrals themselves to receive a profit sharing contribution. If you have a lot of employees who don’t earn enough to save for retirement, profit sharing could be an excellent way to take care of them and make your benefits more competitive.

Reasons to avoid

Adding this discretionary contribution feature to a 401(k) plan could set an expectation with employees that a contribution will be made when in fact there is little to no chance of it.

59.70% of Small Businesses Add A Discretionary Match

One of most effective ways a small business can persuade employees to contribute pre-tax or Roth salary deferrals to a 401(k) plan is by matching some portion of them. This is unsurprising when you consider an employer match is like a guaranteed return on salary deferrals - or “free money.” 

Most employer matches that aren’t intended to meet safe harbor 401(k) requirements are discretionary in nature – so small businesses have the option to make them or not. A discretionary match made to a traditional (non-safe harbor) 401(k) plan must pass the ACP test to be considered nondiscriminatory, while a discretionary match made to a safe harbor plan can be exempt from the ACP test when certain conditions are met.

Reasons to add a discretionary match feature

• Employees must contribute salary deferrals themselves to receive an employer match. Because few employees tend to leave this “free money” on the table, an employer match usually increases the salary deferrals made to a 401(k) plan.
• The ADP test is used to test the salary deferrals made to a traditional (non-safe harbor) 401(k) plan for nondiscrimination. A discretionary match can help a plan pass the ADP test by increasing salary deferrals. A “stretch” match (e.g., 25% of salary deferrals up to 10% of compensation) can increase salary deferrals even further.
• if your business is a startup, has erratic profitability, or frequently acquires other companies, you may not be in a position to make an employer contribution every year. This isn’t a problem with a discretionary match. At the end of each year, you have control over whether to contribute, and if so, how much.

Reasons to avoid

Adding this discretionary contribution feature to a 401(k) plan could set an expectation with employees that a contribution will be made when in fact there is little to no chance of it.

There’s No Such Thing as a One-Size-Fits-All 401(k) 

401(k) providers will sometimes limit your plan design options to a handful of canned, “off-the-shelf” designs. While this limitation can seem convenient, it’s not meant for your benefit. It’s meant to steer you towards basic plan designs that are cheap for your 401(k) provider to administer.

Don’t fall for it! There is no such thing as a one-size-fits-all 401(k) plan and choosing the wrong combination of contribution features can cost your small business thousands of dollars in unnecessary contributions or hours in unnecessary hassle. 

If a 401(k) provider is unwilling to custom design a plan for you based on your specific goals and budget – go elsewhere. This process is can often be completed in 30 minutes or less - a small amount of time to spend when you consider the consequences of poor plan design.