5 reasons to start a 401(k) plan on January 1

Thinking of starting a 401(k) plan? Great! Not sure when to actually start it? No problem.

While many business owners want to start as soon as possible, this can cause some unintentional issues that can last for years. We say, the earlier within a calendar year, the better. Here are some reasons why starting a new 401(k) at the beginning of a new year is a smart idea.

1. Employees will have the full year to make deferrals.

In general, you can only contribute up to 100% of your paycheck for each pay period. And, you can’t retroactively make 401(k) contributions from paychecks received before the plan started. So if an employee doesn’t make at least $20,500 from the start of the plan to the end of the year, they won’t be able to max out for that year.

As a business owner with a high income, you might be able to max out your contributions. But if your employees don’t have funds to max out their contributions, your plan may have nondiscrimination testing issues (see #3 below).

Starting your 401(k) on January 1 may take a lot of these issues off the table and help to prevent any mistakes in over-contributing during a short plan year.

2. Employer matching contributions may be limited otherwise.

Many people think they can still take full advantage of an employer match late in the year, by contributing larger sums of money in just a few months. But many 401(k) plans (including Guideline plans) calculate matching on a per-pay-period basis. For these plans, your matching contribution is calculated based only on that pay period’s contribution—not the whole year.

Let’s look at an example:

Adam’s Apples sets up a 401(k) plan to start November 1, with 4 pay periods left. They provide a dollar-for-dollar match up to 5% of an employee’s pay. Adam makes $250,000 and contributes 5% of his total yearly pay, $12,500. It seems like Adam should get $12,500 in employer matching as well. But if it’s a per-pay-period match, Adam will only get a match during the pay periods he contributes. Since there are only 4 pay periods, and his per-pay-period deferral rate is nearly 30%, he would only get $2,083 in matching contributions, as opposed to the full $12,500 from contributing each of the 24 pay periods ($520.83 is the 5% match x 24 pay periods).

If you start your plan on January 1, you can generally avoid this confusion for your employees and prevent a lot of unintended miscommunication. Most employees tend to spread their contributions throughout the year to keep things manageable. Be sure to also inform your employees of how the per-pay-period match works, even if it’s January, so that the certain strategic employees understand not to front or backload their contributions for the full year.

3. Nondiscrimination testing is more predictable.

Many business owners intend to put as much money as they can into their accounts before the end of the year. The biggest problem with this is that most of their employees won’t be able to do the same thing. When you have a big discrepancy between the contributions of owners and executives, versus those of other employees, you will most likely have a problem with nondiscrimination testing — which can result in unexpected costs to the employer.

In a short plan year, there’s not much time to figure out whether your plan will pass or fail nondiscrimination testing. Starting a 401(k) plan on January 1 will give you a full 12 months to monitor your plan’s activity and assess its compliance testing risk. Some plan providers, like Guideline, will conduct preliminary testing for you throughout the year so that you can strategize on how to best make your plan work for your company.¹  

4. Safe Harbor match plans can’t be started after October 1.

Many small business owners avoid nondiscrimination issues by setting up a Safe Harbor 401(k) plan. These are especially great for small businesses, since fewer employees make it harder to pass testing. The deadline to set up a new Safe Harbor 401(k) plan with one of the required matching formulas is October 1, of any given year. Any plans that start after that aren’t eligible for Safe Harbor status based on a match formula but would have to include a non-elective contribution which would have to be given to all participants, even those who do not defer into the plan.  

As a small business, starting your plan as Safe Harbor on the first day of the following year is a great way to have a clean benefit offered for the full year to employees, while helping minimize compliance headaches.

5. Changing with other benefits keeps things clean.

Finally, sometimes it just makes sense to start a new benefit at the start of the new year. Many companies switch benefits providers or start new benefits on January 1 of any given year. Your employees will appreciate being able to learn about their health, retirement, and other benefits all at once, and not have to remember different start dates for different benefits.

There are many reasons why a January 1st start to your 401(k) makes sense, but that doesn’t mean you have to wait until the last minute to set one up. Guideline can help you with all the details several weeks before the plan starts, so that you won’t be rushed through the process. Contact us at hello@guideline.com or (888) 228-3491 to get started.

The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax advice that considers all relevant facts and circumstances. Guideline makes no representations or guarantees with regard to investment performance as investing involves risk and investments may lose value. Clients should consult a qualified investment or tax professional to determine the appropriate strategy for them.

¹ All plans of related entities must be administered by Guideline in order to provide compliance testing.