There are four types of contributions that may be made to a 401(k) plan: elective contributions, after-tax employee contributions, matching contributions, and nonelective contributions. Effective for plan years beginning in 2006 and later, there are two types of elective contributions—pre-tax elective contributions and designated Roth contributions. We’re going to look at employer matching contributions, types of match contributions, and show you some examples of match formulas that are most common.
Matching contributions are employer contributions that are made on account of elective contributions (or after-tax employee contributions). The term also includes forfeitures that are allocated as matching contributions. These types of contributions are tested for nondiscrimination purposes in the actual contribution percentage (ACP) test under IRC §401(m) – this is where you’d want a 401(k) TPA like Uniglobal to help.
You’ve just started a new job, maybe this is your first job right out of college, or you’ve decided a career shift was in order. Whatever the case may be, your new employer probably offers some kind of retirement plan program. This could be a 401(k) or perhaps a 403(b) plan (and if not, here is where you can send them to get one started). Although a traditional 401(k) can have a matching component, it is not mandatory that the employer make a match. On the other hand, if the employer is sponsoring a Safe Harbor 401(k) plan, wherein the Match is the Safe Harbor contribution, then it is mandatory.
We will cover the two main types of 401(k) plans that offer an employer match in this post. The IRS discusses the different types of 401(k) plans that could have an employer match as well, but we go into a little more detail here.
As mentioned above, a traditional 401(k) could have a 401(m) component which the employer may or may not elect to offer. These types of employer contributions are discretionary; whether or not they are afforded is at the discretion of the company. More often than not, when offered, we see a vesting scheduled tied to the employer match. A vesting schedule determines what percentage of the participants’ employer match account is theirs and which is subject to forfeiture. A participant who leaves the employ of an employer that has contributed a discretionary match to his or her account that is subject to a vesting schedule, may not receive 100% of that money source.
Example 1:
Cynthia has worked for almost 3 full years as a full-time employee since she was hired one January; during which time she has contributed to her 401(k) and received a discretionary employer match on her contributions. The match has a vesting schedule of 25% per year of service, where a year of service is defined as working 1000 hours or more. Since she works more than 1000 hours in a year she should be 100% vested by the middle of her 4th year. Unfortunately, Cynthia found a better position elsewhere, with a better retirement plan. She leaves in November of her 3rd year. She is only 75% vested in the match. When she rolls her money over to her new employers plan, only 75% of her match account will come with her. The remaining 25% remains in the plan and is forfeited to a holding account in the plan called a forfeiture account.
Had Cynthia remained with her employer for another 7-8 months (assuming 160 hours a month) she would have been 100% vested by July of her 4th year.
This might seem unfair but think of it from the employers perspective. This is free money to the participant. If the match is thought of as a reward for plan participation and contributing towards a participants own retirement, should there be a reward for leaving the job early? Many employers might not think so. Ergo, the vesting schedule. But, there is another type of Match that is almost always 100% vested when made – the Safe Harbor Match.
These plans are great, for everyone – employer and employee. The Match is 100% vested almost always immediately and it is guaranteed. So long as the participants contribute of they own volition a match is allocated to their account.
Example 2:
Sandy was recruited for her prowess in her field. Her new employer understands that a good well-rounded benefits offering is in order, not just for this one hire but for the whole company. Since Sandy is of such value to the company, the employer elects a Safe Harbor plan rather than a traditional. The employer feels that everyone should receive, as a match, 100% of what they contribute up to the first 5% of their compensation. This means that if a participant contributes 5% the employer will match 5%, if one contributes 3% the match is 3% or if 10% is contributed only 5% of compensation is a match.
Sandy earns $150,000 in W2 compensation for years 1 and 2. She deferred $12,000 in each year, which is 8% of her compensation. The employer match is 5%, or $7,500 a year, and is 100% vested immediately.
This is great, right? Sandy has $15,000 in match in her account in just 2 years. For Sandy, this is fantastic! But what about the employer? There is no vesting schedule on that money. If Sandy leaves after her second year, she can take all the match in her account with her.
Here is why this is good for the employer. If you recall, Sandy was recruited because of her talent in her field. In a Safe Harbor plan, the ACP test is deemed to pass if no other employer contribution is provided except for the Safe Harbor match. This is good for the employer because under a traditional 401(k) the match would have to be tested, and if the test fails, Sandy may have received not just part of her deferrals back as a refund for test failure but the match on those deferrals would have been taken from her account as well. Why is this so you ask? Well, Sandy, in this example, is an HCE, a highly compensated employee. The plan cannot favor the highly compensated employees over everyone else.
Electing a Safe Harbor plan could avoid a situation where an employee is unable to really benefit from the plan like the other participants, so, the win for all is a guaranteed match that satisfies testing.
A Match formula takes not only salary deferrals, or Roth contributions, into account but also the compensation that is involved. If a participant earns $1,000 before taxes every pay period and defers $100 from that, which is 10%, the match would take the $1,000 in compensation and the $100 deferred into consideration. An employer match formula may look something like this:
Whatever the match formula is, the key is to defer as much as possible to get the full employer match, without strapping yourself financially.
In either case, a traditional 401(k) with a match that has a vesting schedule or a Safe Harbor 401(k) plan with a Match it’s always a good idea to participate. Employees save for retirement and are rewarded with free money in the form of an employer match.