A matching contribution is a match of an elective deferral. If the employee does not contribute to the plan through payroll deduction, then they won’t get a match. A matching contribution provides an incentive for the employee to deposit funds in the 401(k). This is helpful for plans that are not Safe Harbor, as the increased deferrals help the 401(k) testing rules. (See our blog on 401(k) rules for more information on testing)
- Discretionary match. Under this option, the Plan document leaves the matching contribution formula up to the employer’s discretion. It can be declared in advance, and contributed as frequently as each pay period. Or it can be determined after the end of the year once the budget is more established.
Formulas can range with your imagination. From as little as 10% of elective deferral, to 200% of the deferral. Limits can be placed on the match too. For example, if your budget for the match is 2% of pay, the formulas below all cap the match at no more than 2% of pay:
- 100% of the deferral capped at 2% of pay, or
- 50% of the deferral capped at 4% of pay, or
- 25% of the deferral capped at 8% of pay.
Discretionary matching contributions may be subject to a vesting schedule, so an employee may have to work up to 6 years to be fully vested in the contribution made by the company.
If allocated as of the end of the year, the employer may also have restrictions that an employee work for 1000 hours, and be employed on the last day of the year to receive the match for that year. There are rules about coverage, but this option can avoid having to fund a match for former employees.
- Fixed match. The employer may choose to establish a fixed matching contribution formula in the Plan document. Under this option, the formula outlined in the plan document must be funded until the document is amended.
Contribution formulas, vesting, testing, and allocation provisions are the same as a discretionary match.
- Safe Harbor match. Safe Harbor provisions change the complexion of a 401(k) plan. By adopting Safe Harbor rules, you plan will automatically pass the 401(k) compliance tests, and satisfy top-heavy minimum contributions. With these benefits come rules, though. For full details see our blog post on Safe Harbor plans.
There are two options for Safe Harbor match:
- Basic match: 100% match of the first 3% of pay deferred, plus 50% on the next 2% of pay deferred. So if the employee defers 5% of pay or more, the company will match 4% of pay.
- Enhanced match: 100% match of the first 4% of pay. The enhanced match can be increased to as much as 6% of pay.
A Safe Harbor match is implemented annually, and notices about the upcoming year must be provided to all employees 30-days before the beginning of the plan year.
A Safe Harbor match may be used in conjunction with Fixed and/or Discretionary matching contributions on a limited basis. The Safe Harbor match must be 100% vested at all times, and must be allocated to all eligible for the plan regardless of hours and service on the last day of the year.
PROFIT SHARING CONTRIBUTIONS
401(k) contributions are a provision available within profit sharing plans. In addition to matching contributions, the employer may also select from a variety of profit sharing allocation formulas. Profit sharing contributions are discretionary, and are allocated to all eligible employees regardless of their election to defer. The Plan document may be drafted to require that the employee work 1000 hours and be employed on the last day of the plan year to be eligible for the contribution.
There are five options for allocation of the profit sharing contribution. The basics of each option is outlined here, and if you’d like to see how any of these options would compare for your company, contact us, and we’ll prepare a free design illustration for you.
- Pro-Rata. Under a pro-rata formula, all employees receive a contribution equal to the same percentage of pay. For example, assume that you have two participants in the plan; Aidan earns $200,000, and Jonah earns $50,000. If the contribution is 10% of pay, Aidan will receive $20,000, and Jonah will receive $5,000.
- Integrated. This formula is integrated with Social Security. This option allows for a pro-rata contribution on all compensation, plus a contribution of up to 5.7% on compensation earned in excess of the Social Security wage base. In 2017, that wage base is $127,200. For example, using Aidan and Jonah again Aidan would receive $24,150 and Jonah would still get $5,000. The contribution for Aidan is calculated as follows: [($200,000 - $127,200) * 5.7%] + ($200,000 * 10%) = $24,150.
- Unit Credit. You can apply points for years of service and/or compensation to develop an allocation formula. For example, you may wish to apply 1 point for every $1,000 in compensation, and 10 points for every year of service. Compute the points for each person, then the contribution is allocated pro-rata based on their points relative to the total points.
- Age Weighted. This formula allows for larger contributions for participants who are closer to retirement age. In general, we compute the future value of today’s contribution to its value at Normal Retirement Age. The future value of the contribution is roughly equivalent as a percentage of pay for all participants. For example, assume Curtis is age 60 and Rose is age 27. They both earn $100,000. Curtis’s contribution could be $22,600, while Rose’s contribution is $2,400.
- Cross-Tested. This formula takes the best of pro-rata and age-weighted formulas into play. The employer can elect to allocate a different percentage of pay to different groups of employees. Those contributions are future valued out to retirement age, and non-discrimination is determined based on those future values. So once again, the formula favors participants closer to retirement age, but there is more flexibility than the age weighted formula. There are minimum contribution requirements for all eligible participants. For example, the employer can choose to allocate 20% of pay to business owners, 10% of pay to managers, and 5% of pay to all other staff. These are subject to rigorous compliance tests, so it’s important to understand your demographics before adopting such a formula.
One of the reasons 401(k) plans are so popular is because of the flexibility. The employer can have a plan with 401(k) deferrals only, add one of three different matching contribution formulas, and one of five different profit sharing formulas.
All employer contributions to a 401(k) plan are deductible from corporate income taxes, and not subject to payroll taxes. These funds are deferred from income taxes to the participant until they are withdrawn.
To decide what might work best for your company, we can run a free design illustration comparing any of the formulas outlined here. We’re your online 401(k) solution, and we’re happy to help you design the best plan for you. Give us a call to learn more about the Employer Contribution Options available to you.