Have you outgrown the need for matching 401(k) contributions?
From time to time, it can be helpful to question the way you’ve been administrating your retirement plan. For example, many plan sponsors provide matching contributions on participant 401(k) plan deferrals believing it’s essential to motivate employees to set aside enough for retirement, and to maximize overall plan contributions for ERISA discrimination testing purposes.
Yet some sponsors don’t realize there’s an alternative: making substantial nonelective contributions instead of matching contributions. It’s not a strategy that will work for all employers, but there is nothing to lose — and perhaps much to gain — by at least considering it.
2 questions to ask
Some plans routinely make periodic small nonelective contributions merely to supplement matching contributions, but won’t suspend those matching contributions. To start exploring the idea, ask these two questions about the traditional matching contribution approach:
- By essentially subsidizing (with matching contributions) only employees who can afford to contribute to their retirement today, are you discriminating against employees who have more pressing immediate financial needs, such as paying unexpected large medical bills?
- Are matching contributions really necessary to communicate to employees the importance of saving for retirement?
Beyond the fairness question, the main reason you might replace matching contributions with nonelective contributions is to gain some flexibility in allocating the dollars you want to distribute. Within limits, you could steer a higher proportion of those dollars toward key employees.
If this sounds good, here are some alternative strategies to look into:
A safe harbor plan. An option is to make solely safe harbor nonelective contributions for all eligible participants. Under the safe harbor formula, each participant receives at least a 3% contribution and your plan automatically passes muster with ERISA nondiscrimination requirements.
Social Security “integration.” This option takes advantage of “permitted disparity” rules. Essentially it allows you to adjust for the fact that employees with earnings significantly above the Social Security taxable wage base ($132,900 in 2019) will wind up with a disproportionately lower (relative to their earnings) Social Security retirement benefit than workers whose compensation during most or all of their working careers has been below the wage base. The potential adjustment is making higher (subject to certain limits) proportionate contributions to retirement plan accounts for employee earnings above the Social Security wage base. Nondiscrimination and top-heavy testing apply to this allocation formula.
Comparability allocation. Another opportunity to direct disproportionate amounts of nonelective contributions involves something called a “comparability allocation” or a “cross-testing” formula. This entails divvying up employees into “allocation groups” and varying the amount of dollars as a percentage of compensation allocated to each group. While possible, there are still complex discrimination hurdles to clear, and with complexity comes higher administrative costs.
Regardless of which option you may choose, the sky isn’t the limit on the amount of dollars that can be steered to employees with nondiscretionary contributions; aggregate per-participant limits applicable to garden variety 401(k) plans with matching contributions apply to all defined contribution plans. This year the limit on “annual additions” including elective deferrals, matching contributions, nonelective contributions and allocations of forfeitures from former participants is $56,000 ($62,000 when you add in catch-up contributions for participants at least 50 years old).
Consider the options
Perhaps you’re not a good candidate for a dramatic plan design change now. Circumstances and philosophies can change — and, if they do, the ideas presented here may provide ways to change with them. Consult your employee benefits specialist to find out whether nonelective contributions may be right for your plan.