Many employers are looking for ways to enhance their 40(k) plans. One of the best ways to do this is by offering a matching contribution to plan participants.
A matching contribution is when an employer contributes to an employee’s retirement account based off of the employee’s deferrals. There are several reasons an employer may want to offer a matching contribution as part of the 401(k) plan. They receive tax benefits, have higher participation and deferral rates among their employees, and are more easily able to pass annual non-discrimination testing. Employees are also treated to tax benefits and higher retirement account balances as a result of matching contributions.
Let’s take a closer look at the mechanics of matching contributions.
Types of Matching Contributions
An employer may make either a fixed match or a discretionary match.
A fixed match is when the employer has a set matching formula outlined in the plan document. Contributions are made on a set schedule and cannot be altered without a plan amendment. Alternatively, an employer may offer a discretionary matching contribution. The plan document doesn’t specify a matching contribution formula. The employer has the ability to determine the matching contribution at the end of the year, or they could contribute as frequently as each pay period. Many small business owners like the discretionary match for the flexibility it affords them.
Matching Contribution Formulas
A common matching formula for 401(k) plans is the employer matching a percentage of the employee’s deferral, capped at certain limit stated in the plan document. For example, the employer may match 100% of employee deferrals up to a percentage of total compensation – most employers limit the matching contribution to 6% of the employee’s compensation. Alternatively, an employer may offer a partial match. For example, they’ll match a portion of the employee’s deferrals (ie: 50%) up to a certain portion of compensation (say, 6%).
Pre-tax deferrals are the most commonly matched contributions. However, employers are permitted to match after-tax Roth contributions as well. Notably, the employer matching contributions for both pre-tax deferrals and Roth contributions are pre-tax.
Matching Contribution Formulas & Safe Harbor Plans
A 401(k) safe harbor plan is exempt from non-discrimination testing. As a trade-off, employers are required to make either a matching contribution or a nonelective contribution. Employers can make either a basic or enhanced matching contribution, or a non-elective contribution.
Basic Match: 100% match up to 3% of compensation plus a 50% match on the next two percent of compensation.
Enhanced Match: Generally, the enhanced match is 100% match up to 4% of compensation. But the enhanced match only has to be more generous than the basic match.
Non-elective Contributions: These aren’t technically a match, since they’re not based on employee contributions. However, they are employer contributions made to the employees based on a certain percentage of the employee’s compensation. Many employers choose the nonelective contribution route to maintain their safe harbor status.
Each year, the IRS sets a limit on benefits and compensation. In 2020, employee contributions cannot exceed $19,500. The combined limit for employer and employee contributions is capped at $57,000.
The limits for 2021 have not been released by the IRS yet.
Timing of Contributions
Employers are permitted to make contributions throughout the plan year. Or they can wait until the end of the plan year, whichever works best for the employer. The plan document will state how frequently matching contributions will be allocated and any allocation requirements, such as employment on the last day of the plan year.
Since matching contributions are based off of participant deferrals, they’re typically made per payroll period, monthly, or quarterly. One thing to bear in mind, is that the timing of the allocation date impacts which investment gains and losses are allocated to the participant accounts.
Many employers bake in a vesting schedule to their plan document as a way of retaining their employees. A vesting schedule requires a certain number of years of service before the matching contributions are fully vested. There are two types of vesting: graded and cliff.
With graded vesting, the employee becomes more vested in his or her account after each year of service.
Year 1 0%
Year 2 20%
Year 3 40%
Year 4 60%
Year 5 80%
Year 6 100%
6 years is the statutory maximum number of allowable years for a graded vesting schedule. If an employee were to leave in year 3, he or she would be entitled to 40% of the matching contribution and would forfeit 60% of the matching contributions.
A cliff vesting schedule means that the matching contributions become 100% vested after a certain number of years, but no more than 3. For example, a 2 year cliff means that the employee is 0% vested until he or she has completed two years of service, in which case the employee would become 100% vested in the matching contributions.
An employer can adjust the vesting schedule to suit the needs of the company within the permitted statutory range.
Forfeitures as Matching Contributions
As we discussed, if an employee terminates before becoming fully vested their non-vested balance is considered forfeited. So what happens to the forfeited funds? They may be used to reduce the employer’s matching contribution obligation. The use of forfeitures should be detailed in your plan’s document.
Tax Benefits of a Matching Contribution
The employer receives a tax deduction for all of the matching contributions – up to 25% of covered payroll.
There are several benefits of matching contributions to both the employer and employees. For employees receiving a matching contribution, earnings grow tax deferred and are taxed upon distribution so they’re not included in the employee’s taxable income until retirement. Unlike bonuses, matching contributions are paid to the employee’s retirement account pre-tax.
Matching Contributions Help 401(k) Plans Pass Non-Discrimination Testing
Employees who would ordinarily not contribute to their account often begin contributing for the purpose of receiving the employer match. The increase in NHCE participation may help the 401(k) plan more easily pass the annual non-discrimination testing.
Additionally, employers may give a Qualified Matching Contribution (QMAC) to help with the non-discrimination testing. These are matching contributions made with the intent of passing compliance testing.
Should Your Company Offer a Matching Contribution?
A matching contribution is more than just a retirement plan contribution. It’s a way to capitalize on tax savings and incentivize employees to participate and contribute generously to their retirement plan. Matching contributions can be made in a variety of ways, so finding the right fit for your company’s plan is key.
Need help deciding if a matching contribution is right for your company? Contact us.