Spring/Summer Series Part 4: 401(k) Plans

It seems that everyone loves a 401(k). Employers love that the employees contribute to their own retirement security, and employees love them because employers told them to love them.

I’m just kidding, of course. Employees appreciate these plans as they see their account balances grow over the years, they like that they (generally) have control over their investments, and really, they pay more attention because they feel involved. Employee A makes $50,000, contributes $5,000 to her 401(k) plan, and receives a $5,000 match. Employee B makes $45,000, and his employer contributes $10,000 to his profit sharing plan. They both wind up at the same place, but more often than not, it’s the Employees A of the world who understand more about their retirement plan. And this, I believe, explains the huge success of the 401(k) plan.

But I’m a little ahead of myself. First let’s start with what it is: 401(k) is simply the Internal Revenue Code section that allows a Cash or Deferred Arrangement (CODA) in a profit sharing plan. So, a 401(k) plan is a profit sharing plan that has a CODA, and a CODA is just another way of saying “You Can Take Your Money Now Or You Can Put It In The Plan And Take It Later.” (CODA is much easier than YCTYMNOYCPIITPATIL, isn’t it?)

Now we have a profit sharing plan with two types of allowable contributions: an employer profit sharing (non-elective) contribution and an employee (elective) contribution. But with the employee elective contribution comes a new type of employer contribution, the employer match. The match is a function of what the employee puts in. An employer might, for example, match 50% of what the employee contributes, but not more than 4% of pay. Or the match could be 100% of the employee’s contribution, but not more than 3% of pay. Employers usually put in that second clause to make sure their obligation is not open ended.

One easy-to-predict problem with 401(k) plans is that higher earners are more likely to contribute to such a plan. This is fine for the high earners, but as government policy, the purpose of the 401(k) is to encourage savings among all levels of employees. To address this, there are certain nondiscrimination tests to make sure a plan reaches everyone, effectively limiting what the average Highly Compensated Employee (HCE) contributes in relation to what the average Non-Highly Compensated Employee (NHCE) puts in. And this works well, and for quite a few years everyone was happy. Well, not everyone. Small business owners with even a moderate amount of turnover never knew if their plan would pass the nondiscrimination tests from year to year. In a plan with only a few participants, the termination of one HCE or one NHCE could change the test results dramatically. And so the safe harbor 401(k) plan was invented! Under the safe harbor, a plan is deemed to pass nondiscrimination tests if either a minimum match or a minimum non-elective contribution is offered, regardless of whether the NHCE contribute anything at all.

To recap and expand just a little, a 401(k) plan is a profit sharing plan with employee contributions, plus an employer match, an employer non-elective contribution, both, or neither. (Admittedly, “neither” is rare, but possible.) The match is contingent on the employee contribution, and the non-elective contribution can be allocated in any acceptable way, depending on the employer’s objectives. (Remember, we talked about a straight percentage of pay, Permitted Disparity, age-based, and comparability allocations.) Most 401(k) plans allow the participants to choose their own investments (within the confines of the plan’s options), but that’s not actually a requirement.

I could go on (there’s so much to cover!), but we’ll stop here before everyone gets bored. (Am I being too optimistic?)

Next up: examples of 401(k) designs.

#Spring/Summer Series #401(k)