For many companies and their employees, the 401(k) plan has become the go-to plan retirement plan positioned as an important employee benefit. The 401(k) is considered a defined contribution plan, meaning that promises are made by the employer to contribute on behalf of the employees, either as a non-elective percentage of compensation or more commonly a matching contribution based on the amount the employee defers out of their salary and into the plan.
Defined contribution plans like 401(k)s differ from the older defined benefit pension plans which made promises of lifetime monthly retirement payments. While defined benefit pension plans still exist at some firms, their use today is mostly with federal and state governments for employees of those agencies.
We have three learning objectives for this post:
- To understand the different ways employers can make “matching contributions” to your plan
- Learn how employers’ dollars “vest” and become yours to keep even if you change jobs
- Be aware of the wealth building power of matching contributions
All 401(k) plans are governed by guidelines issued by the Employee Benefits Security Administration of the U.S. Department of Labor. Plans are subject to IRS scrutiny to make sure they are properly structured and that protections for the average worker are followed to prevent the more highly compensated employees and business owners from benefiting in an unfair way.
Employers are not forced to make matching contributions based on the employees’ salary deferrals into their participant accounts, but if the employer doesn’t meet certain requirements for these matching contributions the plan can be deemed to be “top-heavy” and in favor of the highly compensated employees. This can cause the plan to run afoul of the IRS and Department of Labor rules.
To avoid problems with the IRS, a plan can be structured as a safe harbor plan, which means certain minimum employer contributions must be met or exceeded. Most employers today meet the minimum guidelines by either:
- Making a 3% of compensation contribution for all employees, even if the employees do not defer any of their own compensation into the plan.
- Matching $1 for each employee dollar contributed up to the first 3% of compensation and $0.50 for each employee dollar contributed on the next 2% of compensation.
Many employers may exceed these minimum requirements as a commitment to helping their employees save and invest for their eventual retirement. The idea is that a strong employee benefits program, which includes a retirement plan, is a way to keep good employees on staff.
The next thing to understand about your contributions and your employers matching contributions is the vesting schedule. First, you can breathe easy about your own salary deferrals into the 401(k). Money you put into the plan is immediately 100% vested. It will remain invested in your participant account and grow through future contributions and investment growth until you retire and start to draw the money out or when you change jobs and roll over the 401(k) balance to another tax qualified account.
Keep in mind that money you defer into a traditional 401(k) will avoid being assessed for payroll tax and federal income tax liabilities. The money also grows over time with no income tax ramifications until you draw money out in retirement, which is then considered ordinary income for tax calculation purposes.
You employer may offer a Roth 401(k) option. If you use the Roth option for part or all of your plan contributions, you don’t receive any tax benefits at the time you make contributions, but you also won’t pay any tax when you withdraw funds in retirement.
Back to the vesting concept. Employer contributions are generally subject to a vesting requirement, which is based on how long you have been participating in the plan as an employee. The vesting schedule is established by your employer when the plan is set up. It can be a gradual schedule, where you are vested more each year over a period of 5 or 6 years, or the schedule may be set up as a “cliff”, where you aren’t vested at all for the first couple years, but become 100% vested after 3 years.
You should refer to your plan document to learn about the vesting schedule when you begin to participate. The implications for vesting is that if you terminate employment with an employer who made matching contributions and you did not meet the time required for vesting, you will not get to keep the employers contributions. Of course, your own contributions are 100% vested at all times as mentioned before.
If you change jobs, or eventually retire, the option is yours on whether to leave your 401(k) assets in the plan, move them to a new employer’s plan, or most commonly, perform a tax-free rollover to an individual retirement account (IRA). Since workers tend to change jobs more often in today’s economy, rolling over your plan to an IRA is probably preferable to having several old 401(k) plans to monitor.
It’s easy to take the view that the matching contributions made by your employer don’t appear to be significant at any moment in time. But, the power of tax-deferred retirement plans is truly about the time you participate. A dollar-for-dollar match even on a few percent of your compensation represent a 100% investment return on those dollars as long as you meet the vesting requirements. In addition, you are avoiding payroll and federal tax on those dollars if you use the traditional 401(k) and achieving tax-deferred growth of your investment capital with both the traditional and Roth 401(k) options. As mentioned earlier, the choice of the traditional or Roth option is based on when you want the tax benefit. An immediate tax deduction now means you will pay tax at the time of withdrawal in retirement. Using the Roth option will cost you more in taxes now but provide tax-free income later. I think for most participants using a balance between the traditional and Roth options is worth considering and is allowed by most plans.
For help in determining the best 401(k) options for you call us today at 941-778-1900 or visit www.integracapitaladvisors.com to schedule an appointment today.