In addition to setting up a 401(k) plan to enable employees to save for retirement, many companies also choose to make tax-deductible contributions to their 401(k) plan. Employer contributions must conform with IRS-prescribed limits, however. So if your company is interested in maximizing allowable employer contributions, you should understand the contribution limits applicable to employers, as well as IRS nondiscrimination regulations.
Here are some important concepts to consider for purposes of designing your company’s 401(k) plan to make the most of tax-deductible employer contributions:
- Aggregate Contributions Limit
- Compensation Limit
- Employer Contribution Limit
- High Matching Rates Raise ACP / ADP Compliance Risk
- Employer Matching Limited by Employee Limits
- Nonelective Contributions Are Less Restricted
- Consider Profit Sharing
The IRS places an overall limit on the total amount of contributions that employers and employees may make to any defined contribution plan(s) offered by the employer, or entities related to the employer. As of 2018, combined participant and employer 401(k) contributions are limited to the lesser of $55,000 or 100% of your annual compensation. Contribution limits are adjusted annually based on cost-of-living adjustments. If you will be over 50 years old in 2018, you may make additional catch-up contributions which will not count toward the $55,000 limit
Employer contributions may not be calculated based on annual compensation in excess of the IRS’s Annual Compensation Limit, which is $275,000 for 2018. For example, if you earn $1,000,000 in 2018 and your company offers a match of 5%. You will only be eligible for a matching contribution of $13,750 (5% of the $275,000 maximum set by the IRS), rather than $50,000 (5% of $1,000,000).
Employer contributions to a 401(k) plan are limited to 25% of total compensation. Any contributions that exceed this limit are not deductible for tax purposes. This limit is applied on a per plan basis (and not a per employee basis). To ensure that a plan stays within this limit, we recommend not offering matching or profit sharing in excess of 25% of compensation.
Though it would be permissible to provide employee matching contributions on up to 100% of compensation, doing so puts your plan at high risk for failing compliance testing. The IRS designed testing requirements to ensure retirement plans do not unfairly benefit highly compensated employees and business owners over their non-highly compensated colleagues.
In particular, the Actual Contribution Percentage (ACP) test compares employer contributions to highly compensated employees (greater than 5% owners, and those who earned more than $120,000 in the prior year) as a percentage of compensation with employer contributions to non-highly compensated employees as a percentage of compensation.
Generally, higher matching limits tend to favor highly compensated employees, as they are better positioned to contribute a high percentage of their income towards retirement than, non-highly compensated employees. The result may be that highly compensated employees end up benefiting disproportionately more from the plan by deferring a greater portion of their income and thus receiving higher employer contributions.
This can lead to a plan falling outside of IRS ACP limits which generally limit the ACP of HCEs to the lowest of twice the ACP of NHCEs; 2% more than the ACP of NHCEs, or 125% of the ACOP of NHCEs. When a plan is outside these limits, HCEs may require refunds of contributions and forfeitures of matching, or nonelective contributions will need to be made to NHCEs.
Safe Harbor plans were designed to achieve a more fair result-- by giving employers a pass on compliance testing for offering up to a 100% match of at least 4% of deferrals, not to exceed a deferral percentage of 6%.
Employer matching contributions are also limited by the $18,500 limit for employee deferral. Once you reach this limit you will not be able to make additional contributions and thus cannot receive additional matching amounts. For example, an employee earning $200,000 (enrolled in a plan with a 100% match up to 10% of compensation) will only be able to defer $18,500. Accordingly, the maximum match the employee could receive is $18,500 not the full $20,000 (10% of $200,000).
If employees “frontload” and reach the maximum contribution amounts early in the plan year, they may receive fewer matching dollars. We recommend that employees level contributions throughout the year to ensure they don’t miss out on employer matching.
Nonelective contributions made equally to all eligible employees can be less restrictive than matching contributions. They will still be subject to the $55,000 aggregate Contribution limit, the $275,000 compensation limit, and the 25% employer contribution limit, but are less likely to cause compliance testing issues and are not limited by employee contribution amounts.
Year-end profit sharing contributions can be an effective means of maximizing employer contributions, particularly when a safe harbor profit sharing allocation is utilized. Safe harbor allocation methods include a) a same dollar contribution to all eligible employees or b) a percentage contribution of each employee's compensation as compared to your company’s total compensation pool, among other alternatives. The aggregate contribution limit of $55,000 for each account would still apply, as would the $275,000 compensation limit for purposes of calculating allocations.
Want to help employees take advantage of maximum contribution limits? Contact us for more information on how to tailor your existing Guideline 401(k) plan or to discuss how Guideline can help you create a well-loved 401(k) plan.