High Matching Rates Raise ACP Compliance Risk
Though it would be permissible to impose a cap on employer matching contributions of more than 25% of compensation, doing so exposes the company to a heightened risk of making nondeductible contributions and the applicable 10% excise tax. The exception is in the case of a 401(k) Safe Harbor Plan, where it would expose the plan to an increased risk of failing the Average Compensation Percentage (“ACP”) nondiscrimination test. Generally, a higher matching percentage or a higher cap on the matching contribution tends to favor highly compensated employees, as they are better positioned to defer more of their income towards retirement than non-highly compensated employees. The result may be that the group of highly compensated employees, on average, benefit much more than the group of non-highly compensated employees and the plan will fail the ACP test.
Safe Harbor Matching 401(k) plans are exempt from the ACP test, the ADP test and the Top-Heavy Plan limitations. In exchange for this relief the plan must adopt employer contribution provisions that meet rigid standards. See if a Safe Harbor plan is right for you!
Employer Matching Limited by Employee Limits
Employer matching contributions are by design a percentage of a participant’s deferrals up to a maximum or cap expressed as a percentage of the participant’s annual compensation (as limited by the Annual Compensation Limit of $285,000 for the 2020 year). The IRC limits a participant’s deferrals to an annually adjusted dollar amount. For 2020, the annual deferral limit is $19,500. Accordingly, since a participant may not defer more than the limit each year, the limit itself acts as an additional stop on the total matching contributions to the plan.
If employees “frontload” their deferrals in a single plan year and reach the maximum limit before the end of the year, Guideline will attempt to cap employee contributions and cease matching contributions as well. This could result in those employees receiving less than the total matching contributions than they otherwise would have received. We recommend that employees make level contributions for each pay period throughout the year to ensure they don’t miss out on the full employer matching contribution available.
401(k) Plans With Nonelective Contributions Are Less Restricted (Non-Safe Harbor)
Nonelective contributions, which are made as a uniform fixed percentage of compensation to all eligible employees, are a substitute for matching contributions. While the plan will not be subject to the ACP test if the plan does not provide matching contributions, it will still be subject to the other compliance and nondiscrimination tests. Accordingly, these plans are less likely to cause compliance testing issues and the employer contributions are not limited by the employee deferrals.
401(k) Plans With Safe Harbor Nonelective Contributions
To satisfy the Safe Harbor requirements, the plan must commit the employer to make a nonelective contribution of at least 3% to all eligible employees regardless of whether or not they elect to make deferrals under the plan. These contributions must be immediately 100% vested. Such a Safe Harbor plan is exempt from the ADP test and the Top-Heavy limitations.
Consider Profit Sharing
Year-end profit sharing contributions can be an effective means of maximizing employer contributions. Profit sharing contributions are typically designed to be discretionary based on the employer’s need and ability to make such contributions. Adding a fully-vested 3% minimum employer contribution will satisfy the Safe Harbor Nonelective Contributions.
An employer with a Safe Harbor Matching Contribution plan may also add a discretionary profit sharing contribution (no minimum), subject to a vesting schedule. The plan is still exempt from ADP/ACP testing and Top-Heavy Plan limitations. As long as the profit sharing contributions are allocated on the basis of a uniform percentage of pay to all eligible employees regardless of whether or not they elect to make deferrals, no additional nondiscrimination testing is required. The aggregate contribution limit of $57,000 for each account would still apply, as would the $285,000 Annual Compensation limit for purposes of calculating allocations of the profit sharing contributions.
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 plan well-loved by your employees!