Challenges Can Arise With Service-Based Matching Formulas
By Cal Preisinger, CPC
Can employers design their plan to have a greater matching contribution formula for employees with longer service?
Employers sometimes ask if they can reward their more tenured employees by providing them with a more generous matching formula than their less tenured counterparts. A design such as this might have a set matching percentage as a base rate for all participants, with additional matching percentages added once the participant meets specific tiers of service. A simple example would be a 3 percent match as the base for all contributing participants followed by an additional 1 percent match for every year of service, up to a maximum match percentage (e.g., 3 percent for less than 1 year of service, 4 percent for 1 or more years of service, 5 percent for 2 or more years of service, etc.). The end result is an increasing match benefit for participants who stay with the employer. While it is possible to design this type of a matching formula, there are concerns that should be reviewed first. Otherwise, unintended consequences for highly compensated employees and the employer may result.
Issue 1: More Complex Testing
When a plan uses a nonuniform match formula, such as this one based on a participant’s years of service, matching contributions become subject to additional nondiscrimination testing under Internal Revenue Code Section (IRC Sec.) 401(a)(4) for the availability of benefits, rights, and features. This test is a two-part test to determine whether the benefit, right, or feature is 1) currently available (whether enough participants are benefitting under IRC Sec. 410(b)), and 2) is effectively available (a facts and circumstances-based determination). The employer would need to confirm with its retirement service provider whether this specialized testing is included in its service agreement or needs to be requested, and if additional fees may apply. Some retirement service providers do not perform the “effectively available” portion of the test, and the employer may have to seek outside counsel to perform it. Either option will generally result in greater cost of administering the retirement plan.
Issue 2: Timing Challenges
The employer needs to be aware of the required tests involved—including the timing requirements and the timing of potential corrections. A 401(k) or 403(b) matching contribution that does not use a safe harbor design is subject to annual actual contribution percentage (ACP) testing. If a failure—known as an excess aggregate contribution—results after performing the ACP test, the employer can choose to correct the failure by removing the contribution. This must occur within 2½ months after the end of the plan year (e.g., March 15 for a plan year ending December 31), or within 6 months after the end of the plan year if the employer offers an eligible automatic contribution arrangement. If excesses are not timely removed, the employer must pay a 10 percent excise penalty tax, which is calculated on the principal amount of the excess not timely removed. It is this coordination of testing for benefits, rights, and features and ACP testing that can be difficult for the employer to meet.
A potential alternative to a service-based match? Provide a profit sharing contribution using a new comparability formula with individual allocation groups instead of a match. This type of formula provides the greatest flexibility in allocating varying contribution amounts to different participants, and the employer has assurance that the profit sharing contributions will pass required testing before they are funded. Also, by providing a profit sharing contribution instead of a matching contribution, the deadline to complete the ACP test and remove any applicable excess aggregate contributions no longer applies. And, last but not least, the cost for a new comparability calculation is generally much lower than the cost for performing benefits, rights, and features testing that includes a facts and circumstances based determination.
