Last week, we explained the basics of 401(k) plans and how employees can use them as savings vehicles to accumulate wealth for retirement. In addition to contributions made by employees, also called salary deferrals, there are other types of contributions. We’ll discuss the various types of contributions to 401(k) plans here.
Employer Discretionary Contributions
Some employers make contributions to 401(k) plans, a type of profit sharing plan, regardless of whether employees defer compensation to the plan.
Employers find contributing to 401(k) plans attractive for the following reasons:
- It makes them competitive with other firms that offer qualified plans.
- Contributions made to the plan are deductible.
- It helps to attract qualified employees and retain existing employees.
- It encourages loyalty among existing employees by requiring a specified number of years of service before an employee is entitled to employer contributions through vesting.
Employee Salary Deferrals
In a 401(k) plan, employees may defer a percentage of their compensation, up to the specified annual limits set by the IRS. (See our Nov. 1, 2012 post for 2012 contribution limits.)
The deferral percentage varies from plan to plan. Some plans, for example, allow employees to contribute 15% of their pay, while other plans allow a smaller percentage. The plan limits will be specified in the 401(k) plan document.
The deferred amounts are not subject to income tax but are subject to payroll taxes such as Social Security and Medicare.
Employer Matching Contributions
- Many employers match employee contributions to encourage participation in the 401(k) plan.
- Employer matching contributions are based on how much the employee contributes to the plan.
- Some employers match dollar for dollar up to a certain percentage, while others match 50 cents for every dollar contributed up to a certain percentage. The percentage paid will be listed in the 401(k) plan document, along with any restrictions that apply, such as vesting.
Investment Earnings (or Losses)
In addition to the contributions made above, 401(k) plans are subject to investment earnings and losses. Earnings and losses will depend on the types of investments made by the 401(k) plan. These earnings and losses are typically reported to employees on a quarterly basis, and can often be accessed online so that employees can change their investment selections, if desired.
In our next post, we’ll talk about how vesting works and how money from the plan can be distributed (loans, hardship withdrawals, retirement distribution, etc.). If you have any questions, please let us know. We’d love to help!