Key Terms and What They Mean

etirement plans involve numerous legal requirements and terms. Given the scrutiny plans receive, sponsors should understand what key terms mean for their plan and its participants. Online definitions from the IRS are a good starting place; the Department of Labor also provides definitions for plans and for compliance with the Employee Retirement Income Security Act.

Plan Eligibility

Generally, a plan may require an employee to 1) be at least 21 years old and 2) have a year of service, typically defined as working at least 1,000 hours in a 12-month period, before the employee can participate in a plan. However, plans can allow employees to begin participation before reaching age 21 or before completing one year of service.

Employers frequently provide more generous enrollment requirements to enhance employee recruitment, says Marc Fowler, director of retirement education with retirement plan provider Human Interest in San Francisco: “Often what we see is that they put immediate eligibility in place because that is very attractive in terms of being able to bring new talent into the organization.”

Matching Contributions

Defined contribution plans can structure matching contributions in several ways. These include:

• Dollar-for-dollar match: Employers contribute $1 for every $1 an employee contributes, up to a certain percentage of the employee’s salary;
• Single-tier percentage-based match: Employers match a fixed percentage of employee contributions, often up to a specified limit;
• Multi-tier match: The match rate varies based on the employee’s contribution level or years of service;
• Discretionary match: Employers determine the match amount yearly based on company performance or other factors; and
• Safe harbor match: The plan’s match allows it to pass several nondiscrimination tests automatically.

Among Human Interest’s plans, about 70% use a single-tier formula; 23% have multiple tiers; 6% use dollar caps; various formulas are split among the remaining 1%.

“Typically, people want an easily describable, easily implemented plan when it comes to matching, and that tends to be the single-tier formula,” says Fowler.

Vesting Options

Some contributions vest 100% immediately, including:

• Employee contributions, such as salary deferrals and Roth contributions;
• Rollover contributions; and
• Traditional safe harbor contributions.

The DOL states that, for an employer’s matching 401(k) contributions, employers can choose from two vesting schedules. The first option is cliff vesting, under which employees are 100% vested in employer contributions after three years of service. The second option is graded vesting, which requires employee vesting of at least 20% vested after two years, 40% after three years, 60% after four years, 80% after five years and 100% after six years. However, automatic enrollment 401(k) plans that require employer contributions must vest those contributions after two years.

Employers facing highly competitive hiring markets might consider immediate vesting, says Fowler. Companies with more frequent turnover of newer employees are likelier to use a graded vesting schedule.

True-Ups

A 401(k) plan true-up is an additional contribution the employer makes at the end of the year to give employees the total matching contribution to which they are entitled based on their total annual contributions. Shortfalls can occur when the employer matches annually but calculates matching contributions with each pay period. This practice can affect employees who make uneven contributions during the year, front-load their contributions early or join a plan later in the year.

Carol Buckmann, a partner in the law firm Cohen & Buckmann P.C. in New York City, notes that true-ups are not required, but the transactions benefit employees. She explains that at year-end, sponsors review employees’ total contributions for the year and calculate the hypothetical match if the employee had contributed evenly throughout the year. If the employee has received less than the calculated matching contribution, the employer adds additional funds to “true up” the account. Buckmann says this puts participants in the same position as if they had contributed evenly throughout all payroll periods.

Safe Harbors

401(k) plans face annual nondiscrimination tests to ensure that the plans benefit all employees and not just business owners or highly paid employees. Retirement plan safe harbor provisions allow 401(k) plans to satisfy specific nondiscrimination testing requirements automatically. Employers must commit to making the required contributions for the entire plan year.

Funding methods can include:

• Basic match: The employer matches 100% of employee contributions up to 3% of compensation, plus 50% of contributions between 3% and 5%;
• Enhanced match: The employer’s match that is at least as generous as the basic match. For example, a 100% match on the first 4% of employee contributions; and
• Nonelective contribution: The employer contributes at least 3% of each eligible employee’s compensation, even if the employee does not contribute anything.

Safe harbor provisions simplify plan administration and benefit both employers and participants because:

• Safe harbor plans automatically pass critical nondiscrimination tests;
• Employer contributions are typically 100% vested immediately;
• Higher contribution limits allow all employees, including highly compensated employees, to maximize their contributions; and
• They reduce compliance burdens and associated costs for employers.