How Employers Penalize Ambitious 401k & 403b Savers

Normally, companies reward ambitious and productive employees. After all, these employees make their employers lots of money. In this case, though, it’s the reverse. Many “on the ball” retirement plan savers are being penalized by unknowingly missing out on thousands of employer matching dollars.

The Retirement Plan Employer Match

Most employers contribute to their employees’ retirement plans in an effort to encourage participation. According to a Vanguard analysis of about 1,900 qualified plans and more than 3.6 million participants, 94% of plans offer an employer contribution. This employer contribution can come in several forms – including matching contributions & non-matching contributions.

With employer matching contributions, employees contribute money from their paycheck and, as a result, receive some form of “match” from their employer. The most common type is the “% of pay” match. For example, your employer might match employee contributions dollar for dollar up to 5% of compensation.

So if you make $10,000 and contribute 5% ($500), your employer then matches that $500. There are many variations but the gist is that employees contribute and employers match those contributions up to a certain amount (based on the plan formula).

Non-matching contributions are also pretty self explanatory on the surface. Unlike matching, these employer contributions are most commonly structured as profit-sharing contributions. Companies typically make these profit-sharing contributions annually based upon a wide range of factors (not including matching employee contributions). Against popular belief, profit sharing contributions can be totally independent of company profits.

The key consideration for employees is how your specific employer determines it’s contribution/match. With non-matching contributions, the employer contributions are not going to change based upon how aggressively employees fund their retirement plans. It is what it is. With matching contributions, though, it’s a totally different story.

How Matching Contributions Technically Work

“It depends on the terms of the plan document. Typically matching contributions are calculated on a payroll basis,” sais Michael Marx, CEO of Benefits Administrators, a Lexington KY based TPA firm specializing in Retirement Plan Design and Administration. W-2 employees are paid each payroll period and employer matching is based upon the same pay-period time frame.

How Ambitious Employees Miss Out

So what’s the big deal? Well, for company partners, sole proprietors and members it’s not a big deal. In those cases, matching is typically determined on an annual pay-period basis. But let’s consider an example of a proactive employee who maxes our their retirement plan sometime before the end of the year. This employee’s matching is determined on a monthly (per pay-period) basis. Let’s assume this employee has a salary of $250,000/yr and wants to max out their 401k as quickly as possible. They decide on 15% contributions which should max it out around mid year.

Now here’s the kicker with employer matching…technically, the employee must make a contribution during that payroll period to receive the match. Therefore, this employee will miss out on half the year’s employer matching contributions. Here is how this would look over the 12 month period:

What’s the cost of this sort of missed opportunity? For this example, it costs the employee $6,250! The 5% matching contribution effectively gets reduced to 2.5% as a result of the employee’s aggressive savings.

If this employee tried to spread the maximum amount out over the year but ended up hitting it a month early, using the same example above, this would still cost them $1,042 for the one month of missed employer matching.

Many employees are sure they are maxing out their 401k’s but they aren’t usually certain WHEN that occurs.

So how can you figure out if you are missing out on matching contributions – and if so – by how much? The easiet way is to look at your last pay stub for the year. Look at the total employer matching contributions for the year. Divide that amount by your total compensation. If this is less than the matching contribution should be AND you know you maxed out the 401k, odds are you are missing out on employer matching somewhere along the way. The missed opportunity would be the full match potential (total eligible compensation multiplied by the matching percentage) minus your actual match.

How To Avoid This Going Forward

The good news is, for most, it’s an easy fix. Ideally, your company allows for unlimited changes to employee contribution elections AND offers a dollar amount choice on contributions per period (versus a % of pay – it’s harder to be exact when you can only elect a %). If you are fortunate enough to work for a company like this, your next step is easy.

If it’s the first day of the year, simply take the annual employee 401k maximum and divide it by the number of pay periods you have. Make that your per pay-period election. If you’re already partially through the year, take the annual 401k max ($18,000 for 2016) and subtract your year to date 401k contributions. Take this number and divide it by the remaining number of pay periods. You can see the resulting calculation below.

As long as you contribute for EVERY pay period (including the last one) at the level necessary to maximize the employer matching contribution, you will avoid missing out.

Unfortunately, many 401k plans aren’t so easy to fix. For employees with variable income – especially those that are limited to a percentage of compensation election – it’s like throwing darts at a moving target. For these people, choose a conservative percentage that will get you close to maxing out BUT not going over, while still contributing enough to get the full match. Plan to revisit this around October to see how you’re progressing. If necessary, change the percentage again using the same method. Check your progress once more sometime before your last pay period. Give yourself enough time for potential changes to process BEFORE the last payroll. With this last tweak, you can adjust to make sure you max out for the year.

Some employees are also limited in the number of contribution changes they can make during the year. This is incredibly annoying, especially when you realize you’re missing out on free money. Use the same general strategies listed above BUT plan ahead and make those changes when eligible.

Implications For Plan Fiduciaries

What’s interesting about all this is that employers must act as fiduciaries to their 401k plans. This means they must always act in the best interest of plan participants. If a plan document is designed to allow for this to occur, is it truly in the best interest of the participants?