Our business is considering setting up a 401(k) plan for our employees. We know that it can include both employee contributions and company contributions, but we keep hearing about all sorts of other contributions. There are profit-sharing contributions, matching contributions, qualified nonelective contributions, and Roth contributions.
My head is spinning a little bit. Can you explain what all of these types of contributions are?
No problem. We know it can get confusing and we’ve got you covered. Some of the confusion stems from trying to simplify the complexity. For example, since 401(k) deferrals come out of employee paychecks, they are often described as employee contributions. However, under the regulations, they are considered employer contributions. We’ll spare you a detailed explanation and get back to the question at hand. Since many of these descriptions refer to other potentially confusing terms, we’ve included explanatory links to other pages on our site.
401(k) Contributions Made By Employees
The following types of contributions are made by employees and must be fully vested at all times, regardless of the employee’s length of service with the company.
These are the 401(k) contributions that come out of employee paychecks. They may also be called elective deferrals, and they can be made as either pre-tax (a/k/a tax-deferred) contributions or Roth contributions. Both pre-tax and Roth deferrals are subject to what is called the ADP Test each year, and they are generally not available for in-service distribution before age 59 ½.
The full name in the regulations is designated Roth contribution, but they are sometimes called Roth deferrals. Unlike pre-tax deferrals, employees are subject to income tax on these amounts at the time of contribution; however, if left in the plan long enough, they are tax-free (including all investment gains) at the time of distribution.
These are additional salary deferrals that are available to those participants who are at least age 50 and who are already making deferrals up to the limit. They are disregarded for nondiscrimination testing purposes.
Although it is reasonable to think these are the same as a Roth contribution, they are actually quite different. Similar to Roth, these so-called voluntary contributions are taxed at the time of contribution; however, when it comes to future distributions, all investment gains remain subject to tax. After-tax contributions are combined with company matching contributions and tested via the ACP Test. After-tax contributions are not subject to the same age 59 ½ restriction when it comes to in-service distributions.
Rollovers are amounts that an employee elects to move into a plan from another company-sponsored retirement plan or IRA. They can be either Roth or pre-tax and are generally not included in any nondiscrimination tests.
Contributions Made By Employers
These are amounts that the company contributes on behalf of employees who make salary deferrals. The amount of match is expressed as a formula such as 50% of the first 6% deferred by each participant. The plan can specify that the formula is applied on an annual basis, each pay period, each month, etc. Matching contributions can be discretionary, leaving the company to decide on the amount each year, or they can be hard-coded into the plan document and mandatory. The match is the only type of contribution that can be conditioned on participants contributing for themselves, and they are subject to the ACP test. Matching contributions can be subject to a vesting schedule.
Qualified Matching Contribution
Abbreviated as QMAC, this is a special type of match that is used to correct certain nondiscrimination testing issues. They must be fully vested at all times, and they are subject to the same distribution restrictions as salary deferrals. Safe harbor matching contributions are QMACs.
Profit Sharing Contributions
The “legal” name is the nonelective contribution, because unlike a match, the employee does not have to elect to defer in order to share in a nonelective contribution. In fact, there is a rule that specifically prohibits conditioning receipt of a profit sharing contribution on making 401(k) deferrals. The contributions can be subject to vesting, and depending on the method used to allocate them to participants, there may or may not be any separate nondiscrimination testing requirement. Although it is possible to have a profit sharing formula hard-wired into a plan, it is far and away more common for them to be discretionary, allowing the company to decide from one year to the next if a contribution will be made and, if so, how much.
Qualified Nonelective Contribution
You guessed it. Similar to the QMAC, a QNEC is a special type of nonelective contribution that is also used to correct failed nondiscrimination tests. Other types of plan corrections are also made via QNECs. They must be fully vested and are subject to the same distribution restrictions.
Money Purchase Contribution
The money purchase pension plan was a pretty popular design prior to 2002. However, a tax law change effective that year made them much less attractive. A money purchase contribution is very similar to a nonelective contribution in that it isn’t based on 401(k) deferrals, but the important difference is that it is a mandatory, fixed amount that is written into the plan. These types of contributions are also subject to special distribution requirements that set the default payout method as an annuity. They can be subject to a vesting schedule, and they are not available for in-service distribution prior to age 62.
This explanation may not have completely stopped your head from spinning, but hopefully the RPMs are bit lower. Have no fear—if you still have questions and want to understand how any of these apply to your company or your plan, just give us a call. We’re happy to help you make sense of it all.