I personally deal mostly with taxes in my professional capacity of an accountant. However, I have also come across a lot of the ins-and-outs when it comes to 401(k) plans as I used to audit 401(k) plans for large companies, and currently am involved in the setup, administration of, and accounting for 401(k) plans for many of my current small accounting clients. Whenever the subject of 401(k) plans comes up among friends, family, or professional or finance discussion groups, I always find it a good time to educate people on some of the ins and outs of 401(k)s. Most commonly, people come to me telling me it is not fair that their new employer limits contributions or that they have to wait a year to begin contributing, etc.
Of course the interesting thing through all these conversation is I often learn something new. Retirement plan laws can be very complex and no two employer 401(k) plans will generally be alike. I am still learning about some of the pitfalls of some 401(k) plans myself. Below I share a few good things to know about how different 401(k) plans can bet set up. When interviewing for potential jobs also keep in mind that no two plans are alike. Understanding more about these plans and asking the right questions can help you make sure you find a 401(k) plan that works for you. Below are five things you should know about your own, or any potential employers’, 401(k) plan.
1. Waiting Periods
As with many benefits, employers generally have waiting periods before you can begin to participate in a 401(k) plan. On average, most employers make you wait one year before you begin to participate in a 401(k) plan. However, I do hear it is more common these days to have a shorter waiting period. On the other hand, as with many of these rules, do not get too upset at the employer for choosing the waiting period if you are unhappy with it. I had a client who wanted to decrease the waiting period for their employees (in order to recruit an employee who balked at the long wait). The best they could do was change it from 12 months to 9 months due to the way the plan was set up, and the rules of ERISA (Employee Retirement Income Security Act).
The retirement administrators keeps on top of all the ins-and-outs of ERISA and it is really Greek to me as it just can get so complex. Just know there are many rules how plans can be set up, and once set up many rules are nearly impossible to change — one reason being to be fair to other employees (in this case the other employees who had to wait one year). There are a lot of rules with ERISA meant to keep favoritism to certain employees out of 401(k) plans.
This is good to keep in mind when looking for a job. Given 2 exact job opportunities, the one with a shorter waiting period into the 401(k) plan will be to your benefit.
Also, keep in mind that some of these 401(k) plans are set up so that you can only enter the plan on certain dates of the year. If you begin a job on January 3, and the only entrance date is January 1, technically you would have to wait another 6 months.
Most plans let you enroll multiple times throughout the year, but this is something to keep an eye out for, so you don’t falsely believe that you have to wait 6 months. In an example like I mentioned, if you notice you are close to, but after, an enrollment date, ask if you can get your employment start date officially changed so you can start in the plan sooner. Some employers will oblige.
Vesting is also something very important to keep in mind when comparing more than one 401(k) plan. Vesting refers to how much money you get to keep from a particular retirement plan. If you put money into a 401(k) plan you get to keep 100% of your contribution, and any earnings that your investment makes. It is your money. However, vesting will refer to the employer match.
For example, an employer match that vests over 5 years will generally vest 20% every year. What this means is if they contribute any money to your account (match) during the first year and you left your job before the year was over, you would be 0% vested. You would not get to keep their matching contribution. If you stayed on one full year you would then be vested 20% and would able to keep only 20% of the match that your employer had given you. The following year you would vest to 40% which means you would get to keep 40% of all the monies they had matched you over the years, and so on. Vesting schedules are all set up differently as well, but the most common vesting schedule is 100% over 5 years, or 20% per year.
It is important to know this when evaluating 401(k) plans. Say employer #1 has a 3% employer contribution but vests over 3 years. Employer #2 has a 10% match but vests over 6 years. Employer #2 sounds like it has a really nice match, which would be a great addition to your retirement. However, you would have to work for that employer for 6 years to see the full benefit. In this case, if you left after 3 years, neither employer is offering much more than the other. Likewise, if you don’t expect to be at a job very long, there may be no reason to even worry about the 401(k) plan. You may never be able to contribute, much less see a dime of employer match.
3. Automatic Enrollment
Historically, if you decide to participate in your employer’s 401(k) plan you have to decide how much of your paycheck to contribute and you also have to choose what mutual funds or other investments that you want to contribute to. Indecision is a big factor for putting off the decision to participate. New laws, however, are making it easier for employers to set up automatic enrollment for their 401(k) plans.
What this means is as soon as their employees meet the requirements to participate in the plan, the employer automatically begins to withhold a set percentage from their employee’s checks and the employer can also choose the funds for these investments. Your employer can also increase your contribution percentage by one percent every year.
This is good news for the lazy savers out there, or the procrastinators who never got around to filling out all the paperwork. However, employers must disclose their automatic enrollment plan and give you an option to opt out. So don’t worry, this is not anything that can be done against your will. However, I point it out as something that is becoming more common when it comes to 401(k) plans. Don’t use this as an excuse to sit back and be lazy. Evaluate your investment choices and see if you can contribute more than the token 3% of pay that your employer is going to start you with.
4. Read the Fine Print on 401(k) Matches
Not all employer matches to 401(k) plans are good matches. Of course they have to word these things in an extremely complicated manner and make it difficult to understand, maybe in the hopes to make the match appear better than it really is. Often 401(k) matches are worded as to not be entirely clear. They will usually contribute x% of the first y% of money that you contribute to your 401(k). Confused?
Sometimes employers will contribute a certain percentage of your pay as a match, but usually it will be a percentage of your 401(k) contribution, worded confusingly as stated above. Here is a good example when it comes to the complexities of 401(k) plans. I usually advise that people who want to contribute the maximum to their 401(k), which according to federal tax law is the lesser of $15,500, in 2007, or 100% of your compensation, to contribute as much on as early as possible. The reason being that if you leave your job (by choice or by unexpected layoff) that you will be able to make the max for the year since by starting a new job you may need to wait a while before you can participate in the 401(k) plan.
I recently learned that this is not exactly the best advice in that some employers structure their match so that they only contribute a certain amount of each of your paycheck. The wording would be something like the first 6% of each paycheck that is contributed to a 401(k) plan will receive a match of 50%. In this case, if you contribute to your 401(k) plan only a few months out of the year, the odds are you will lose out on some significant employer matching. So read the fine print in your 401(k) plan and structure your contributions accordingly.
5. Employer Can Impose Limits to your Contributions
Another thing to watch for is employer limits on your 401(k) contributions. You may be excited to get a big raise and might be ready to attempt to max out your 401(k) for the year (again the maximum is the lesser of $15,500 or 100% of your compensation, in 2007). However, you may just find out that your employer will not let you put away so much. Worse, they may have no cap on your contributions, but they could come back at the end of the year and say you have to take back some of your contribution. What is going on?
Well, for one, employers can set limits on how much their employees can contribute to the 401(k) plan. Every plan is different, every employer is different. So this is definitely something you need to ask about when comparing potential employers. However, most of the time that you will come across this limit is if you are a “highly compensated employee” as determined by ERISA.
By law (a very complicated law at that) employers can not have highly compensated employees (generally those who make six figures or more) participate in and contribute to their 401(k) plans at a rate much higher than other employees. The rules are extremely complex and hard to figure out, so generally employers set a cap on what their employees can contribute, to avoid problems. The last thing they want is for the entire retirement plan to be disallowed because they did not follow all of the rules.
Employers will tend to be conservative in this case and set a lower contribution limit for its employees. The fact is how much one can contribute will not really be known until the “nondiscrimination” rules are tested, most likely after year-end. This is why in some cases some employers can never have a problem, and then suddenly find themselves afoul of the nondiscrimination rules, and they may find some employees have contributed more than allowed. This is rare, but it does happen. This is why most employers will err on the side of caution, as well as to simplify the whole process.
The bright side in this is that the new automatic enrollment procedures have so far meant better participation in 401(k) plans. A lot of the key in avoiding this higher compensation conundrum is getting more lower-wage employees to participate in the 401(k) plan.
Some employers also set up “safe harbor plans” where they agree to match a flat 3% of every employee’s salary to the plan, whether they participate or not. In this case the discrimination rules do not have to be followed and the top earners can contribute the max (while no one else has to). The interesting thing is that these safe harbor plans are quite common for small employers, so the business owners can max out their retirement, by giving a token match amount to their few employees. They can also skirt a lot of the costs of compliance by getting around the more complicated maintenance of most 401(k) plans. Just an interesting tidbit that small employers can offer really good retirement benefits for this reason. For any company where management is eager to contribute the max to their retirement plan you will be more likely to see a plan like this.