Posted by Tyler Starr
We often ask the question, “How does our 401(k) plan stack up?” When you are an employee, you will consider items such as the investment choices, administration fees, or loan terms. However, if you are an owner, the most important thing to think about may be how to contribute the highest amount you can under Section 415. For 2016, the defined contribution plan annual addition limit without catch-up is $53,000, and will rise to $54,000 next year.
The Internal Revenue Code (IRC) subjects qualified employer plans to compliance testing. Employer 401(k) plans must pass the “actual deferral percentage” (ADP) test, and if there are employer match contributions, the “actual contribution percentage” (ACP) test. However, safe harbor plans are not subject to discrimination testing if the plan sponsor contributes a pre-approved safe harbor employer contribution.
Safe harbor plans guarantee that the Highly Compensated Employees (HCEs) will be able to contribute the maximum deferral amount of $18,000, but not necessarily the maximum annual addition under Code Section 415. In those cases, the triple stack match formula may be the solution, as follows:
Stack One: 100% of the first 3% of deferrals, plus 50% on the next 2% of deferrals. That means that if an employee defers 5%, they will receive the maximum 4% of compensation match on the first stack. If we also assume our owner is doing extremely well and earning the maximum includible annual compensation of $265,000, he/she would have to be deferring at least 6.79% of compensation. At this point, our owner has contributed $18,000 and received a match of $10,600 without being subject to any discrimination testing.
Stack Two: A discretionary match of 66-2/3 % of deferrals up to 6% deferred. To continue to qualify as safe harbor, the allocation of an additional discretionary match cannot exceed 4% of compensation and the match is limited to the first 6% of compensation deferred. Since 4% divided by 6% is 66.67%, this means that matching up to 6% of compensation to achieve an overall 4% of compensation match would require a 66.67% match for every dollar contributed up to 6% of compensation. Still using $265,000 as compensation, we have another contribution of $10,600 ($265,000 x 6% x 66.67%) for a total annual addition after stack two of $39,200 ($18,000 deferral + $10,600 stack one match + $10,600 stack two match).
Stack Three: A fixed match of X% of deferrals up to 6% deferred. To meet safe harbor requirements, participant deferrals above 6% cannot be matched and can never be greater than 6% of compensation. To find our third stack, we must solve for the percentage that will get our owner to the maximum contribution. $53,000 – $18,000 – $10,600 – $10,600 = $13,800. If we take 6% of our owner’s compensation of $265,000, the maximum amount of deferrals to be matched is $15,900. If we divide $13,800 by $15,900, we find out that the owner in our example must receive a third matching contribution of 86.79% of deferrals up to 6% deferred to get to the maximum annual addition of $53,000.
With this triple stack match formula, the plan qualifies as safe harbor and is also exempt from top-heavy rules, because it only permits deferrals and matching contributions that meet the ADP and ACP requirements and it has no profit sharing component. In addition to the requirements discussed above, it is important to remember that none of the stacked matches can require 1,000 hours of work or employment at year end. Stack One also cannot be subject to vesting, as it must be fully vested to qualify as safe harbor. Provisions for the triple stack match must be in place before the start of the plan year in which they are effective.
The triple stack match may be a great way to get around cross-testing, but it creates an even greater emphasis on making sure that each participant that does not want to defer received the safe harbor notice and still does not want to defer. A budget risk to an employer that adopts a triple stack match formula is that the NHCEs who weren’t deferring previously will now be compelled to defer 6% of their wages, since the plan’s match is well over 250% of up to 6% of deferrals. Employees would be foolish to turn down that match, but employers would be in even bigger trouble if they to hide the opportunity from its employees. Participants may have previously passed on a single stack, but who would forego a triple stack for the price of one?