With the potential for lower corporate tax rates, many employers and their benefits advisers have been focusing on the potential benefits of prefunding retirement contributions in order to secure deductions at the current higher deduction level.
To date, the primary tax reform-related considerations for 401(k) plans have focused on possible changes to the deductibility of employee contributions. However, plan sponsors may want to take this opportunity to consider prefunding their 401(k) plans, and reap potential savings in net-after tax costs.
What Would Prefunding a 401(k) Plan Look Like?
The concept behind 401(k) prefunding is straight-forward: increase the contribution(s) in a high-tax-rate year and decrease them when tax rates are lower. As an example, a match of 50% could be increased to 75% for one year, reduced to 25% the next year, and then returned to 50%. Similar changes could be made to non-matching contributions.
The increased contributions would be allocated to employee accounts just like regular 401(k) contributions. Plan sponsors need to plan in advance in order to coordinate funding with any changes to the tax rates. The 401(k) contributions for Year 1 can be deducted for Year 1 if they are made before the corporate tax deadline in Year 2. This deadline could be as late as mid-September for a calendar-year tax entity.
What Should Plan Sponsors Consider?
Turnover. Employee turnover impacts both cost and benefits delivery. Because any contributions must be allocated to employee accounts, an employee who terminates employment shortly after the higher contribution is made will receive a larger benefit. This results in an increase in cost relative to the current design, which would almost certainly be more than offset by the larger tax deduction.
Individuals hired late in the first year or in the second year may receive lower employer contributions as well (since the contribution rate is lower in Year 2), producing a counter-balancing savings.
These pluses and minuses mean that an employer considering this type of action needs to perform a thorough analysis to measure the potential savings across the two years.
Plan design. While prefunding can be accomplished with almost any 401(k) plan design, it is more complicated to implement with matching contributions than with non-matching contributions. Further, it can be particularly challenging to implement with certain “safe harbor” matching designs, where considerations are more detailed. The cost impact will also vary based a range of factors, including contribution levels, vesting provisions, possible salary increases, the change in tax rates, implementation costs, and other factors.
Cash flow and deductibility. Cash-flow timing is another important consideration. Since the focus is on taxes, the ability to take advantage of deductions obviously must be taken into account as well. In addition, since contribution timing is changing, the cost of money relative to that change needs to be considered.
Benefits delivery and employee communication. From the benefits delivery and communication perspective, 401(k) plan sponsors should consider the following:
- Addressing new employees (new plan participants) in the “low” benefit year
- Employees reducing their contributions in the “low” benefit year and the resulting implications on retirement savings
- Communicating the change and the rationale for it, and the timing of that communication. The later the communication, the greater potential for negative employee reactions, such as “if I had known the match would be increased, I would have contributed more.”
- Addressing administration and compliance activity such as compliance testing, plan documentation, and coordinating changes with service providers.
What Could the Financial Impact Be?
While situations will vary, higher turnover and shifting less of the benefit to the higher tax year will decrease the savings. A larger decrease in tax rate and a larger population that is not vested in their benefits will increase the savings.
We can consider a hypothetical two-year example for a plan that typically offers a 50% matching contribution on the first 6% of employee contributions and a 5% non-matching contribution. To capture the advantages of prefunding, the plan is changed to provide a 75% match in Year 1 and 25% in Year 2, and the non-matching contribution is changed to 9% in Year 1 and 1% in Year 2. This design provides a small benefit in Year 2 to encourage employees to continue to make contributions toward their retirement.
Final Word
As the tax-reform discussion continues, we feel prefunding 401(k) contributions should be considered. Advance planning is vital so that employers can be prepared to take action within possibility limited windows of opportunity. Employers also will need to consider employee communication, since employer contributions are visibly allocated to employee accounts. But for the right and prepared organizations, prefunding 401(k) plans can pay off.
Bruce Bach and Robyn Credico are senior retirement consultants at Willis Towers Watson.