Welcome to the third part in my series about creating the best 401(k) any potential employee has ever seen. If you haven't already done so please read part 1, part 2, and part 3. You should be familiar with those concepts and in a mindset that you're providing them before continuing to this portion.
Once you're providing a safe harbor 401(k) and matching contributions the next step is to provide employees with the assurance that no matter what happens with their 401(k) contributions throughout the year as long as they max their contribution you will max the matching contribution.
This may seem obvious but very few employers handle a true-up correctly and even fewer understand why it causes stress for their employees. Let's look at some examples to help establish why not providing a true-up is stressful for employees.
Say an employer matches 5% of an employee's total salary. They're making $100,000 so the 401k match should be $5,000. It may seem obvious but depending on how payroll works this may cause employee strife. This is where the true-up comes in to play. Suppose an employee is contributing $1,625 per month (a total of 19500 per year, the current 401(k) limit). Doing so would mean on every paycheck you match 5% of their per paycheck salary, fulfilling the employer's end of the bargain to contribute $5,000 total by the end of the year.
This makes sense until you start thinking about how the employee may change their contribution. What happens if they over contribute early in the year and have to reduce their contributions later? As long as they contribute 5% of their paycheck the match will stand, but what if they have to reduce to 4%? In situations where a true-up does not exist they would simply lose that 1%. It may not seem significant but it may affect multiple paychecks or even multiple months if the employee contributed too much too early in the year.
It also negatively impacts employees that prefer to max their 401(k) early in the year to take advantage of longer term growth on their money. What happens if they've maxed out their 401(k) in the first 6 months of the year? Without a true-up that 5% match is now reduced to 2.5% in most situations because the max per paycheck a company will match is 5%. This is essentially an employer sponsored punishment for an employee caring about their financial future.
This is a huge negative and a source of stress for various reasons. It means employees have to make sure their contribution calculation is correct for every paycheck or they risk losing out on the match. It means they can't front load their 401(k) for the year if they desire. It also means that if raises occur mid-year employees will have to remember to check their contribution to make sure it didn't increase or they may miss out on the match.
The true-up resolves all of these issues and it exists in several different forms which will be discussed. A true-up ensures that no matter what happens with an employee's contribution they get the full 5% match for the year. Since this doesn't actually cost employers any more to do than matching contributions already does and it reduces what employees have to worry about it's a clear win for both employers and employees. Unfortunately many companies still do not perform a true-up and none of the reasons I've ever heard were valid or worthwhile. It boils down to companies caring more about doing a little paperwork than they do about reducing mental distractions employees have to deal with.
Now that you understand how important a true-up is let's look at the various types of true-up. Some are far superior to others.
The first true-up method is to finalize the match with the final paycheck of the year. Say an employee contributes $19,500 in the first 6 months of the year which means they only got half of the match. Under this system you won't match anything until their final paycheck of the year where you will then pay the other half. This is the old school way of handling a true-up and by far the worst. It means companies have a large expense at the end of the year if many employees are doing this, employees will miss out on their money growing for 6 months, and if an employee leaves the company they won't get the matching 401(k) contributions that they should have. The only positive of this method is that the employer is providing a true-up.
The second true-up method which has become much more common in the past few years is matching every paycheck as long as the employee has made their contributions. In our example above this would mean at the 6 month mark when the employee has contributed $19,500 the employer continues to match 5% on every paycheck until the end of the year because the employee has already made the equivalent of their contributions on those paychecks, they simply did so early. This method is much better than the end of the year contribution as it ensures employees see the match every paycheck. There's no surprise accounting at the end of the year and employees are paid the match even if they leave before the end of the year.
The third true-up option is one that is ideal for employees who are front loading their 401(k) every year. This is usually a lower number of employees so while this method is appreciated it's not typical. In this situation let's say an employee contributes $19,500 within the first 2 months of the year. In this scenario once they have hit the max contribution the company immediately pays their matching percentage on that paycheck with no additional contributions the rest of the year. This is the ideal scenario as it combines the second method with showing additional care and consideration for highly compensated employees who are financially literate and trying to put their money to work even faster.
The three options above are the most regularly encountered 401(k) true-up scenarios with number 3 being very rare. Option 2 is not as typical but it's the best for everyone involved and it's strange not to see it more since it benefits employees greatly and reduces the end of the year burden on companies. Any employer trying to recruit top talent should consider option 2 as the minimum offering.
No matter which true-up decision you make there is an additional consideration to make and that's for employees who simply cannot afford to contribute 5% of their paycheck. If you aren't performing automatic enrollment of your safe harbor 401(k) then certain rules don't apply but it's worth considering that no matter what amount an employee contributes that the employer will contribute the maximum value (5% in this case). It's a minimal cost and a big boon for employees at all levels.
Bettering your true-up offering may give you the edge over other employers and being able to answer questions related to this topic is crucial. Employees are becoming more financially literate so it's important that companies are as well.
This is part 4 of a 5 part series talking about making a 401(k) so good employees won't believe that it's real and employers won't believe how cheap it is to implement.