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In the situation where an employer is contributing a match to a 401(k), apparently a common formula is to match 50% of employee contributions up to a percentage of their salary. I have also seen this phrased as "50 cents for every dollar".

If the amount is 50% match up to 6% of salary, this equates to "you put in 6% and we'll put in 3%".

Why would they choose to do this, instead of simply offering a match up to 3%?

The match is not more or less either way. It instead forces the employee to put in more money, which has no benefit to the employer. I don't see any advantage to the employer to do it this way, there is only disadvantage to the employee.

What is the logic behind offering a ratio match instead of a 1:1 match?

  • IIRC when 401K's became popular (1980s, roughly speaking) it was not uncommon for companies to offer a 100% match. But by the early to mid 1990s the "50% or 6%" had become pretty standard. I'm not sure if this was just gravitation to the lowest common denominator or if other factors (e.g. the early 1990s recession) played a part. – David Jun 13 '17 at 12:48
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    My employer has the odd policy to contribute 150% up to 6% of salary. I agree with the high rated answer that your policy is intended to capitalize on low-contributing employees. – Brian R Jun 13 '17 at 14:57
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Many employees don't contribute enough to maximize the match, so the cost to the employer is not the same. Under the 50% of 6% strategy an employee contributing 5% would get a 2.5% match not a 3% and that saves the company 0.5%.

@TTT provided an excellent link in the comments below to a study titled "How much employer 401(k) matching contributions do employees leave on the table?" performed by Financial Engines, an independent financial advisory service. The information meaningful to this answer is on Page 5 (Page 7 of the PDF):

  • 4,378,445 eligible employees were included in the study

  • 1,077,775 of the eligible employees did not contribute enough for the full match; of them,

    • 285,386 Received zero match funds

    • 792,389 Received some match funds, but not the full match available

So 792,389 or 18% of the employees studied contributed in to employer 401(k) plans but not enough to maximize their available match.

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    Proof that you are right: financialengines.com/docs/… (About 25% of employees don't contribute enough to max-out the employer match.) – TTT Jun 12 '17 at 20:50
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    Well, maybe... anecdotally, I have known many people who didn't contribute to the 401(k) at all despite the match. I have known very few people who contributed, but at a level that earned less than the full match. – stannius Jun 12 '17 at 21:45
  • That "study" doesn't indicate what percent fall into that latter group. It just says that X% failed to get the full match. – stannius Jun 12 '17 at 21:56
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    @stannius, Page 5 under the Overall Findings heading: "Of the employees contributing below the full employer match level, 285,386 (7 percent) received no match, and the rest (792,389) received only a partial match." – quid Jun 13 '17 at 16:52
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This creates incentive for the employee to contribute more and increases the funds under management of the 401(k) plan. The size of the plan influences the fees that are charged in each of the funds offered. (The more assets under management, the better for those in the plan.)

More importantly, 401(k) plans are not allowed to discriminate in favor of highly compensated employees. That discrimination is determined by calculating the average deferrals by your lower compensated employees and comparing them to the average deferrals of your highly compensated employees. If highly compensated employees are saving too much compared to the rest of the pack, they will have some of their contributions returned the next year (with all the tax implications of that). Forcing everyone to contribute 6% to get the full match helps the plan to not fail the discrimination test and protects the highly compensated employees from losing some of their tax deferrals.

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    I'm not sure how matching 50% of 6% vs 100% of 3% protects against HCE discrimination. If anything HCEs have more ability to save 6% versus 3% (more disposable income). – D Stanley Jun 12 '17 at 18:14
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    @DStanley - the calculation for discrimination is simply to look at the results, not to look at how that was achieved. Interesting discussion, but in my answer I noted that it was protecting HCEs from losing their deferral. I didn't state that it was actually less discriminatory. I hope I implied that this was all done for the benefit of the HCEs with less consideration of the needs of the NHCEs. – Nathan L Jun 12 '17 at 18:19
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    @DStanley if they just wanted to rig it in favor of people with more disposable income they'd just say 50% match up to 3% and then 100% up to 6%. The IRS doesn't let you do that though. I still am skeptical that protecting high comps is why companies go with this strategy though. – Jared Smith Jun 12 '17 at 18:23
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    @JaredSmith do you have a source for the rate at which companies fail discrimination testing? – quid Jun 12 '17 at 19:09
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    The HCE discrimination tests are based on the deferral as a percentage of each individual's salary, not absolute dollars. So if a 50% match gets NCHE's to defer a slightly higher percentage, that helps meet the test. – stannius Jun 13 '17 at 18:02
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Another factor to consider is that it encourages employees to contribute more into to the plan so that they'll be able to comfortably retire. Getting the full match encourages people to put at least 6% in to avoid leaving money on the table; 100% of the 1st 3% would see a lot of people only putting 3% in instead. While 9% of your income is still a rather marginal amount to be saving; it will leave you in a much better place in your 60's than if you had only put in 6%/year.

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    +1 for giving management the benefit of the doubt. ;) – Nathan L Jun 12 '17 at 19:12
  • @NathanL It's a strategy I've seen recommended before as a way to encourage people to save more. – Dan Neely Jun 12 '17 at 19:30
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    This assumes the company sets the policy based on benefit to the employees rather than to the company. While there are some companies that are known for employee altruism, it's probably not as common as this policy. – Barmar Jun 14 '17 at 21:26
  • A reason like this would be more likely if it were a government mandate, rather than an employer option. – Barmar Jun 14 '17 at 21:27
3

401k contributions are exempt from employee and employer FICA withholding. The employer withholding is approximately 7% of the gross. The closer the employer match ratio is to 7%, the closer it is to paying for itself.

Example: Assuming an employee is match-maximizing and in very round numbers grosses 100,000 per year. A 50% match schedule is about $350 cheaper per employee than a 100% match schedule:

Default non participant: The employee will see about 7000 deducted for FICA, and the employer will pay 7000 to FICA if they don't participate.

First case: the match is 100%, 1-for-1 to a 5% cap, the employee will deduct 5000, and have 6650 withheld for FICA. The employer will pay 6650 to FICA. The total employer cost of withholding and match is 11,650.

Second case: If the match is 50%, 1-for-2 to a 5% cap, the employee will deduct 10000, and have 6300 withheld for FICA. The employer will pay 6300 to FICA. The total employer cost of withholding and match is 11,300.

  • Exemptions don't pay for themselves, they just cost a bit less. You may be confusing exemptions with credits. – Ben Voigt Jun 13 '17 at 15:16
  • @BenVoigt There is a tax expense employers pay on post tax income (but not pre-tax deductions) that is not a line item on the employee paycheck. While a 401k match will not fully pay for itself, a brochure from a regional commuter benefit administrator made exactly the case that the commuter benefit would put bottom line money in the pockets of the business, even with the benefit administrator charging a 3% handling fee, by the 7% FICA withholding. – user662852 Jun 13 '17 at 16:50
  • There's only money "in the pockets of the business" if the match comes out of the salary paid to the employee, but then it isn't a match, it is just an employee contribution. I guess you're assuming that the employee contribution in order to qualify for the match saves the employer money, but (1) the employer only saves 7% of the amount of the contribution, but matches 50% or 100% and (2) if the employee makes a Roth contribution then withholding doesn't go down at all. – Ben Voigt Jun 13 '17 at 17:03
  • @BenVoigt I added an example. The point is to directly answer the question posed by the OP, why a company might choose a 50% match schedule versus a 100% match schedule. This difference is worth about $300 to them per 100K employee. – user662852 Jun 13 '17 at 17:58
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    "401k contributions are exempt from employee and employer FICA withholding." This true for traditional 401(k) plans, but not for Roth 401(k) plans, for which the contributions are made post-tax. – shoover Jun 13 '17 at 22:38

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