Jan
28
2022
What Is 401k Auto Escalation?

What Is 401k Auto Escalation?

By | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off on What Is 401k Auto Escalation?

One way to ensure you’re steadily working toward your retirement goals is to automate as much of the process as possible. Some employers streamline the retirement savings process for their employees with automatic enrollment, signing you up for a retirement plan unless you choose to opt out.

There are many ways to automate a 401(k) experience at every step of the way. You can have contributions taken directly from your paycheck before they ever hit your bank account and invest them right away. With automatic deductions, you’re more likely to save for your future rather than spending on immediate needs.

In some cases, you may also be able to automatically increase the amount you save. Some employers also offer an auto escalation option that will increase your retirement savings amount as you get older. Here’s a closer look at how 401(k) auto escalation works and how it may help speed you on your way to your retirement goals.

401(k) Recap

A 401(k) is a defined contribution plan offered through your employer. It allows employees to contribute some of their wages directly from their paycheck. Contributions are made with pre-tax money, which may reduce taxable income in the year they are made, providing an immediate tax benefit.

In 2022, employees can contribute up to $20,500 a year to their 401(k), up from $19,500 in 2021. Those aged 50 and older can contribute an extra $6,500, bringing their potential contribution total to $27,000 per year.

For many individuals, the goal is to eventually max out a 401(k) up to the contribution limit. Employers may offer matching funds to help encourage employees to save. Individuals should aim to contribute at least enough to meet their employer’s match, in order to get that “free money” from their employer to invest in their future.

💡 Recommended: Understanding the Different Types of Retirement Plans

How 401(k) Auto Escalation Works

An auto escalation is a 401(k) feature that automatically increases your contribution at regular intervals by a set amount until a preset maximum is achieved. The SECURE Act, signed into law in 2019, allows auto escalation programs to raise contributions up to 15%. Before then, the cap on default contributions was 10% for auto escalation programs.

For example, you may choose to set your auto escalation rate to raise your contributions by 1% each year. Once you hit that 15% ceiling, auto escalation will cease. However, you can still choose to increase the amount you are saving on your own beyond that point.

Advantages of 401(k) Auto Escalation

When it comes to auto escalation programs, there are important factors to consider — for employees as well as for employers who sponsor the 401(k) plan.

Advantages for Employees

•   Auto escalation is just one more way to automate retirement savings, so that it is always prioritized.

•   Auto escalation may increase the amount employees save for retirement more than they would on their own.

•   Employees don’t have to remember to make or increase contributions themselves until they reach the auto escalation cap.

•   Increasing tax-deferred contributions may help reduce an employee’s tax burden.

Advantages for Sponsors

Employers who offer auto escalation may find it helps with both employee quality and retention as well as with reducing taxes.

•   Auto escalation provides a benefit that may help attract top talent.

•   It helps put employees on track to automatically save, which may increase retention and contribute to their sense of financial well-being.

•   It reduces employer payroll taxes, because escalated funds are contributed pre-tax by employees.

•   It may generate tax credits or deductions for employers. For example, matching contributions may be tax deductible.

•   As assets under management increase, 401(k) companies may offer lower administration fees or even the ability to offer additional services to participants.

Disadvantages of 401(k) Auto Escalation

While there are undoubtedly benefits to 401(k) auto escalation, there are also some potential downsides to consider.

Disadvantages for Employees

Even on autopilot, it can be important to review contributions so as to avoid these disadvantages.

•   Auto escalation may lull employees into a false sense of security. Even if they’re increasing their savings each year, if their default rate was too low to begin with, they may not be saving enough to meet their retirement goals.

•   If an employee experiences a pay freeze or hasn’t received a raise in a number of years, auto escalation will mean 401(k) contributions represent an increasingly larger proportion of take-home pay.

Disadvantages for Sponsors

Employers may want to consider these potential downsides before offering 401(k) auto escalation.

•   Auto escalation requires proper administrative oversight to ensure that each employee’s escalation amounts are correct — and it may be time-consuming and costly to fix mistakes.

•   This option may increase the need to communicate with 401(k) record keepers.

•   Auto escalation may cause employer contribution amounts to rise.

Is 401(k) Auto Escalation Right for You?

If your employer offers auto escalation, first determine your goals for retirement. Consider whether or not your current savings rate will help you achieve those goals and whether escalation could increase the likelihood that you will.

Also decide whether you can afford to increase your contributions. Perhaps your default rate is already set high enough that you are maxing out your retirement savings budget. In this case, auto escalation might land you in a financial bind.

However, if you have room in your budget, or you expect your income to grow each year, auto escalation can help ensure that your retirement savings continue to grow as well.

If your employer does not offer auto escalation, or you choose to opt out, consider using pay raises as an opportunity to change your 401(k) contributions yourself.

The Takeaway

A 401(k) is one of many tools available to help you save for retirement — and auto escalation can help you increase your contributions regularly without any additional thought or effort on your part.

If you’ve maxed out your 401(k) or you’re looking for a retirement account with more flexible options, you may consider opening a traditional or Roth IRA with SoFi Invest®. Both types of IRA offer tax-advantaged retirement savings, and in 2022, individuals can save $6,000 per year across IRA accounts, with an extra $1,000 catch-up contribution available to those aged 50 and older.

You can also work toward savings goals by investing in a taxable brokerage account. These accounts allow you to save beyond what you can contribute to retirement accounts, but don’t offer any tax advantages.

Find out how SoFi can help you save for retirement.

FAQ

Is 401(k) auto enrollment legal?

Yes, automatic enrollment allows employers to automatically deduct 401(k) contributions from an employee’s paycheck unless they have expressly communicated that they wish to opt out of the retirement plan.

What is automatic deferral increase?

Automatic deferral increase is essentially the same as auto escalation. It automatically increases the amount that you are saving by a set amount at regular intervals.

Can a company move your 401(k) without your permission?

Your 401(k) can be moved without your permission by a former employer if the 401(k) has a balance of $5,000 or less.

Photo credit: iStock/Halfpoint

SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Update: The deadline for making IRA contributions for tax year 2020 has been extended to May 17, 2021.
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Jan
27
2022
What to Know About Orphan 401k Accounts

What to Know About Orphan 401k Accounts

By | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off on What to Know About Orphan 401k Accounts

The term “orphan 401(k)” refers to 401(k) plans that former employees have forgotten about or otherwise abandoned. (It can also refer to a workplace retirement account that no longer has a sponsor.)

Someone could end up with one or more orphan 401(k) plans if they make frequent job changes throughout their working years. If you have dormant 401(k) accounts with previous employers, you could be leaving a significant amount of money on the table.

Knowing how to find orphan 401(k) plan assets — and what to do with them once you do — matters for planning your financial future.

What Is an Orphan 401(k) Account?

A 401(k) retirement account is a defined contribution plan that allows employees to save money for retirement on a tax-advantaged basis, using elective salary deferrals. A 401(k) plan also allows employers to make matching contributions on the employee’s behalf.

An orphan 401(k) account or dormant 401(k) is a 401(k) plan that a plan participant has left behind after leaving a job. Many people have one or more orphan 401(k) plans. That’s because the typical worker changes jobs approximately 12 times during their lifetime, according to data from the Bureau of Labor Statistics (BLS).

Assuming you enroll in their employer’s 401(k) plan with each new job, you could easily end up with a dozen orphan 401(k) accounts by the time you’re ready to retire. The money left behind in orphan accounts doesn’t disappear but it doesn’t automatically follow the plan participant either.

Orphan 401(k) plans can be costly for employers to maintain on behalf of former employees. And the employee, of course, misses out on the benefit of the money saved in those accounts as they work to get on track for retirement.

What to do with an Orphan 401(k) Account

It’s important to understand what to do with orphan 401(k) accounts, because doing nothing could mean missing out on a valuable addition to your retirement plan. If you have one or more orphan accounts, there are several options for managing them, including:

•   Cashing the plan out

•   Rolling the money into a 401(k) plan at your current employer

•   Rolling orphan 401(k) amounts into an Individual Retirement Account (IRA)

•   Leaving it with your former employer

Each option has pros and cons. Cashing out an orphan 401(k), for example, could put a lump sum of cash into your hands. But you’ll owe income tax on the full distribution, along with a 10% early withdrawal penalty if you’re younger than 59 ½.

Rolling the money over into your current 401(k) or into an IRA can help you avoid both taxes and penalties, assuming you pursue a direct rollover. If you don’t have as much extra money as you’d like to invest in your 401(k) at your current job, for example, rolling over money from an orphan 401(k) could give your balance a boost. But it’s important to evaluate investment options when doing so, as you could end up paying higher management fees.

If you’re satisfied with your former employer’s investment options and fees, you could leave your orphan 401(k) where it is for the time being. Keep in mind, however, that your employer may cash you out of the plan if your balance is below $1,000.

If you have one or more orphan 401(k) plans, here’s a simple checklist of what to do next:

•   Locate each account, taking note of the account balance and plan investments.

•   Consider your overall retirement goals and how much you have saved in total so far.

•   Estimate the potential tax consequences and costs of cashing out your old orphan accounts and think about how you’d use those funds.

•   Evaluate your current 401(k) and/or IRA to determine if rolling over orphan 401(k) plans makes sense, based on the investment options available and whether doing so might yield fee savings.

Looking at your entire retirement outlook can help you decide the best way to manage orphaned 401(k) accounts while minimizing taxes and investment fees.

Pros and Cons of Orphan Accounts

A 401(k) can be an incredibly useful type of retirement plan, given the tax benefits it infers. With a traditional IRA, the money you contribute is tax-deductible and growth is tax-deferred. If your employer offers a matching contribution, that’s free money you can put toward your retirement.

Your plan may also allow in-service loans at low interest rates, which is helpful if you need to borrow money in a pinch.

Orphan 401(k)s, however, have their own benefits and drawbacks.

Orphan 401(k) Pros

These accounts represent money you could add to the retirement savings pot that informs your retirement plan. You could roll the funds over to your current 401(k) or an IRA in order to keep growing retirement wealth on a tax-advantaged basis. Or you could withdraw the cash in a lump sum if needed.

Orphan 401(k) Cons

Orphan 401(k) accounts may be difficult to track down if you’ve changed jobs frequently. Even if you know where your orphan 401(k) accounts are, it can be hard to manage multiple accounts and keep track of your investments and fees across your entire portfolio.

Summary of Pros and Cons of Orphan Accounts

Pros

 Cons
You have several options from which to choose (keeping the orphan account, rolling it over, cashing out, etc.) It can be difficult to manage multiple 401(k) accounts and make holistic portfolio decisions.
You may have access to unique investments or lower fees through an old 401(k) than you have at your current account. It’s easy to lose track of old 401(k) accounts.
Money maintained in a 401(k) account may have better protection from creditors than other types of accounts. If you keep the account with your former employer, you’re only able to invest in those investment options on the plan menu.

Pros and Cons for Employers

Some employers prefer having orphan accounts remain in plan, but others do not. That’s because keeping former employee assets in plan may give them access to better pricing from financial services providers. But there is also an added administrative cost for employers to manage orphan plans.

How to Find Orphan 401k Plans

It’s possible that you could have one or more orphan accounts you’ve forgotten about over the years. But that doesn’t mean your money is lost forever. Fortunately, there are different possibilities for how to find orphan 401(k) plan assets.

1. Contact Previous Employers

The simplest way to find an old 401(k) account may be to reach out to your previous employer. You can contact your former company’s human resources administrator or the plan administrator who should be able to tell you the status of your orphan account.

There may be three possibilities, depending on the account balance:

•   Balance of $1,000 or less: Your former employer could have cashed out the account and sent the check to your last-known address on file.

•   Balance of $1,000 to $5,000: Your former employer could have rolled the money over to an IRA on your behalf.

•   Balance greater than $5,000: Your account should still be intact with your former employer.

If your employer claims that they sent you a check but you didn’t receive it, you’ll need to try and track that payment down.

If your employer rolled the account into an IRA, your plan administrator or HR administrator should be able to provide the details of the account. You can then reach out to the financial institution that holds the IRA for more details on your account balance and investments.

Assuming your orphan 401(k) is still in place with your former employer, you can then decide whether you’d like to leave it where it is, cash it out or roll it over.

2. Dig Deeper

It’s possible that your former plan administrator may not have details available for where your 401(k) money went. In that case, you’ll need to do a little more digging to try to find it. There are several resources you can use to search for orphan 401(k) accounts online, including:

•   Department of Labor’s abandoned plan database

•   FreeERISA, which allows you to search for employee benefit plans by zip code

•   National Registry of Unclaimed Retirement Benefits , which could help you find orphan 401(k) plans if your former employer’s are registered

The more information you can provide, the easier it may be to find missing 401(k) accounts. For example, to use the Department of Labor’s abandoned plan database, it helps to know your plan name, employer name, city, state and zip code when completing a search.

3. Search Unclaimed Property Databases

If you’re still unsuccessful in turning up orphan 401(k) plans, there are some other databases you can use to search for them. Employers who can not track down plan owners may turn over their assets to their state’s unclaimed property department.

You can look for missing money through these sites:

•   Unclaimed.org , sponsored by the National Association of Unclaimed Money

•   Administrators

•   MissingMoney.com

•   Unclaimed.com

You can also search for abandoned or orphaned pension plans through the Pension Guaranty Corp.’s unclaimed pension benefits database .

Retirement Investing With SoFi

Finding orphan accounts could help you to boost your total retirement savings balance overnight. One way to put that money to use is by rolling that money over to a new IRA to streamline your investment strategy.

If you don’t have one yet, the SoFi Invest® investment app makes it easy to open a Traditional or Roth IRA. Once you’ve created an account, you can use it to build a portfolio of stocks and exchange-traded funds.

FAQ

How can I find out if I have an old 401(k) account?

The easiest way to find out if you have an old 401(k) account is to contact your former employer’s human resources administrator or plan administrator and ask. They should be able to tell you if you were enrolled in the company’s 401(k) plan and if so, where that account is now.

How do I find all my retirement accounts?

If you believe you have multiple orphan 401(k) accounts floating around, you could use a retirement benefits database to search for them. There are multiple databases you can use to search for orphan accounts, including 401(k) plans and pension plans. You can also use unclaimed money databases to search for inactive or dormant 401(k) accounts.

Are unclaimed retirement benefits legit?

The National Registry of Unclaimed Retirement Benefits is a legitimate resource for finding lost or missing retirement accounts. The database allows you to search for orphan 401(k)s simply by entering your Social Security number. If the database finds an unclaimed retirement account, you can then reach out to the employer whose contact information is listed for more information.

Photo credit: iStock/LaylaBird

SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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Jan
27
2022
Everything You Need to Know About Lifestyle Funds and Lifestyle Investing

Everything You Need to Know About Lifestyle Funds and Lifestyle Investing

By | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off on Everything You Need to Know About Lifestyle Funds and Lifestyle Investing

Lifestyle funds are investment funds that base their asset allocation on someone’s age, risk tolerance, and investing goals. Individuals who want to grow wealth over the long term in a relatively hands-off way might consider lifestyle investings.

There are different types of lifestyle funds investors may choose from, based on their appetite for risk, the level of risk needed to achieve their goals, and their investing time horizon. Lifestyle assets often also appear inside different types of retirement accounts, including employer-sponsored retirement plans and Individual Retirement Accounts (IRAs).

Whether becoming a lifestyle investor makes sense for you can depend on what you hope to achieve with your portfolio, how much risk you’re comfortable taking, and your overall time horizon for investing.

What Are Lifestyle Funds?

A lifestyle fund or lifestyle investment holds a mix of investments that reflect an investor’s goals and risk tolerance. These investment funds tailor their investment mix to a specific investor’s needs and age to provide a simplified solution for reaching their goals.

Lifestyle funds may invest in both equities (i.e. stocks) and fixed-income securities, such as bonds and notes. These funds may require fewer decisions by the asset owner, since they adjust automatically through changing lifestyle needs until you reach retirement. With lifestyle assets, as with other types of funds, it’s important to consider the balance between risk and reward.

Lifestyle funds that carry a higher degree of risk may offer higher returns to investors, while those that are more conservative in terms of risk may yield lower returns.

How Do Lifestyle Funds Work?

Typically purchased through a retirement account or a brokerage account, lifestyle funds work by creating a diversified portfolio to meet an investor where they are, while also taking into account where they’d like to be 10, 20 or 30 years from now.

An investor can choose from an initial lifestyle fund allocation, then adjust the risk level up or down based on their preferences. A fund manager reviews the asset allocation for the fund and rebalances periodically to help an investor stay on track with their goals.

The level of risk an investor takes may correlate to the average age of retirement, which for most people is around 65. So someone who’s 25 years old now has 40 years to invest for the future, meaning they can afford to take more risk to achieve their goals. As they get older, their tolerance for risk may decrease which could mean moving away from stocks and toward fixed-income investments.

Unlike target-date funds, the level of risk in lifestyle funds doesn’t change significantly over time. So if you were to choose an aggressive lifestyle fund at 25, the asset allocation of that fund would more or less be the same at age 65. That’s important to understand for choosing the lifestyle fund that’s appropriate for your risk tolerance and goals.

Recommended: Explaining Asset Allocation by Age

Two Stages of Lifestyle Funds

Lifestyle investing can work in different stages, depending on where you are in your investing journey. Lifestyle funds accommodate these different stages by adjusting their asset allocation.

This is something the fund manager can do to ensure that you’re working toward your goals without overexposing yourself to risk along the way. The two stages of lifestyle funds are the growth stage and the retirement target date stage.

1. Growth Stage

The growth stage represents the period in which a lifestyle investor is actively saving and investing. During the growth stage, the emphasis is on diversifying investments to achieve the appropriate balance between risk and reward. This phase represents the bulk of working years for most people as they move from starting their careers to reaching their peak earnings.

In the growth stage, lifestyle funds hold an asset allocation that reflects the investor’s goals and appetite for risk. Again, whether this is more conservative, aggressive or somewhere in-between depends on the individual investor. At this time, the investor is typically concerned with funding retirement accounts, rather than withdrawing from them.

2. Retirement Target Date

The retirement target date stage marks the beginning of the countdown to retirement for an investor. During this stage, the focus shifts to preparing the investor to begin drawing an income from their portfolio, rather than making new contributions or investments.

At this point, a lifestyle investor may have to decide whether they want to maintain their existing asset allocation, shift some or all of their assets into other investments (such as an annuity), or begin drawing them down in cash. For example, an investor in their mid-50s may decide to move from an aggressive lifestyle fund to a moderate or conservative lifestyle fund, depending on their needs, anticipated retirement date, and how much risk they’re comfortable taking.

Different Types of Lifestyle Funds

Lifestyle funds aren’t all alike and there are different options investors may choose from. There are different ways lifestyle funds can be structured, including:

•   Income-focused funds. These lifestyle funds aim to produce income for investors, though capital appreciation may be a secondary goal. Fixed-income securities typically make up the bulk of lifestyle income funds, though they may still include some equity holdings.

•   Growth-focused funds. Lifestyle growth funds are the opposite of lifestyle income funds. These funds aim to provide investors with long-term capital appreciation and place less emphasis on current income.

•   Conservative asset allocation funds. Conservative lifestyle funds may have a long-term goal of achieving a set total return through both capital appreciation and current income. These funds tend to carry lower levels of risk than other lifestyle funds.

•   Moderate asset allocation funds. Moderate lifestyle funds often take a middle ground approach in terms of risk and reward. These funds may use a “fund of funds” strategy, which primarily involves investing other mutual funds.

•   Aggressive asset allocation funds. Aggressive lifestyle funds may also use a “fund of funds” approach, though with a slightly different focus. These funds take on more risk, though rewards may be greater as they seek long-term capital appreciation.

Lifestyle Investment Risks

Investing for retirement with lifestyle assets has some risks, so it’s important to make sure that the fund you choose matches your risk tolerance. Risk tolerance refers to the amount of risk an investor is comfortable taking in their portfolio. Risk capacity is the amount of risk needed to achieve investment goals.

Typically, younger investors can afford to take more risk in the early years of their investment career as they have more time to recover from market declines. But if that investor has a low risk tolerance, they may still choose to stick with more conservative investments. If their risk tolerance doesn’t match up with the amount of risk they need to take to achieve their investment goals, they could fall far short of them.

When considering lifestyle funds, it’s important to consider your risk mix and risk level. While lifestyle funds can simplify investing in that you don’t necessarily need to make day-to-day trading decisions, it’s still important to consider how your risk tolerance and risk capacity may evolve over time. As you move from the growth stage to the retirement target date stage, for instance, you may need to make some adjustments to your lifestyle fund choices in order to keep pace with your desired goals.

Advantages of Lifestyle Funds

In addition to their risks, lifestyle funds offer numerous advantages to investors, starting with simplicity. When you invest in a lifestyle fund, you know more or less what to expect in terms of asset allocation, based on the risk tolerance that you specify. These funds don’t require you to be an active investor in order to realize returns.

Some funds also automatically rebalance on behalf of investors, so there’s very little you need to do, other than be mindful of how the fund’s risk mix reflects your risk tolerance at any given time.

A lifestyle fund can offer broad diversification, allowing you to gain exposure to a variety of assets without having to purchase individual stocks, bonds or other securities.

Compared to other types of mutual funds or exchange-traded funds (ETFs), lifestyle funds may carry lower expense ratios. That can allow you to retain more of your investment returns over time.

Finally, lifestyle funds encourage investors to stay invested through market ups and downs. That can help you to even out losses through dollar-cost averaging.

Lifestyle Funds vs Target Date Funds

If you have a 401(k), then you’re likely familiar with target date funds as they’re commonly offered in workplace retirement plans. A target date fund, or lifecycle fund, is a mutual fund that adjusts its asset allocation automatically, based on the investor’s target retirement date. These funds are distinguishable from lifestyle funds because they typically have a year in their name.

So a Target Date 2050 fund, for example, would attract investors who plan to retire in the year 2050. Target date funds also take a diversified approach to investing, with asset allocations that include both stocks and fixed-income securities.

The difference between target date funds and lifestyle funds is that target date funds follow a specific glide path. As the investor gets closer to their target retirement date, the fund’s asset allocation adjusts to become more conservative. Lifestyle funds don’t do that; instead, the asset allocation remains the same.

Recommended: Target-date Funds vs. Index Funds: Key Differences

The Takeaway

Whether you choose to invest with lifestyle funds, target date funds, or something else, the most important thing is to get started saving for retirement. The longer your time horizon until retirement, the more time your money has to grow through the power of compounding interest.

An easy way to get started is by opening a retirement account on the SoFi® Invest investment app. Through it, you can open an IRA or taxable account and use it to build a portfolio of stocks and exchange-traded funds.

FAQ

What is a lifestyle pension fund?

A pension fund is a type of defined benefit plan, in which employees receive retirement benefits based on their earnings and years of service. A lifestyle pension fund is a pension fund that allocates assets using a lifestyle strategy in order to meet an investor’s goals and needs.

What is a lifestyle strategy?

In investing, a lifestyle strategy is an approach that chooses investments that can help an investor to reach specific milestones or goals while keeping their age and risk tolerance in mind. With lifestyle funds, the asset allocation doesn’t change substantially over time.

What is a lifestyle profile?

A lifestyle profile is a tool that investors use to help them select the most appropriate lifestyle funds based on their age, risk tolerance goals.

Photo credit: iStock/GaudiLab

SoFi Invest®
SoFi Invest refers to the two investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA(www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of SoFi Digital Assets, LLC, please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Bank, N.A.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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Jan
27
2022
What Is Compliance Testing for 401k?

What Is Compliance Testing for 401k?

By | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off on What Is Compliance Testing for 401k?

To maintain the tax-advantages of a 401(k) or 403(b) retirement plan, employers must follow the rules established by the Employment Retirement Income Security Act (ERISA) of 1974, including nondiscrimination testing.

Compliance testing ensures that companies administer their 401(k) plans in a fair and equal manner that benefits all employees, rather than just executives and owners. In other words, a 401(k) plan can’t favor one group of employees over another.

Companies must test their plans yearly and address any compliance flaws surfaced by the tests. Often a third-party plan administrator or recordkeeper helps plan sponsors carry out the tests.

Understanding nondiscrimination tests for retirement plans is important both as an employer and as an employee.

401(k) Compliance Testing Explained

Compliance testing is a process that determines whether a company is fairly administering its 401(k) plan under ERISA rules. ERISA mandates nondiscrimination testing for retirement plans to demonstrate that they don’t favor highly compensated employees or key employees, such as company owners. Compliance testing for 401(k) plans is the responsibility of the company that offers the plan.

How 401(k) Compliance Testing Works

Companies apply three different compliance tests to the plan each year. These tests look at how much income employees defer into the plan, how much the employer 401(k) match adds up to, and what percentage of assets in the plan belong to key employees and highly compensated employees versus what belongs to non-highly compensated employees.

There are three nondiscrimination testing standards employers must apply to qualified retirement plans.

•   The Actual Deferral Percentage (ADP) Test: Analyzes how much income employees defer into the plan

•   The Actual Contribution Percentage (ACP): Analyzes employers contributions to the plan on behalf of employees

•   Top-Heavy Test: Anayzes how participation by key employees compares to participation by other employees

The Actual Deferral Percentage (ADP) Test

The Actual Deferral Percentage (ADP) test counts elective deferrals of highly compensated employees and non-highly compensated employees. This includes both pre-tax and Roth deferrals but not catch-up contributions made to the plan. This 401(k) compliance test measures engagement in the plan based on how much of their salary each group defers into it on a yearly basis.

To run the test, employers average the deferral percentages of both highly compensated employees and non-highly compensated employees to determine the ADP for each group. Then the employer divides each plan participant’s elective deferrals by their compensation to get their Actual Deferral Ratio (ADR). The average ADR for all eligible employees of each group represents the ADP for that group.

A company passes the Actual Deferral Percentage test if the ADP for the eligible highly compensated employees doesn’t exceed the greater of:

•   125% of the ADP for the group of non-highly compensated employees Or

•   The lesser of 200% of the ADP for the group of non-highly compensated employees or the ADP for those employees plus 2%

The Actual Contribution Percentage (ACP) Test

Plans that make matching contributions to their employees’ 401(k) must also administer the Actual Contribution Percentage (ACP) test. Companies calculate this the same way as the ADP test but they substitute each participant’s matching and after-tax contributions for elective deferrals when doing the math.

This test reveals how much the employer contributes to each participant’s plan as a percentage, based on their W-2 income. Companies pass the Actual Contribution Percentage test if the ACP for the eligible highly compensated employees doesn’t exceed the greater of:

•   125% of the ACP for the group of non-highly compensated employees OR

•   The lesser of 200% of the ACP for the group of non-highly compensated employees or the ACP for those employees plus 2%

Companies may run both the ADP and ACP tests using prior year or current-year contributions.

Top-Heavy Test

The Top-Heavy test targets key employees within an organization who contribute to qualified retirement plans. The IRS defines a key employee as any current, former or deceased employee who at any time during the plan year was:

•   An officer making over $200,000 for 2022 ($185,000 for 2021 and 2020)

•   A 5% owner of the business OR

•   An employee owning more than 1% of the business and making over $150,000 for the plan year

Anyone who doesn’t fit these standards is a non-key employee. Top-heavy ensures that lower-paid employees receive a minimum benefit if the plan is too top-heavy.

Under IRS rules, a plan is top heavy if on the last day of the prior plan year the total value of plan accounts for key employees is more than 60% of the total value of plan assets. If the plan is top heavy the employer must contribute up to 3% of compensation for all non-key employees still employed on the last day of the plan year. This is designed to bring plan assets back into a fair balance.

Why 401(k) Compliance Testing Is Necessary

Compliance testing in 401(k)s ensures that investing for retirement is as fair as possible for all participants in the plan, and that the plan continues to receive favorable tax treatment from the IRS. The compliance testing rules prevent employers from favoring highly compensated employees or key employees over non-highly compensated employees and non-key employees.

If a company fails a 401(k) compliance test, then they have to remedy that under IRS rules or risk the plan losing its tax-advantaged status. This is a strong incentive to fix any issues with non-compliant plans as it can cost employers valuable tax benefits.

Nondiscrimination testing can help employers determine participation across different groups of their workers. It can also shed light on what employees are deferring each year, in accordance with annual 401k plan contribution limits.

Highly Compensated Employees

The IRS defines highly compensated employees for the purposes of ADP and ACP nondiscrimination tests. Someone is a highly compensated employee if they:

•   Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation they earned or received, OR

•   Received compensation from the business of more than $130,000 (if the preceding year is 2021 or 2020) or $135,000 (if the preceding is 2022) and, if the employer so chooses, was in the top 20% of employees when ranked by compensation

If an employee doesn’t meet at least one of these conditions, they’re considered non-highly compensated. This distinction is important when compliance testing 401(k) plans, as the categorization into can impact ADP and ACP testing outcomes.

Non-Highly Compensated Employees

Non-highly compensated employees are any employees who don’t meet the compensation or ownership tests, as established by the IRS for designated highly compensated employees. So in other words, a non-highly compensated employee would own less than 5% of the interest in the company or have compensation below the guidelines outlined above.

Again, it’s important to understand who is a non-highly compensated employee when applying nondiscrimination tests. Employers who misidentify their employees run the risk of falling out of 401(k) compliance. Likewise, as an employee, it’s important to understand which category you fall into and how that might affect the amount you’re able to contribute and/or receive in matching contributions each year.

How to Fix a Non-Compliant 401(k)

The IRS offers solutions for employers who determine that their 401(k) is not compliant, based on the results of the ADP, ACP or Top-Heavy tests. When a plan fails the ADP or ACP test, the IRS recommends the following:

•   Refunding contributions made by highly compensated employees in order to bring average contribution rates in alignment with testing standards

•   Making qualified nonelective contributions on behalf of non-highly compensated employees in order to bring their average contributions up in order to pass test

Employers can also choose to do a combination of both to pass both the ADP and ACP tests. In the case of the Top-Heavy test, the employer must make qualified nonelective contributions of up to 3% of compensation for non-highly compensated employees.

Companies can also avoid future noncompliance issues by opting to make safe harbor contributions. Safe harbor plans do not have to conduct ADP and ACP testing, and they can also be exempt from the Top-Heavy test if they’re not profit sharing plans. Under safe harbor rules, employers can do one of the following:

•   Match each eligible employee’s contribution on a dollar-for-dollar basis up to 3% of the employee’s compensation and 50 cents on the dollar for contributions that exceed 3% but not 5% of their compensation.

•   Make a nonelective contribution equal to 3% of compensation to each eligible employee’s account.

Safe harbor rules can relieve some of the burden of yearly 401(k) testing while offering tax benefits to both employers and employees.

The Takeaway

A 401(k) represents one of the most valuable links in the chain when planning retirement goals. Part of the value of a 401(k) is its tax-preferred status, so it’s important for employers to conduct IRS-mandated compliance testing in order to maintain that tax treatment. However, the 401(k) is not the only way to save for retirement in a tax-favored way.

If you don’t have a 401(k) at work, however, or you’re hoping to supplement your 401(k) savings you may consider opening your first Individual Retirement Account (IRA) instead. Since IRAs are not employer-sponsored, they’re not subject to 401(k) compliance testing, though they do have to follow IRS rules regarding annual contribution limits and distributions. An easy way to open an IRA online is by creating an investment account on the SoFi Invest app.

FAQ

What is top-heavy testing for 401(k)?

Top-heavy testing for 401(k) plans determine what percentage of plan assets are held by key employees versus non-key employees. If an employer’s plan fails the top-heavy test, they must make qualified, nonelective contributions on behalf of non-key employees in order to bring the plan into compliance.

What happens if you fail 401(k) testing?

If an employer-sponsored plan fails 401(k) compliance testing, the IRS requires the plan to make adjustments in order to become compliant. This can involve refunding contributions made by highly-compensated employees, making qualified nonelective contributions on behalf of non-highly compensated employees or a combination of the two.

What is a highly compensated employee for 401(k) purposes?

The IRS defines a highly compensated employee using two tests based on compensation and company ownership. An employee is highly compensated if they have a 5% or more ownership interest in the business or their income exceeds a specific limit for the preceding year. Income limits are set by the IRS and updated periodically.

Photo credit: iStock/tumsasedgars

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