Order of Benefit Deductions from Employee Pay
From time to time we field questions about the order in which deductions for various employee benefits (e.g., 401(k) plan elective deferrals and insurance premiums for welfare benefit plan benefits) should be taken from an employee’s pay. The questions range from whether ERISA mandates a specific order to what happens to a participant’s 401(k) plan deferral election when gross pay is not sufficient to permit all benefit deductions.
Some employers may view medical and other welfare benefit plan benefits (particularly during a pandemic) as a higher priority than 401(k) plan elective deferrals. Accordingly, they program their payroll system to take employee contributions for all welfare benefit plan benefits first (e.g., premiums for medical, dental, disability and life insurance, and health care reimbursement account contributions), with pre-tax employee contributions typically preceding post-tax employee contributions, then 401(k) plan loan payments, and then 401(k) plan elective deferrals. Other employers may prioritize retirement savings and, accordingly, program payroll to take 401(k) plan loan payments and elective deferrals before any welfare benefit plan deductions.
Bottom line: Nothing in ERISA mandates a specific order for benefit deductions, and we are not aware of any U.S. Department of Labor or Treasury rules or other formal guidance on this topic applicable to private sector employers.[1] In the absence of such rules or guidance, we have advised that employers are free to establish their own internal policy governing the order of benefit deductions and should consistently apply it.
As for the ordering of 401(k) plan loan payments and 401(k) elective deferrals, we think loan payments should be taken prior to elective deferrals to minimize the potential for default (and consequent deemed distribution of the outstanding loan balance for federal income tax purposes should the participant fail to make a missed loan payment by the end of the plan’s cure period).
Employers should take care, however, to ensure that their internal policy governing the order of benefit deductions does not inadvertently create an operational failure with respect to their 401(k) plan.
Example: Employee X’s weekly gross pay is $1,000, and the definition of “pay” for purposes of making elective deferrals under the 401(k) plan is gross pay. Employee X has an outstanding loan from the 401(k) plan, and the weekly loan payment amount is $400. Employee X’s deductions for various welfare benefit plan benefits total $500 per week, and Employee X has a 401(k) plan deferral election (pre-tax) of 20% in effect.
No matter the order in which the loan payment, elective deferrals and welfare benefit plan deductions are taken, under the terms of the 401(k) plan $200 (20% x $1,000) should be withheld from the employee’s gross pay and contributed to the 401(k) plan as a pre-tax elective deferral. If the 401(k) loan payment ($400) and the deductions for welfare benefit plan benefits ($500) are taken first, the remaining cash from Employee X’s weekly gross pay ($100) will not be sufficient to permit the full amount of elective deferrals ($200) to be made to the 401(k) plan, and there will be a 401(k) plan operational failure (i.e., a failure to implement Employee X’s deferral election).
To avoid the 401(k) plan operational failure illustrated in the example, we recommend that the plan administrator of the 401(k) plan adopt a written administrative rule (1) referencing the employer’s policy governing the order of benefit deductions, and (2) providing that in the event the employee’s gross pay for a payroll period is not sufficient to implement the employee’s 401(k) plan deferral election, the employee’s deferral election will be reduced automatically for such payroll period to 0%, or, if greater, the percentage that can be supported by the employee’s remaining gross pay for such payroll period. Similarly, it may be appropriate for an employer to establish a written policy relating to its Code Section 125 cafeteria plan that addresses what happens to benefit elections under that plan when gross pay is not sufficient to permit all deductions.
Please contact a member of our Employee Benefits & Executive Compensation Group if you have questions relating to the order of benefit deductions from an employee’s pay.
[1] Interestingly, in 2008 the United States Office of Personnel Management issued an Order of Precedence When Gross Pay Is Not Sufficient to Permit All Deductions that applies to civilian Federal employees. The Thrift Savings Plan contributions referenced at item 11.h. of the Order of Precedence are analogous to 401(k) plan elective deferrals.
