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Seeking Fairness: 401ks & Highly Compensated Employees

If you meet the IRS definition of being a highly compensated employee (“HCE”), you may find yourself in an unlikely position come tax-time: having to pay tax on your 401k contributions.

But aren’t 401k contributions tax-free?  They are – but as an HCE, you’d owe tax on any 401k contributions refunded to you. This could happen if your company 401k plan fails its nondiscrimination tests.

Non-discrimination tests are administrative tests associated with 401ks that were put in place to ensure that all employees are benefiting from 401k plans and that company executives are not benefiting disproportionately.  In other words, they’re meant to ensure 401ks are fair.  It’s a great goal, but a potential perverse effect is that you might face lower contribution limits – or worse, that you might have to pay taxes on an amount that you thought you were contributing to your 401k if your plan fails to meet the tests.

In the following post, I review the IRS definitions of an HCE and describe the tests that your employer (or more likely, your 401k recordkeeper) needs to take to ensure your 401k plan is compliant.  And more importantly, I review your options if you find yourself in the situation that your 401k retirement savings are limited because you’re an HCE.

Who Is a Highly Compensated Employee?

For IRS purposes, an HCE is someone who owns a higher than 5 percent stake in a company for the current tax year or the previous year.  You are also considered a highly compensated employee if you were paid more than $115,000 for 2014. In some cases (if your employer had elected this option), you will be considered a highly compensated employee only if you’re paid more than $115,000 and are among the highest-paid 20 percent of employees of your company.

IRS Tests

So how do non-discrimination tests work?  Essentially, they look to see if HCEs are deferring disproportionately more of their income through 401k plans than the rank-and-file employees and also if the total 401k contributions of the executives are disproportionately higher than the total 401k contributions of the other employees. To get into the weeds, the first test needs to show that the average deferral percentage (ADP) is no more than 2% (or 125% of, whichever is more) than non-HCEs. The second test needs to show that the average contribution percentage (ACP) is similar, but also takes into account employer matching and after-tax contributions.

In reality, your HR department should work with your company’s 401k providers to sort out whether the nondiscrimination tests affect your ability to save in a 401k.  If you’re an HCE, your effective annual limit may be lower than the standard $17,500 (or $23,000 if you’re over 50).  Typically, HR should inform you of your maximum contribution in advance, and you won’t have to worry about taxes.  However, if your company’s plan fails the nondiscrimination tests, you will be faced with a refund of your contributions – and owe Uncle Sam tax.

Next Steps?  Talk to HR, and then to Other Employees, or Save Elsewhere.

So as an HCE facing potentially limited retirement savings opportunities, what do you do?

The first step: talk to your employer about setting up the plan as a safe harbor plan.  That means, if your plan meets certain IRS requirements, it can avoid discrimination tests altogether.  You might also ask about a nonqualified deferred compensation plan, which would enable you to save much more than the $17,500 cap on a tax-deferred basis. The plan horizon could even be five or 10 years and you could save for purposes other than retirement. (NB: this sort of plan falls outside the government protections that a 401k plan offers and if the company goes bankrupt, you could lose your money).

If that’s not an option, you can talk to HR about how to get more people in the company to save.  That’s because the equations look at proportionate saving; so getting people throughout the company to save more will increase your potential savings levels. Setting up automatic 401k enrollment for employees and setting default savings rates has proven to help encourage savings.  Further, in the event that a company fails its non-discrimination test, it can elect to distribute a qualified non-elective contribution (QNEC) to some or all of non-HCEs (rather than issue a refund to HCEs).  So if you’re facing a refund, you can ask your HR if they’ve considered this option as an alternative.

If neither of these is an option, you can take matters into your own hands.  What would that mean?  Talking to colleagues about the benefits of retirement planning and touting the benefits of getting the employer match, which is essentially a benefit they don’t have to pay for.  While this course of action may sound implausible, it actually might have the most widespread benefit and is worth a second thought.

And finally, if you’re out of employer-sponsored options, you could also opt to go the IRA route to save additional money of up to $5,500, or $6,500 for those 50 or older.   To learn more about IRA options, check out the Daily Capital write-up about how to think about IRAs.

Want help sorting through your options? Speak to a Personal Capital advisor to help you figure out the best way to save for retirement as an HCE.

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32 Comments

  1. Cee Cee

    Allow me to sum this up. The HCE limits are socialism in action. The 2014 limit for 401K pre-tax contributions is $17,500. If we are all to be treated equally under the law, that should be the rule. Period. Due to the upcoming generation of baby boomers that will be drawing social security, I will very likely not see benefits for myself when I reach retirement age in 2035. I will also not have a lifetime pension plan like Congress (who voted for this law) or the IRS (who enforces this law). This scares me. A lot. Rather than just being scared and angry, I prefer to take action and save as much as I can. With this new “fairness” rule, I am now handicapped in reaching my investment and retirement goals and ultimately living my senior years without fear of poverty. Why should I be dragged down by my fellow employees because they only contribute 5% toward their 401K? Why should this statistic prevent me from saving for my retirement? What about other companies where the investment average might be 10%? Why does where someone works have any influence on how much percentage can be set aside in a 401K? It doesn’t make sense. The new rule for “fairness” is actually unfair.

    Reply
    • wdh

      I agree with you. I don’t get the “fair” part of the situation. Why is it our problem if we maxed our contribution limit and someone else didn’t. Change the law to a max percentage of earnings from the outset if you want to make it fair! That way we’ll all be limited to 7% or whatever. Don’t dangle the $17,500 then take it away!

      Reply
    • Doug

      Very well said!

      Reply
  2. Brian

    Derek,
    If you don’t have a lot of cash laying around, and you need money to put your three kids through college, then why are you bothered that you are capped at 5%? Your two statements point at not having enough money available to invest in retirement.
    The reason you’re capped at 5% is because the employees at your company who make less than $115k per year are contributing less than 5% on average. The point of the law is to get people like you to get others to contribute more, either through direct interaction, or pressuring your company to implement policies that encourage others to save.
    First, be happy that you make a decent salary. Second, I suggest that you either do something about it, or stop complaining. I doubt that any of those at your company who make less than you will feel sorry for your situation.

    Reply
    • DB

      The problem with the 5% cap on HCE’s is that it is usually an “unwritten” rule and the HR guys would call you up and bully you into “willingly” limiting your contribution. Note that 5% on $100,000 is only $5000 and is hardly 401k-worthy (you could do the same in an IRA).

      I think the actual written rules (ie in the full plan description) say something totally different, and I think legally HR should not be allowed to force you to follow their “unwritten” rule based on their facile strategy for passing the ADP test.

      Reply
    • Dan

      I find this response to Derek’s situation absolutely outrageous. Who do you think you are? Generally, people do not want to be told what to do with their income – rather, they prefer to make their own lifestyle choices. It is not Derek’s fault that some of his co-workers making less than he does decide to live in a way that prevents them from saving more for retirement than they should. Maybe they wanted to buy that new car and consume their income now, maybe they wanted to go on that vacation even though they couldn’t afford it, or maybe they had kids before they should have. Maybe Derek thought about these things and intentionally planned for them. Who is Derek to strike up a conversation at the water cooler to let his fellow employees know they are living beyond their means. And who in the world are you to determine that $115k is officially too much money for somebody to earn relative to others who may lack the ambition Derek does….It’s an absolute shame people like you, Brian, have been allowed to influence policy….Simple solution to retirement savings problem is automatically signing up employees in America into plans and them letting them opt out if they need to, remember choice? If they don’t save enough, then they keep working or scale back. It’s not the fault of the people who plan (yes, even lower income people can plan) to pay for the people who don’t.

      Reply
    • Jaime

      Brian. I don’t think Derek meant he has surplus cash just laying around his home. From my understanding of Derek’s question, he probably has enough money to contribute to his retirement maximum, in this case $18,000 under 50 years old, despite his ability to fund all 3 of his children’s college education (he doesn’t say if it’s half, all or part of his children’s education). He simply wants to contribute the max allowable without any strings attached.

      Reply
  3. Derek

    I just searched for and came here looking for info on HCE. I could not understand why I was capped at 5%. I earn 109k and get a bonus that takes me over 115K. I am just stunned I am capped at 5% and not allowed to invest more. It is not like I have lots of cash laying around saving for my retirement. I have to put 3 kids through college.. why am I penalized just because I earn a little over 115k. The cap should be higher so that normal workers are not effected.

    Reply
  4. Poonka

    Thanks for your comment, Sam. I’m sure HR people are vigilant about watching for such discrepancies.

    I imagine they won’t want to have to face HCEs who find they have to pay tax on their excess 401(k) contributions since their plan failed the ADP or ACP tests, which are easy enough to figure out.

    That’s why a safe harbor plan would also be a good option.

    Reply
  5. Financial Samurai

    Thanks Poonka. I’ve never heard of HCE as it pertains to retirement plans, perhaps because such discrimination doesn’t happen often given if it did, HR wouldn’t be doing their jobs?

    Can you use some sample income figures of a HCE and other employees to help illustrate a point of non compliance and how HR would change the system too comply?

    Thanks

    Reply