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 non-discrimination tests.
What are 401k Non-Discrimination Tests?
Non-discrimination tests require employees at or above a certain compensation threshold to stay within a specific 401k contribution rate. This ensures that all employees benefit from 401k plans and prevents company executives from benefiting disproportionately. In other words, they ensure that 401ks are fair. It’s a great goal, but one potential negative effect is that you might face lower contribution limits. Worse yet, you if your plan fails the non-discrimination tests, you might have to pay taxes on an amount you thought you were contributing.
Let’s review the IRS definitions of an HCE and describe the tests your employer (or, more likely, your 401k record keeper) needs to take to ensure that your plan is compliant. Most importantly, let’s also review your options should you find that your retirement savings are limited because you’re an HCE.
Who Is a Highly Compensated Employee?
For IRS purposes, a highly compensated employee is someone who meets one of two criteria:
- Someone owns a higher than 5% stake in a company for the current or previous tax year
- Someone who was paid more than $130,000 in 2021. If your employer selects this option, you’ll be considered a highly compensated employee only if you’re paid more than $130,000 and are among the highest-paid 20% of employees of your company.
How Do the 401k Non-Discrimination Tests Work?
Non-discrimination tests look to see if HCEs are deferring disproportionately more of their income through 401k plans than lower-paid employees. They also look to see if executives’ total 401k contributions are disproportionately higher than the total of other employees’ contributions. The tests need to show that the average contribution percentage is similar, taking employer matching and after-tax contributions into account.
Your HR department should work with your company’s 401k providers to determine 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 $19,500 (or $26,000, if you’re over 50). HR should inform you of your maximum contribution in advance, in which case you won’t have to worry about taxes. However, if your company’s plan fails the nondiscrimination tests, you’ll be faced with a refund of your contributions—and you’ll have to pay Uncle Sam.
Next Steps for You
If you’re an HCE facing potentially limited retirement savings opportunities, what should you do?
Talk to Your Empower
First, you should talk to your employer about setting up your 401k as a safe harbor plan. That means that if your plan meets certain IRS requirements, it can avoid discrimination tests altogether. You can also ask about a non-qualified deferred compensation (or NQDC) plan, which would allow you to save much more than the $19,500 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. It’s worth noting that this sort of plan falls outside the government protections that 401k plans offer; 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 employees in your company to save. Why? Because the equations look at proportionate savings, 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 have been proven to encourage savings. And if 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 as opposed to issuing a refund to HCEs. If you’re facing a refund, you can ask HR if they’ve considered this option as an alternative.
Talk to Your Colleagues
If neither of these is an option, you can take matters into your own hands. Talk to your colleagues about the benefits of retirement planning, and tout the benefits of getting the employer match, which is a benefit they don’t have to pay for. While this course of action may sound implausible, it may actually have the most widespread benefit and is worth considering.
And finally, if you’re out of employer-sponsored options, you could also opt to go the IRA route. It could help you save an additional $6,000, or $7,000 if you’re 50 or older. To learn more about IRA options, check out the Daily Capital writeup on how to think about IRAs.
Talk to an Advisor
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.