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.
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.