Most people never need to worry about a special category of limits on 401k contributions. As a matter of fact, most people don’t even know that this category exists. However, those who have found themselves included in the highly compensated employees (HCE) category, learn quickly about the additional limits that are placed on their 401k contributions.
What Constitutes Highly Compensated Employee
In order to be considered a highly compensated employee, the employee must make over $110,000 per year (2011) AND be in the top 20% of earners within their company. So even if you are the highest paid person working at your company, if you make less then $110,000 annually, then the limits do not apply to you.
Understanding 401k Contribution Limits
Money contributed to a 401k plan is done so tax free. Therefore, in order to keep people from money, there are limits imposed on how much can be contributed per year. In 2011, the maximum individual contribution per year is $16,500. In addition to an individual contribution, employers can make matching contributions. So if an employer pays a 50% matching contribution, and the employee contributed $10,000, then the employer would contribute an additional $5000.
However, the maximum amount that an employer is allowed to contribute is 6% of the employes compensation (salary). So to use nice round numbers, if an employee earns $100,000 per year, the maximum an employer can contribute is $6000. With the 50% match program mentioned before, if an employee were to contribute the full $16,500 per year, the employers matching contribution would be $8250, however for a $100,000 per year earner, that would exceed the 6% limit, therefore the most the employer could contribute would be $6000. This would make the contribution for the year $22,500.
Individuals can contribute to their 401k on an after tax basis. The maximum total contribution for a calendar year is $49,000 or 100% of their salary (compensation), whichever is less.
Additional Limits for Highly Compensated Employees
In addition to the limits set for all individuals mentioned above, HCE’s are subject to further limitations on their 401k contribution limits. For someone who falls into the category of a highly compensated employee, meaning they make over $110k and are in the top 20% of earners in their company, the total contribution that an employer can make is limited. The limit is based on the employers overall 401k participation rate. The contribution to the pool of HCE’s can not be more then 125% of the average of all on the non-HCE’s contributions. So the amount of the contribution is really dependent on how many non-highly compensated employees are participating in the companies 401k plan.
If payments in excess of 125% were made to highly compensated employees, then the funds must be returned to the employee. The employee may use those funds to re-contribute to their 401k as a post tax employee contribution. Any post tax contributions made must be reported as taxable income for tax filing purposes.