Most people recognize that a 401(k) is one of the very best retirement programs available. If your company offers one, you should definitely take advantage of it. It allows for more generous contributions than most other plans available to employees and often comes with an employer matching contribution. But what most people are less aware of is that there are 401(k) limits for highly compensated employees.
Guide to 401(k) Contribution Limits for Highly Compensated Employees
Understanding 401(k) Contribution LimitsThe main attraction of 401(k) plans is the amount you can contribute. For 2020, it’s $19,500, up a bit from $19,000 in 2019. You can also make a “catch up” contribution if you’re 50 or older. That adds another $6,500 to the contribution (up from $6,000 in 2019). If your employer has a matching contribution, it turns into a serious wealth accumulation scheme. For example, let’s say you make the full $19,500 contribution. But you’re 50 years old, so you can add another $6,500. That’s $26,000 coming from you. Your employer has a 50% match, and contributes another $9,750, and you’re already fully vested in the plan. That brings your total contribution for the full year up to $35,750. That’s the kind of money that early retirement dreams are made of. It’s also why 401(k) plans are so popular.
- Account Set Up Fees $0
- Trade Commission $4.95
- Mutual Fund Commission $9.95
- Annual Fee $0*
- Account Minimum $0
- Promotion up to $150
Additional Limits for Highly Compensated EmployeesAs attractive as that looks, there are serious limits on the plan if you fall under the category of highly compensated employee, or “HCE” for short. The thresholds defining you as an HCE are probably lower than you think. I’m going to give the definition in the next section, but suffice it to say that if you fall into this category your 401(k) plan suddenly isn’t as generous.
What Determines a Highly Compensated Employee?The IRS defines a highly compensated employee as one who…
- Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
- For the preceding year, received compensation from the business of more than $125,000, and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
Non-discrimination TestsI may be guilty of giving you more information here than you want to know. But this gets down to the mechanics of the whole HCE thing. If you’re an employee, you don’t have to worry about this – your employer will perform these tests. But it might be important if you are the owner of a small business, and need to actually perform the test yourself. If you don’t have an appetite for the technical, feel free to skip over this section. To make sure all goes according to regulation, the IRS requires that employers perform non-discrimination tests annually. 401(k) plans must be tested to make sure the contributions made for lower paid employees are “proportional” to those made for owners and managers who fit under the category of highly compensated employees.
ADP and ACP TestsThere are two types of tests: Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP). ADP measures elective deferrals, which includes both pretax and Roth deferrals, exclusive of catch-up contributions, of both highly compensated employees and non-HCEs. Using this method, the participants’ elective deferrals are divided by their compensation, which produces the actual deferral ratio (ADR). as calculated for both HCEs and non-HCE employees. (Stay with me now!) The ADP test is met if the ADP for eligible highly compensated employees doesn’t exceed one of:
- 125% of the ADP for non-HCEs, OR
- The lesser of 1) 200% of the ADP for non-HCEs, or 2) the ADP for the non-HCEs, plus 2%.
- 125% of the ACP for non-HCEs, OR
- The lesser of 1) 200% of the ACP for the group of non-HCEs, or 2) the ACP of non-HCEs, plus 2%.
The 2% RuleNotice that on each test, there’s the provision of “plus 2%”. That’s significant. The average 401(k) contributions of HCEs in the plan cannot exceed those of non-HCEs by more than 2%. In addition, collective contributions by HCE’s cannot be more than twice the percentage of non-HCE’s contributions. One of the biggest problems with non-discrimination tests is that the results can be exaggerated if non-HCEs make relatively small percentage contributions, or if few participate in the plan. As a highly compensated employee, you might max out your contributions every year. But employees who earn more modest incomes may go for minimal contributions. That can skew the results of the testing. Unfortunately, there’s no easy way around that problem.
What Happens if Your 401(k) Plan Fails the Test?This is where the situation gets a bit ugly. The test can be performed within 2 ½ months into the new year (March 15) to make the determination. They’ll then have to take action to correct it within the calendar year. If the plan fails the test, your excess contribution will be returned to you. You’ll lose the tax deduction, but you’ll get your money back and life will go on. There’s a bit of a complication here too. The excess contribution to the plan during the last tax year will be refunded the following year as taxable income to the HCE. That means that when you get your excess contribution refund, you’ll need to put money aside to cover the tax liability. Better yet, make an estimated tax payment to avoid penalties and interest. That’ll be important if the excess refunded is many thousands of dollars. What happens if the problem isn’t identified and corrected within that time frame? It gets really ugly.
Manage Your 401(k) with BlooomEven though you will encounter contribution limits to your 401(k) if you meet the criteria above, you can still benefit from contributing to one. While multiple robo-advisors can help you manage your 401(k), Blooom is the only platform built solely around 401(k)s, meaning they do it really well.
Blooom allows for rebalancing your portfolio, keeping your stock to bond ratio in check, researching market trends, avoiding hidden fees, and getting you your match.Your employer never has to play a part in the process. You also get access to living breathing financial advisors, even though Blooom is a robo-advisor. All of these services come at the cost of $10 a month, with no minimum balance requirement. Your contributions may be capped due to your earnings, but with Blooom you can rest easy knowing you aren’t losing money elsewhere. Open a Blooom account today >>
Highly Compensated Employee 401(k) Workaround StrategiesIf you’re a highly compensated employee, are there any strategies to reduce the impact? Yes – none as good as being able to make a full tax-deductible 401(k) contribution, but they can minimize the damage.
- Make nondeductible 401(k) contributions. You can still make contributions, you’ll just lose the tax deduction. That’s isn’t a complete disaster though. Those contributions will still generate tax-deferred investment income.
- Make a 401(k) catch-up contribution. 401(k) catch-up provisions aren’t restricted by highly compensated employee rules. This offers potential relief – providing you’re 50 or older. 401(k) plans come with a catch-up provision of $6,500 if you’re 50 or older. If you’re considered to be highly compensated, you can still make this contribution.
- Have your spouse max-out his or her retirement contribution. That is, if they’re not also considered a highly compensated employee.
- Set up a Health Savings Account (HSA). This isn’t a retirement plan, but it will provide tax-deferred savings. That will help you build up a plan to pay health costs in your retirement years. For 2018 you can contribute up to $7,100 (married) or $3,550 (single). You get a tax break on your contribution.
- Save money in taxable accounts. Naturally, some sort of tax-sheltered savings plan is always preferred, especially if you’re seriously limited in your 401(k) plan. But this option should never be ignored. If you’re a highly compensated employee, but your retirement contributions are limited, you’ll need to do something to make up the difference.