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.
Understanding 401(k) Contribution Limits
The main attraction of 401(k) plans is the amount you can contribute. For 2018, that $18,500, up from $18,000 in 2017. You can also make a “catch up” contribution if you’re 50 or older. That adds another $6,000 to the contribution. If your employer has a matching contribution, it turns into a serious wealth accumulation scheme.
For example, let’s say you make the full $18,500 contribution. But you’re 50 years old, so you can add another $6,000. That’s $24,500 coming from you. Your employer has a 50% match, and contributes another $9,250, and you’re already fully vested in the plan. That brings your total contribution for the full year up to $33,750.That’s the kind of money that early retirement dreams are made of. It’s also why 401(k) plans are so popular.
Additional Limits for Highly Compensated Employees
As 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.
This is how the HCE provisions can limit 401(k) plan contributions by highly compensated employees.
If you’re determined to be an HCE after the fact – like after you’ve made a full 401(k) contribution for the year – the contribution will have to be reclassified. The excess will be refunded to you, and not retained within the plan. An important tax deduction will be lost.
Here’s another little wrinkle…an HCE isn’t always obvious. The IRS has what’s known as family attribution, which means you can be determined to be an HCE by blood. An employee whose a spouse, child, grandparent or parent of someone who is a 5% (or greater) owner of the business, is automatically considered to be a 5% (or greater) owner.
Let’s dig down a little deeper…
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 $120,000, and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
Right away, I think I know what’s going through your mind: $120,000 is highly compensated? I know, right? In much of the country, particularly the big coastal cities, like New York and San Francisco, that’s barely enough to get by. But this is just where the IRS drew the line, and we’re stuck with it. If I were to guess, I’d say the base is probably a number set years ago, it’s never been adequately updated.
The whole purpose of highly compensated employee 401(k) (HCE 401(k)) is to prevent higher paid workers from getting most of the benefit from employer-sponsored retirement plans. After all, the higher your income, the more you can pay into the retirement plan. An employee being paid $150,000 per year can contribute a lot more than someone making $50,000. The IRS regulation is designed to reduce this imbalance.
I 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) tests, and
- Actual Contribution Percentage (ACP) tests
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 the greater 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%.
Are you still with me???
Notice 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 timeframe?
It gets really ugly.
There’s a bit more to this, but I’m not going to go any further. This is just to give you an idea as to how serious the IRS is about an HCE 401(k).
Highly Compensated Employee 401(k) Workaround Strategies
If 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 $6,000 if you’re 50 or older. If you’re determined 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 $6,900 (married) or $3,450 (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.
The Humble IRA to the Rescue
An even simpler option is just to make an IRA contribution. There’s nothing fancy here, but if you’re a highly compensated employee, never overlook the obvious. There are three ways you can do this:
Make a contribution to a traditional IRA. Virtually anyone at any income level can make a contribution. But the tax deduction for a contribution – if you’re already covered by an employer plan – phases out at $121,000 for married couples, in $73,000 for singles . But if HCE status limits your 401(k) contributions, this will be a way to take advantage of tax deferral of investment income. Contributions aren’t nearly as generous as they are for 401(k) plans, at djust $5,500 per year (or $6,500 if you,re 50 or older), but every little bit helps.
Make a contribution to a Roth IRA. You can make a contribution if your income doesn’t exceed $135,000 (single), or $199,000 (married). There’s no tax deduction with Roth IRA conversions, but you will have deferral of investment income. Best of all, once you retire, withdrawals can be taken tax-free.
Make a non-deductible traditional IRA contribution, then do a Roth conversion. If you do, you can avoid the tax liability of the conversion. But you’ll be converting tax-deferred savings into tax-free with the Roth. One of the biggest benefits of this strategy is that there’s no income limit. Even if your income exceeds the thresholds above, you can make a nondeductible contribution to a traditional IRA, and then convert it to a Roth IRA.
Final Thoughts on 401k Limits for Highly Compensated Employees
If you’re an employee of a large organization, your employer has probably figured out how to avoid the HCE problem. It’s more of an issue for smaller employers. If you are the employer, this is a situation you’ll need to monitor closely. Your plan administrator should be able to help.
There are two of the ways to fix the problem. You can offer a safe harbor 401(k) plan, which is not subject to the discrimination tests. Otherwise, you can provide a generous employer match. The match can boost employee participation in the plan to well over 50%, which often fixes the HCE problem.
But if you’re a highly compensated employee in a small company, you won’t know it’s a problem until you get notification from your employer. That will come in the form of a return of what is determined to be your excess contribution, and a potential tax bill as a result.
Are you considered to be a highly compensated employee, or have you been in the past? Did you get hit with a refund and a subsequent tax bill? What are you or your employer doing to fix the problem?