Many employers offer 401k plans to their employees for varying reasons. However, the major incentive for starting one is the plan’s tax deferral benefits, which allow high contribution limits.
The current contribution limit for 2021 reaches up to $19,500 for employees under the age of 50, which was the same for 2020. The total contribution limit, including employer contributions, increased from $57,000 in 2020 to $58,000 in 2021. In addition, employees over age 50 and above can bump up their savings through a catch-up contribution with a limit of $6,500, which is unchanged from 2020.
401k plans can be beneficial for employees in growing their retirement savings, especially if the employer is generous with the matching contributions. By March 31, 2021, 401(k) plans had assets valued at approximately $6.9 trillion in assets and made up almost one-fifth of America’s retirement market worth $35.4 trillion.
But, there are existing rules which limit plan contributions. Employers have to be aware of how to manage their plans and especially when they have highly compensated employees on their payroll.
The Internal Revenue Service (IRS) clearly defines what an HCE is and outlines the provisions of non-discriminating tests which employers must take every year. Compliance is required of employers and their employees to avoid facing IRS penalties.
What Is an HCE?
A Highly Compensated Employee (HCE) has to meet two criteria according to the IRS. The first rule is that they have over 5% ownership in the company providing the plan at any time in the current year or previous year. The second rule is that their earnings amounted to $130,000 or more from the firm if the previous year was 2020 or 2021. And also, if they were in the top 20% of the rank in compensation, if the employer chooses.
The set conditions for an HCE are a part of the non-discrimination test which the IRS requires all 401k plans to undertake annually. The test divides 401 k contributors into two; non-highly compensated employees and highly compensated employees to ensure equal benefits for all employees in the company.
Employers pass the test if the average contributions of HCEs do not exceed 2% of the average contributions of non-highly compensated employees (NHCE). Previously, there were no limits on the contributions by highly compensated employees, meaning their contributions could be higher, equally earning them higher tax benefits.
It is important to note that just 5% ownership does not translate to being an HCE, but it starts from a 5.01% share. In addition, spouses can combine their shareholding to meet the threshold provided they work in the same company. The shares of the employees’ children and grandchildren working in the same company also count.
For clarity, compensation referred to in the second criterion includes basic salary, bonuses, overtime, commissions, among others, including 401k plans.
Why It’s Important
The purpose of the non-discrimination test is to ensure all employees receive equal benefits. This acts as a move to inspire any HR professional working in an organization where the ratio of top executives to employees is unbalanced. This means even low-earning employees have an equal chance to grow their retirement plans. Passing the nondiscrimination test is especially important for a company with HCEs or they risk facing penalties from the IRS and other administrative challenges.
There are three main tests to determine if a plan is discriminating:
1. Actual Deferral Percentage (ADP)
This test makes a comparison of the average deferral rates (Pretax and Roth deferrals) of both highly compensated and non-highly compensated employees. ADP is a percentage of the employee’s compensation deferred to the 401k plan. A plan passes the test if the average deferral of the HCE does not exceed 125% of the average deferral of a NHCE. Alternatively, it passes the test if the HCE deferral rate is not more than the lesser of 200% of the average deferral rate of an NHCE or the average deferral rate of the NHCE plus 2%.
2. Actual Contribution Percentage (ACP)
It applies similar tests as ADP but compares the average employee contributions of both HCEs and NHCEs.
3. Top Heavy Test
This targets key employees, and compares their assets with all the assets under the plan. The plan fails the test if the value of assets in the accounts of key employees exceeds the value of total assets in the plan by 60%.
The general rule for a nondiscriminatory plan is that HCEs or top employees do not access more benefits from the plan, and that a good number of non-HCEs participate in the plan.
What to Do If the Plan Fails the Test
There should be no worry if the plan fails the test as there are corrective actions to take. At the minimum, any excess contributions will be refunded to the employee losing out on the tax deduction. However, the excess contribution from the previous year will be reimbursed to the HCE as taxable income in the current year.
Second, the employer can boost the minimum contribution rates of non-HCEs to meet the minimum rates by making non-elective employer contributions. The top-heavy test fail can be corrected through non-key employees receiving a contribution of up to 3% of compensation from the employer.
The IRS 401k Plan Fix-it Guide offers more details on how to rectify ACP and ADP test failure.
Ways to Minimize the Damage
Employers can bypass the HCE rule by taking some steps:
- One solution is for the employee to continue making nondeductible contributions to the 401k plan. However, they will be trading off on accessing tax deductions.
- Another solution is to consider saving money in a taxable account. The employee will not have any limits to their retirement savings even if they are an HCE. They can manage their investment income as they see fit.
- There is also making catch-up contributions if the employee is 50 years or older. If the employee is 50 years or older, they can raise a $6,500 catch-up contribution in 2020 up to $26,000, and this amount extends to 2021.
- Opening a Health Savings Account (HSA) will allow employees to grow tax-deferred savings. This is useful as it will help cover their healthcare costs in the future. Participants save significantly on medical costs because they can withdraw money from an HSA without any tax deductions.
How Does It Affect Your 401k Plan?
Having an HCE in a 401k plan means foregoing some retirement savings and tax breaks. In addition, employers tend to fail the nondiscrimination test conducted every year largely due to its complexity.
So, employers have to manage their 401k plans to ensure the contributions of HCEs do not exceed the contributions of non-HCEs by more than 2%.
Failure to take action will lead to the plan no longer claiming tax-qualified status, and all contributions will have to be redistributed to the participants in the plan. In principle, HCEs might feel constrained in maximizing their retirement contributions.
Why You Might Want To Consider a Safe Harbor 401k
One downside of non-discriminating tests is locking out mostly small to medium-sized companies from passing them. When compared to larger businesses, they have a disproportionate number of HCEs compared to non-HCEs. So, with more HCEs on the payroll going through the test, it is challenging as the contributions of non-HCEs have to be higher.
A safe harbor 401k plan allows employers to find a way around the annual tests. With this plan, an employer is required to contribute to their employees’ retirement accounts in three ways.
The first is the nonelective contribution of 3% made by the employer to every employee, including those not making contributions. The second way is to match 100% of the employees’ contributions on the first 3% of their compensation, and 50% on the next 2% of their compensation. The third option is for a company to match 100% of employees’ contributions with up to 4% of their compensation, but not exceeding a 6% limit.
Integrating a safe harbor 401k means an HCE can max out their contributions, and employers do not have to deal with non-discriminating tests. It is important to note that the plan also has the same deferral limits as other 401ks, which are up to $19,500 per year for employees under 50 years, and a catch-up contribution limit of $26,000 for employees over age 50 or older.
Providing a 401k plan is a solid step towards ensuring a bright retirement future for your employees.
Being a highly compensated employee as stipulated by the IRS can place a significant constraint on maxing out retirement savings. Fortunately, there are ways to counter this, such as opening an HSA account or taking advantage of the catch-up provision.
For employers, they have the option of adopting a safe harbor 401k plan which is exempted from the complex non-discrimination tests and limit on contributions.
The bottom line is, for any employer to have a highly motivated workforce, they need to effectively manage retirement plans for both highly compensated and non-highly compensated employees.