As discussed in our primer on nondiscrimination testing, given the significant tax benefits of a 401(k), a plan could fall into the trap of being almost exclusively enjoyed by company owners and officers. While the IRS permits participants to defer up to $19,000 (or $25,000 if the participant is over age 50) of compensation and receive annual contributions up to a combined total of $56,000, small business owners often overlook the nondiscrimination rules that limit contributions of certain owners, officers, and other highly-compensated employees (HCEs) if they don’t offer a safe harbor plan.
Who is a Highly Compensated or Key employee?
Within the context of a 401(k) plan, certain participants are considered to be Highly Compensated Employees (HCEs) or Key employees. Participants are classified in this manner for the purpose of conducting required nondiscrimination testing to ensure the plan is not disproportionately benefiting highly-paid employees and owners.
How is ownership determined?
For purposes of your 401(k) plan, owners with an interest of more than 1%, may be considered Key or Highly Compensated employees. A participant’s ownership interest is the highest level of vote or value held at any point during the year. A participant who holds restricted stock or an exercisable option to acquire stock is treated as owning the stock for purposes of determining ownership.
Family Attribution of Ownership
For purposes of your 401(k) plan, a participant’s ownership interest is calculated by combining their ownership interest with that of any family member who is also an owner of and earns income from the company. An employee who is a spouse, child, grandparent or parent of an owner is considered an owner for purposes of nondiscrimination testing. A grandchild, sibling, or in-law of an owner is not considered an owner based on attribution rules.
For example, if Jane owns 0.5% of ABC Company and her husband, John, owns 0.6%, they are both considered to be greater than 1% owners of ABC Company. Similarly, if Jane owns 2% and John owns 0%, both are considered more than 1% owners.
Who is an officer?
For purposes of your 401(k) plan, officers will generally include the president, vice-presidents, general managers, and others who perform duties normally corresponding to those positions. Determination of whether an employee is an officer is based on their actual authority as to the company and not on their title.
So I’m an HCE and/or Key employee -- what does this mean for me?
As explained in our nondiscrimination testing overview, when HCE contributions or Key employee account balances are disproportionate relative to NHCE contributions or non-Key employee balances, corrective action may be required. Corrective action may include refunding deferrals made by HCEs or an employer contribution to non-HCE or non-Key employees or a combination of the two.
Occasionally, if a potential compliance testing failure becomes apparent during the year, we may recommend actions to increase the likelihood of passing and mitigate the impact of any required corrections. These actions include:
- asking HCEs or Key employees to reduce or suspend their contributions, and/or
- encouraging NHCEs to increase their contributions for the remainder of the year.
What if I receive a refund?
Don’t be concerned, refunds to HCEs and owners are routine and Guideline tries to make this process as smooth and transparent as possible.
Frequently, corrections for ADP and ACP testing take the the form of refunds to HCEs with those HCEs who contributed higher dollar amounts receiving larger refunds.
Refunds are issued after the end of the year, typically beginning in February and are taxable as ordinary income in the year of distribution. Before any refunds are issued, the plan administrator will have the opportunity to review the correction and HCEs receiving refunds will be notified. Unlike other cash distributions, nondiscrimination testing refunds are not subject to early distribution penalties.
If you receive a refund, you will receive a 1099-R reporting the taxable income, which you will use in preparing your tax return for the year in which you received the refund. (For example, if excess contributions must be returned to HCEs for the 2018 plan year, these funds will typically be refunded in February 2019, which you’ll report on your 2019 tax return when you prepare your taxes in 2020.)
What can I do as a participant?
- Guideline actively monitors compliance throughout the year, however changes in participation and employee base make exact prediction impossible. Plan to contribute to your 401(k) evenly over the course of the year. Avoiding dramatic contribution changes allows Guideline to better assess risk, and help you to maximize any matching your plan offers.
- Educate your colleagues. If employees collectively save more, HCEs can also save more. Help educate employees who may not be participating on the benefits of 401(k) savings.
What can a plan administrator do?
Guideline helps plan administrators make informed decisions based on the information available. We conduct testing on an ongoing basis and display the results on the Compliance Status page of the Guideline dashboard. We have information on plan design, compliance testing, steps to mitigate risk, how corrections work, and are always happy to answer questions at Guideline Support.
We understand that it can be frustrating to not be able to contribute as much as you would like when you are responsibly prioritizing retirement savings. In addition to discussing other savings options with a financial advisor, consider speaking with your employer about switching to a safe harbor plan or using a discretionary match to stimulate broader participation.