Given the significant tax benefits of 401(k) participation, the IRS maintains rules designed to ensure that the benefits are broadly distributed across employees. Although IRS permits individuals to defer up to $19,000 of compensation and receive annual contributions up to a combined total of $56,000, what is often overlooked is the nondiscrimination rules that limit contributions of highly-compensated employees (HCEs) and Key employee balances relative to contributions and balances of the plan’s other employees.
To understand the significance of being a Highly Compensated or Key employee, you should start by reviewing how nondiscrimination testing works.
Who is an HCE 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.
- Earned more than $120,000 last year from this employer and were in the top 20% of all employees by compensation*; or
- Own more than 5% of the company sponsoring the 401(k) plan, (including stock options and restricted stock), or
- Are a spouse, child, grandchild, or parent of an owner.
- Are an officer earning over $175,000; or
- Own more than 5% of the business; or
- Own more than 1% of the business and earn over $150,000
- Are a spouse, child, grandchild, or parent of a 1%+ or 5%+ owner.
So I’m an HCE and/or Key employee -- what does this mean for me?As explained in the nondiscrimination testing overview, when HCE contributions or Key employee 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, your employer may take actions to increase the likelihood of passing and mitigate the impact of any required corrections. These actions include:
- limiting owner contributions to the plan,
- 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, 401(k) refunds are not uncommon and Guideline works hard to make this a smooth and transparent process.
Frequently, corrections for ADP and ACP testing take the the form of refunds to HCEs. The HCEs who have contributed higher dollar amounts will receive larger refunds. Before any refunds are issued, your employer will approve the correction and HCEs receiving refunds will be notified.
Refunds are issued after the end of the year, typically between February and May (depending on plan type), and are taxable as ordinary income in the year of distribution. Unlike early distributions from the plan, refunds issued as a result of failed nondiscrimination testing are not subject to early distribution penalties.
You will receive a 1099-R reporting the taxable income amount in the year in which the refund was issued, which must be reported in your income tax return filed during the following year. (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.)
How do I know how much I can contribute?While Guideline actively monitors your plan’s compliance throughout the year, factors such as hiring, terminations, and changes in participation make it difficult to predict exactly how much HCEs and Key employees can defer without requiring corrections.
However, Guideline can help you and your company make informed decisions about contributions based on the information available. If you have questions or are concerned about compliance limits, we encourage you to contact Guideline Support to understand whether your plan may be at risk. If your plan is near IRS compliance limits, it may be advisable to reduce your contribution rate and avoid refunds. The good news is that more than 90% of plans will not require any corrections.
If your plan is projected to fail nondiscrimination testing, you may always choose to continue deferring at your current rate, but doing so may increase the risk of your plan failing testing and result in refunds being issued to you and other HCEs. That said, refunds to HCEs are a normal part of 401(k) plan operation. So don’t be alarmed if your plan is required to make ADP or ACP testing refunds.
Helping Prevent Compliance Issues in Small PlansIn smaller plans, HCE and Key employees can assist Guideline to more accurately project risk of a nondiscrimination failure and in some circumstances reduce the need for corrections. Here are some steps you can take as an HCE or Key employee:
- Plan to contribute to your 401(k) evenly over the course of the year. This allows Guideline to better assess risk, and if your plan is likely to fail compliance testing there is greater opportunity to reduce your contributions to prevent a failure. This will also ensure that you maximize any matching you are due.
- Avoid drastic contribution increases. Check with Guideline before making a substantial increase in deferrals, particularly in the latter part of the year. At smaller companies, one drastic jump in the contributions of an HCE can push a plan outside compliance limits. When this happens later in the year, there is limited opportunity to mitigate the failure.
- If your plan is at risk of failing ADP / ACP testing, reducing your contributions can prevent the inconvenience of receiving refunds.
- Monitor Owner / Officer contributions. If Key employees reduce contributions in a coordinated way, it may be possible to prevent a plan from being considered Top Heavy and thus avoid costly Top Heavy minimum contributions.
- 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.