Large variances in employee pay can cause compliance issues for your 401(k) Plan :
- Highly paid employees, owners, and officers known as Key or Highly Compensated Employees (HCE) may wish to defer a greater percentage of their compensation than rank and file employees (Non-highly Compensated Employees or NHCE). This can lead to compliance testing failures.
- Large deferrals made by owners and officers (Key Employees) may cause a plan to be top-heavy.
Example: A business has one Key/Highly Compensated Employee (HCE)earning $185,000 annually and wishing to defer 10% to their 401(k) account, while at the same time having nine employees earning an average of $40,000, who can only defer an average of 3%. The ADP disparity of 7% (10%-3%) exceeds the IRS allowed 2% disparity. Further, the one Key employee’s 401(k) account would likely constitute greater than 60% of total plan assets, making the plan top heavy.
Key employees should be aware of compliance limits. Employers should also consider using employer matching and auto-enrollment plan design features in combination to help NHCEs save more and to reduce the risk of nondiscrimination testing issues.