In most cases employees are happy to know they are considered “highly compensated”, but when the Department of Labor (DOL) is reviewing your company’s 401(k) plan it’s not such a good label always. Being labeled a highly compensated employee (HCE) can reduce the amount an employee may contribute to his or her 401(k). The idea behind the IRS’ rule is to prevent a large discrepancy between the benefits higher compensated employees receive when compared to lower compensated employees. If the difference is too big, employees can lose the tax deduction they get for contributions.
An HCE is defined as an individual who owns more than 5% of the company or who received more than $110,000 for 2011 ($115,000 for 2012) in compensation. The cut-off point varies by company for HCE contributions. The total of elective contributions to a qualified 401(k) plan can be no more than 125% of the average deferral percentage (ADP) of all eligible non-highly compensated employees in a calendar year. Note that the average is taken from all eligible non-HCEs, not just those who are participating. To reduce the chances of having a low cut-off threshold many companies institute an automatic enrollment program that requires new employees to opt out when hired. If they do not opt out, contributions will begin automatically into the plan’s default investments. Employers can also set-up a safe harbor 401(k) plan to avoid the HCE rule. Safe Harbor plans are not subject to these discrimination tests. The downside is the expense for the employer due to the requirement to make fully vested gift contributions or a matching contribution to all plan participants.
In a case where excessive contributions are made by an employee, the excess contributions must be returned to the employee. These redistributed funds will be taxed in the year they are received as income. Employees can inquire with the plan sponsor to find out an estimate of what the cut-off contribution percentage will be. The final exact percentages might not be known until the year is over.
Non-discrimination testing is included at no additional charge for all AF Capital Management managed 401(k) plans.