protect retirement fundsIt didn’t have an incendiary, attention-grabbing headline, but Why You May Not Be Able to Max Out Your 401(k), was provocative enough to make us sit up and read. The superbly detailed story by Christine Benz provides invaluable insights on ”what to do if your company’s plan fails nondiscrimination testing.” Here is the first of two blogs on her excellent article, which is densely packed with useful information.

“’Say what?’

“That was my response when a friend recently told me that she had a portion of her 2012 401(k) contribution refunded back to her in March of this year.

“How could that happen? Maxing out a 401(k) is an article of faith for many higher-income workers. Unlike traditional deductible and Roth IRAs, where income limits may curb contributions, employees can generally contribute the maximum allowable amount to their 401(k)s regardless of how much they earn. In 2013, people under age 50 are able to contribute $17,500, and those over age 50 can make a $23,000 contribution. That’s a decent chunk of change that’s eligible for the tax-deferred compounding that 401(k)s afford. Contributing to a Roth 401(k), if the option is available, helps high earners make an even higher effective contribution, because they’re putting in aftertax dollars.

“And then the Retirement Planning course in the certified financial planner curriculum came rushing back to me: So-called nondiscrimination testing may limit the 401(k) contributions of highly paid workers, especially if they hail from smaller companies with a lot of executives and not many rank-and-file employees. If a company’s 401(k) plan fails the nondiscrimination tests, those workers who are classified as highly compensated employees, or HCEs, may not be able to make the maximum allowable contribution. For 2013, an HCE is defined as someone who had compensation of more than $115,000 during the year or who owns 5% or more of the company. (You can also be classified as an HCE if your spouse, parent, grandparent, or child is a 5% owner of the business that employs you, even if you yourself do not have an ownership stake.)

“The goal of the nondiscrimination tests is a laudable one: to make sure that the HCEs aren’t benefiting disproportionately from the tax breaks that come along with investing in the plan while the non-HCEs (NHCEs, in Internal Revenue Service lingo) are not taking advantage of them. The specifics outlined on the IRS site are somewhat complex. But they basically compare the rates of salary deferral and contributions for the set of HCEs alongside those of rank-and-file employees. If the HCE participation rates are much higher than is the case for non-HCEs, the plan will fail the tests.

“Assuming the 401(k) plan failed the nondiscrimination tests, the company would then need to take corrective action. One way to correct the problem is to return a portion of HCEs’ contributions so that the plan would pass the nondiscrimination tests. Alternatively, the company could make a qualified non-elective contribution to the accounts of NHCEs, correcting the imbalance not by reducing HCE contributions but by boosting those of NHCEs. Not surprisingly, the former route is usually the most common, as it doesn’t result in additional costs being borne by the employer.

“That means that some HCEs, like my friend, may be confronted with a refund of a portion of their 401(k) contributions after a plan fails to satisfy nondiscrimination testing. The refund amount, assuming it went into a traditional 401(k), would be taxable in the year in which it was received, along with any investment earnings on that excess contribution amount. Excess Roth 401(k) contributions, because they were already taxed, would not be taxable when refunded, though any investment earnings on those excess contributions still would be.

“Companies can circumvent such issues in the future by creating what’s called a safe-harbor plan–essentially, contributing enough on behalf of employees to ensure that it doesn’t have to go through nondiscrimination testing.”


To be continued.