Why You May Not Be Able to Max Out Your 401(k), the superbly detailed Morningstar.com story by Christine Benz, provides invaluable information on “what to do if your company’s plan fails nondiscrimination testing.” Here is the concluding part of her excellent article:
“What You Can Do–Unfortunately, some plans fail nondiscrimination testing year after year, meaning that some employees can’t take full advantage of all of their tax-sheltered options. If this is the case with your company’s plan, you have a few options to explore, including the following.
“Work to Enact Change—Job one is to make the higher-ups in your company know that you’re not happy that your retirement contributions are being curtailed. Implementing a safe-harbor plan is the most straightforward way to fix the problem. There’s also the possibility that your benefits administrator isn’t properly categorizing HCEs and NHCEs, which in turn can affect your plan’s ability to pass the nondiscrimination tests. You can also lobby for improved NHCE participation. Ask your benefits administrator to consider an auto-enrollment feature and to step up its educational efforts, while conducting your own grassroots work to encourage participation among other workers. (Of course, if people aren’t contributing because your plan isn’t very good, it’s incumbent on everyone to complain to both the higher-ups and the benefits administrator.)
“Maximize Other Options—If you’ve gotten a refund of a 401(k) contribution, the next step is to put that money to work elsewhere. Fully funding an IRA, if you’re not doing so already, is the smartest place to start. If you’re married, you’ll also want to make sure your spouse is taking maximum advantage of his or her options by fully funding a 401(k) and IRA (including a spousal IRA for nonworking spouses). In addition, you can obtain a reasonable level of tax efficiency (albeit without the benefit of tax-deductible contributions) by investing in a taxable account; broad equity market exchange-traded funds and index funds, tax-managed funds, and municipal bonds are all tax-efficient mainstays. Aftertax 401(k) contributions are also sometimes advised in this instance, but it’s hard to make the case for doing so rather than simply investing in a tax-efficient manner within a taxable account. (The ability to eventually convert 401(k) assets to Roth may be the sole good reason to make aftertax 401(k) contributions.)
“Ask for a Heads-Up—If your plan has a history of failing nondiscrimination testing, ask your benefits administrator for midyear guidance on whether the plan is likely to pass or fail for that particular year. If it appears that the plan won’t pass, it’s better to stop contributing preemptively rather than risk an excess contribution and refund. After all, you might be paying an extra layer of fees to invest inside of the 401(k), and you may not have tax-efficient investment choices within your 401(k), either. You’re likely to be better off investing in an IRA or in tax-efficient investments inside a taxable account than you are making excess contributions to a 401(k) that will eventually be returned.”