Highly Compensated Employee Rules Aim to Make 401k's Fair

When Mike Geersk steps out of his office he is often confronted by nervous colleagues asking, "Will I be getting money?" The funny thing is, they want him to answer "no."

You wouldn't think the prospect of getting money from an employer would be nerve-wracking. But those jittery co-workers are highly compensated employees (HCEs) concerned that they will receive a refund of excess 401k contributions because their plan failed its discrimination test. A refund means they will owe more income tax for the current tax year. Geersk (a pseudonym), who is also an HCE, is in information services and manages the computers that process his firm's 401k plan.

He says his honest answer of "I have no clue" to their questions fails to mollify them. "I don't know if I'm getting one," said Geersk, 39.

All he knows is that his New York-based employer failed the test last November and the human resources department has been scrambling to determine how much will have to be refunded, and to whom, so that the plan can keep operating.

Other employers whose plans failed the discrimination test will also likely be sending refunds to some or all of their HCEs by the March 15 deadline. Employers who miss this deadline must pay the IRS a 10 percent penalty, based on the amount that must be refunded. Plans that fail the test and don't take action to fix the situation would come under government review and could ultimately lose their qualified status, meaning all money in the plan will have to be refunded to all employees.

Highly compensated workers receiving refunds will include the refund as taxable income in the year the refund was received, not the year the contribution was originally made (see IRS Publication 525).

Annual Test

Every year, the IRS requires all 401k plans (except safe-harbor plans, as described below) to take a discrimination test. Most easily pass it. Still, just under 40 percent of plans polled by the Plan Sponsor Council of America reported refunding or restricting HCE contributions in order to pass the test. And, 16.7 percent of plans reported returning excess contributions.

The reason for the test is "Congress didn't want these considerable tax breaks to be only enjoyed by the HCEs. This is the way they encourage employers to let everyone play in the pool," said Martha Priddy Patterson, analyst with Deloitte & Touche LLP's Human Capital Advisory Services group.

The test requires that employees be split into two groups: highly compensated and nonhighly compensated. For the 2017 tax year, highly compensated employees are those who earned more than $120,000, or owned more than 5 percent of the business. (The compensation limit is based on the previous year's compensation, while the ownership limit is based on the previous or current year.) You are considered highly compensated in 2017 if you earned more than $120,000 (no change from 2016).

The test is as follows: the average contributions of highly compensated employees, as a group, cannot exceed the average contributions of nonhighly compensated employees, as a group, by more than about 2 percent. (Age-50 catch-up contributions are not included in discrimination testing.) If the HCEs exceed this threshold and the employer fails to correct the imbalance, the plan could lose its tax-qualified status and all contributions and earnings would have to be distributed to all plan participants. In addition to the 2 percent spread, the contributions of all HCEs as a group may not be more than two times the percentage of other employees' contributions.

Consequently, HCE contribution levels are based on the contributions of non-HCEs. By setting up this carrot-and-stick system, Congress made it in the best interest of highly compensated employees to encourage non-HCEs to contribute to the plan.

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This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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