401khelpcenter.com Logo

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



Resolving Plan Imbalances

If HCEs contribute too much, an employer can choose among several strategies to bring its plan in compliance with the law. Here are some of the most common:

First, an employer may set a percent-of-pay limit within the plan document that HCE contributions may not exceed. The advantage of this strategy is that it removes all doubt about whether a plan will pass its test. The disadvantage is that HCEs could miss out on savings opportunities if the cap ends up being lower than necessary.

Second, an employer may restrict HCE contributions when they reach the maximum allowed by the test. In this case, the employer often runs discrimination test projections in the middle of the year, looking for signs that contribution rates will become unbalanced. The advantage of this strategy is that HCEs will be able to contribute the most allowed given the constraints affecting their plan.

Geersk is upset that his employer didn't run mid-year projections. A coworker in his department ran the test on his computer "for fun" during the summer and found the plan was likely to fail the test. This information was passed to the benefits office, which didn't act on it then, Geersk said, comparing the office to the bumbling Keystone Kops.

Running the test midyear can also show if HCEs can be allowed to increase their contributions above the set percentage limit (if non-HCEs are contributing more than expected, for example).

Third, an employer may choose to refund excess contributions after determining at year-end how much needs to be refunded. Companies using this strategy generally notify their HCEs early on that a refund is likely, and explain why the plan works this way. Some plans deliberately choose this strategy because "you are actually maximizing the amount HCEs can put into the plan," said Rob Vetere, vice president, compliance services, with Diversified Investment Advisors.

How is it decided which HCEs get refunds, and how much they get? "The refunds are to be made to the highly compensated participant or participants who made the largest contributions," said Ted Benna. "This order is to be followed regardless of the compensation levels or individual contribution percentages of the HCEs."

For example, suppose a company has 50 employees and five are HCEs. One (employee A) contributed $10,000, another (employee B) $5,000 and the remaining three (employees C, D and E), each contributed $4,000. Further suppose the plan needed to refund $10,000 to comply with the discrimination test. The refunds would be calculated as follows: the plan would first refund $5,000 to employee A (to bring her in line with the next-highest contributor). Next, employee A and employee B will be refunded $1,000 each, bringing them to the level of the next-highest contributors. But, the plan still needs to refund an additional $3,000. That will be spread among employees A, B, C, D and E, with each receiving a refund of $600.

Boosting Non-HCE Participation

The best way for employers to pass the discrimination test is to encourage greater participation by nonhighly compensated employees. But how?

Roger Brown, a 50-percent owner of a chain of pizza parlors, has been mulling over this question. The low participation rate of his employees in the 401k plan prevents him from contributing the full $18,000 allowed in 2016, because as a 50-percent owner he qualifies as an HCE.

He plans to boost enrollment in two ways: publicizing the plan more, and implementing an automatic enrollment program, in which new employees are automatically signed up for the plan unless they opt out when hired.

One of the most effective methods of boosting 401k enrollment is with an employer match, Benna said. "When you have a plan without a match, it is tough to get above 50 percent participation," he added.

Employers can also set up what is known as a "safe harbor" 401k plan. This is the one type of 401k plan not subject to discrimination tests. But it can be expensive for employers, requiring them to make a fully vested gift contribution to all employees or a matching contribution to plan participants.

Other Resources

ADP Test Basics -- Abstract: The tax code governing 401k plans was written to prevent qualified retirement plans from overly favoring Highly Compensated Employees. A series of non-discrimination tests were devised to measure whether a plan's design or operation lends to favoring the HCEs over the Non-Highly Compensated Employees. This a review of the tests. Source: Legacyrsllc.com


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.

About | Glossary | Privacy Policy | Terms of Use | Contact Us

Creative Commons License
This work is licensed under a Creative Commons Attribution-NoDerivatives 4.0 International License.