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"The check's in the mail."
Usually, this expression shouldn't be taken seriously. But for hundreds of thousands of
highly paid workers in 401(k) plans, it is serious -- and an unwelcome surprise.
Why? If so-called "highly compensated
employees" (HCEs) contribute too much to a 401(k) plan compared with other workers in
the same company, the plan could be in trouble with the IRS. Most employers rectify this
by sending partial refunds to the highly-paid workers. That means some employees receive
checks -- usually between January and April -- worth hundreds or thousands of taxable
dollars.
At this time last year some 300,000 workers
in the U.S. got refund checks from their employers, estimates Ted Benna, the creator of
the first 401(k) plan. A similar number may get them this year, he said.
In 1998, about 16.1% of plans polled by the
Profit Sharing/401(k) Council of America reported returning excess contributions
Non-Discrimination Tests:
Why We Have Them
When the 401(k) plan was created, Congress
devised non-discrimination tests to prevent the plans from becoming a tax-dodge for top
employees.
"If the top people should put the max
in without any tie to the lower-paid employees, there would be little or no incentive for
employers to communicate the benefits of the plan" to all employees equally said
Benna. "Congress wouldn't be happy with the result if you just had the higher people
participating."
Who Qualifies
If you earned $80,000 or more in 1998, or
you owned 5% or more of your business, the IRS will categorize you as a highly compensated
employee for 1999. That $80,000 can be made up of payments such as salary, bonuses,
commissions and relocation expenses, said Paul Neeson, manager, Human Capital Advisory
Services with Deloitte & Touche LLP.
If your company failed to pass its
non-discrimination test, you should be on the lookout for a check.
This rule might not apply to employers with
a high number of highly compensated employees, like a brokerage firm. In that case the
employer often names the top 20% of wage earners as highly-compensated workers who could
be affected by an eventual contribution cap and resulting refund.
For 2000, the HCE income limit rose to
$85,000. But that will only apply to contributions in 2001.
How the Test Works
The test works this way: highly compensated
employees, as a group, can't contribute more than 2% of pay more than the
lower-compensated employees contribute as a group. If they do and the company fails to
correct it, the retirement plan could lose its status as a qualified tax-deferred plan.
This would mean that everyone's money would be refunded and the plan would go out of
operation. In addition to the 2% spread, the HCE contribution may not be more than two
times the percentage of other employees' contributions.
Say XYZ Co. has 10 employees, three of whom
are considered highly compensated. Suppose the other seven, as a group, contribute 5% of
their pay to the retirement plan, while the three HCEs contribute, as a group, 8%. XYZ Co.
would fail its non-discrimination test because the HCEs are putting 1% too much into the
plan. (Since the lower-compensated employees contribute 5%, the HCEs should contribute no
more than 7%.)
The average percentage of salary highly
compensated employees contribute to 401(k) plans is controlled by the average percentage
contributed by non-HCEs.
 |
| If non-HCE's contribute |
HCE's can contribute |
| 1% |
2% |
| 2% |
4% |
| 3% |
5% |
| 4% |
6% |
| 5% |
7% |
| 6% |
8% |
| 7% |
9% |
| 8% |
10% |
| 9% |
11.25% |
| 10% |
12.5% |
| 11% |
13.75% |
| 10% |
15% |
|
|
Source: "Helping Employees Achieve
Retirement Security," by R. Theodore Benna
Fixing a Non-Compliant Plan
There are a few techniques employers use to
make sure their plans pass the test.
The most common remedy is for employers to
refund the excess money to employees.
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"About 99% of companies
(that fail nondiscrimination tests) decide to give a refund."
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-
Linda Kravchick
Director of Operations
Ceridian Retirement Plan Services |
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"About 99% of companies (that fail
nondiscrimination tests) decide to give a refund," said Linda Kravchick, Director of
Operations with Ceridian Retirement Plan Services, a retirement-plan record-keeping firm.
Refunds tend to be somewhat unpopular,
though. First, the money is viewed as taxable income by the IRS, so it can increase your
adjusted gross income. Further, you can lose the ability to invest the money tax-deferred.
Plus, you might only get the refund after you file your tax return, since refunds can be
made up until the tax filing date, so you may have to file an amended return.
Some plans try to avoid failing
non-discrimination tests by slapping on contribution limits for HCEs. For instance, plans
may limit contributions to 5% of salary.
Along those lines, some employers test
their plans regularly through the year. If they find HCE contributions are getting too
high, they impose contribution limits immediately. "A lot of companies have
technology that tracks everything," said David Wray, president of the Profit
Sharing/401(k) Council of America. "When you reach the critical point, the HCEs are
cut off."
The option that is used most rarely is for
the employer to make contributions to lower-paid employees' accounts to raise their
percentage contributions.
Employers can also decide to make employees
wait longer to become eligible to join the plan. Typically, workers with a longer time on
the job have higher participation rates in employer-sponsored retirement plans. So the
thought is that by lengthening the eligibility period, the plan will have higher
participation levels and it won't fail the non-discrimination tests. The government allows
a maximum waiting period of one year.
Over the long term, a good way to fix a
contribution imbalance is to encourage wider participation by lower-paid workers in the
plan.
Sometimes boosting education about the plan
is all it takes, Kravchick says. Sometimes it takes adding a company match if one isn't
currently offered. "There you are really encouraging people to defer money," she
said. "That's a better incentive for employees."
Government Help
In the last few years, Congress has passed
laws making it easier for employers to pass non-discrimination tests.
- A few years ago, as an incentive to include
employees earlier in 401(k) plans, the government started allowing employers to exclude
first-year workers in calculating non-discrimination tests. Many plans took advantage of
this to more easily pass non-discrimination tests.
- In 1997, Congress passed a law making it
easier for employers to calculate non-discrimination tests. That way employers could give
their workers a heads up if they were in the HCE category and let them know how much they
likely can contribute in the next year.
- In 1999, a law took effect defining a new
plan called a "design-based safe harbor." One of the requirements of this type
of plan is 100% vesting of employer contributions. Employers that change to this type of
plan are exempt from the special non-discrimination tests that apply to 401(k) plans,
Benna says.
What To Do If You're
Capped
If you're worried you might get a refund,
or if you already have, Neeson, of Deloitte and Touche offers these options to lessen the
pain.
- Prepare yourself by asking your plan
administrator what happens if the plan doesn't pass the non-discrimination test. Find out
whether the company cuts off contributions at a certain point, refunds excess
contributions, or is one of those rare firms that makes a contribution to the accounts of
non-HCEs.
- See whether your plan permits after-tax
contributions. That way, even if you can't take advantage of the reduction in your taxable
income, you can still benefit from tax-deferred growth of the money once it's in the plan.
Find our whether your employer offers a nonqualified pension plan. You might be able to
put your refund in that plan.
- If you receive a refund for 1999, consider
reducing your contribution this year in order to avoid an excess contribution refund.
Check with your plan administrator to be sure that conditions warrant this.
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