I recently wrote about 401K plans and how they have allowed workers to build wealth over the years to cover the costs of “filling the gap” in retirement.

The main advantage of 401K plans is the amount you can contribute. For 2018, that $18,500, up from $18,000 in 2017. You can also make a “catch up” contribution if you’re 50 or older. That adds another $6,000 to the contribution. If your employer has a matching contribution, it turns into a serious wealth accumulation scheme.

Let’s say for example, let’s say you make the full $18,500, plus the over 50 $6,000 catch up, that’s $24,500 coming from you. Your employer has a 50% match, and contributes another $9,250. That brings your total contribution for the full year up to $33,750! In 2008, the overall limit for 401K contributions, which includes money from all sources, including your employer’s matching contributions, is $55,000.

As Great as that looks, there are serious limits in the plan if you fall under the category of highly compensated employee “HCE”. The thresholds defining someone as an HCE are probably lower than you think. If you fall into this category your 401K plan suddenly isn’t as generous.

First of all contributions made by HCE’s can’t be excessive when compared to those of non-HCE employees. For example, if the average plan contribution by non-HCE’s is 4%, then the most an HCE can contribute is 6%. I’ll tell you why below. But if you make $150,000, and you’re planning to max out your contribution at $18,500, you may find that you can only contribute $9,000. That 6% of your $150,000 salary. Here is something else you’ll learn, if you’re determined to be an HCE after the fact, like after you’ve made a full 40K contribution for the year, the contribution will have to be “reclassified”. The excess will be refunded to you, and not retained within the plan. An important tax deduction will be lost.

And, another little quirk, HCE isn’t always obvious. The IRS has what’s known as family attribution, which means you can be determined to be an HCE by blood. An employee whose a husband/wife, child, grandparent or parent of someone who is a 5%, or greater, owner of the business, is automatically considered to be a 5% or greater owner.

See, what happens is that every year the IRS requires a 410K plan test, these are called Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests.  

The bottom line is that lesser compensated employees may be able to contribute MORE to their plan than a HCE can.

I’ve experienced this situation, it was due to the company failing the test, we had too many newer employees who did not opt-in for their 401K plans. They were at the lower end of the compensation scale. So, these days many companies are, by default signing up all new employees into their 401K plans even with minimum contributions. Besides, without most companies offering pension plans the 410K is in all employees interest.

If you are interested in learning more about these HCE test you can check out the IRS site below:

https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-the-plan-failed-the-401k-adp-and-acp-nondiscrimination-tests

Today employer sponsored 401K accounts are the number one way to both build wealth and supplement your retirement income needs.

It is not unusual to have people retiring today with over a $1M in an IRA, much of this being transferred from an employee sponsored 401K that was converted. While $1M in an IRA might sound like an optimum situation, it may present its own problems when you turn 70 ½ and have to start taking Required Minimum Distributions (RMD), I’ll cover that in a future article. In the meantime let’s make sure you are getting the best deal possible from your current plan. 

Are you sure you are getting the maximum employer matching funds? You might be surprised that you could be leaving money on the table.

True-Up 401K Plans
Sometimes an employee can “contribute too fast” into their employer matching 401K account and thereby NOT get the full employee amount. Here’s how it could happen.

Suppose your employer’s 401K program provides a certain percentage match to each employee contribution “per pay period”. If you max out your 401K contributions early in the year and therefore you would stop making contributions, your employer will also stop making matches, assuming the employer’s plan does not provide for “true up” contributions. There is an annual limit on 401K contributions.

Let’s say an employer match’s 50% of Mary’s contribution per pay period, up to 6 percent of her earnings. Mary earning $75,000 a year, getting paid $3,125 twice a month. To contribute enough money to reach the IRS’s $18,000 contribution limit, she would need to contribute $750 per pay period, or 24 percent of her salary. In this scenario, the employer would contribute $93.75 in matching funds per pay period, since 6 percent of the employee’s pay would be $187.50, and $93.75 is half of that.

If, however, Mary decided to contribute $818.18 per pay period instead, she would max out her 401K contributions before the end of the year—by the 22nd pay period of the year, to be exact. For the two remaining pay periods of the year, her contribution would be $0— and her employer’s matching contribution would be $0 as well because there would be nothing to match. That would mean she missed out on an extra $187.50 in contributions.

Whether Mary had decided to contribute $750 or the $818.18 per pay period, she would have ended up contributing the same $18,000 total during the year to the retirement plan. That $187.50 in matching funds might not seem like much, but it can add up over the years—particularly when you factor in the returns you are missing on that money.

While Mary’s example is modest, I can tell you that if you are a high earner and say you get a large year-end bonus in the next tax year the consequences of a 401K front-loading could be a substantial loss of extra matching. Sales people who have “lumpy” earnings throughout the year can fall into this category also. 

Some employers include a feature in their 401K plans that allows workers to get the maximum employer match even if they’ve finished contributing to their 401K plans early in the year. This is called a True-Up! They calculate at year end the max amount you should have gotten and contribute this amount to your 401K. 

Does your employer offer you a True-UP?

Planning and saving for retirement is key in all of our lives. The planning part raises a lot of questions and there are a lot of misconceptions floating around today. We’ll try and clear up a few for you.

Common Misconception: Contributing to a ROTH IRA is always better than a traditional IRA!

Although there are a lot of variables involved the above statement is not necessarily true.  By design a traditional IRA contribution is a deduction against taxable income, but taxed when you withdrawal it in retirement. However, with a ROTH IRA you contribute after taxes but withdrawals are tax exempt. 

Here is a real world type model that shows similar contributions to both a traditional IRA and ROTH IRA have different outcomes. 

Here is the details behind the above calculations:

As you can see based on the above model, the traditional IRA even with taxes being paid has a better performance than the ROTH IRA. Don’t always take common claims as fitting your situation. Keep in mind that this model is very simple and does not take into consideration such things as Required Minimum Distributions from an IRA at age 70 1/2. You will also not that I included an “effective tax rate” instead of the tax bracket rate to be more precise. 

Spending a little extra time planning can improve your retirement.