Beware the IRS Fools with 410K Limits for High Compensation Employees!


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:



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