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What does it mean to be labeled a "highly compensated employee" in terms of 401k?

I was just notified that I am considered a highly compensated employee in regards to my 401k . What exactly does that mean for me? Is this an overall standard or specific to my company?

Mar 08, 2012 by Everett from Poughkeepsie, NY in  |  Flag
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Being labeled a "Highly Compensated Employee" or HCE is a double-edged sword. It’s great that you're among the top earners at your firm, but now you are subject to certain limits when contributing to your 401(k). You can find the definition of a HCE in the Internal Revenue Code Section 414(q)(1)(B). And no, it isn’t specific to your company.

To be considered an HCE for 2012, unless you or your family has ownership in the company, you will need to have earned at least $110,000 in 2011. This amount can be increased based on cost of living adjustments on an annual basis.

The HCE designation is important when it comes to the nondiscrimination tests that a 401(k) plan needs to take every year. There are 3 major tests: The Average Deferral Percentage (ADP) test, the Average Contribution Percentage (ACP) test, and the Top Heavy Test. The ADP and ACP test look at HCEs and Non HCEs while the Top Heavy Test looks at "Key Employees" and "Non Key Employees".

I've heard many horror stories of bad administrators (mostly the payroll companies) that actually ask the employer "Who are your Highly Compensated Employees?" Naturally, not being versed in the code, the employer sends back who they consider highly compensated without regard to the IRS' definition. Sometime employees are included that shouldn't be, and more often employees that should be are left out (especially family members of the owner, even if they have no ownership stake). This puts the employer in jeopardy if the DOL or IRS ever rolls in to audit the plan.

Any good Third Party Administrator (TPA) will not have to ask the employer but simply look at the census of employees and their compensation and run the calculations. What are they calculating? Whether or not the plan will pass or fail the "nondiscrimination tests".

Unfortunately, a bad administrator will put garbage in and get garbage out. A plan may fail testing because the administrator is not sophisticated enough to know how to use different testing methods to help a plan pass. Good advisors and TPAs will serve as consultants offering advice on how to restructure the plan to make sure it passes now and in the future. I've heard of some brilliantly creative ideas used to help plans pass.

The bottom line for you, Everett, is that if you are indeed a HCE, you will want to make sure the calculation was done correctly, and make sure the plan passes the testing. Failing to pass could mean refunds for you. That is, money you socked away in your 401(k) account will be returned to you and you will have to amend your tax returns to make sure it is accounted for as income. I've seen refunds in the tens of thousands of dollars. You might even consider holding off filing your personal tax returns until you get a clear indication from your employer as to whether or not you will be getting a refund. Also, make sure your firm is working with a reputable TPA and Advisor.

Lastly, some employers opt to implement a Safe Harbor provision which allows them to escape these tests as long as they meet certain requirements which I won't bore you with here. I hope this is helpful and good luck to you!

Comment   |  Flag   |  Mar 09, 2012 from Concord, CA

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Hi Everett, a highly-compensated employee means you're earning more than $115,000 in compensation in 2012 (which will be applied to any plan tests in 2013--kind of messy to explain in detail, but something your retirement plan administrator can spell out for you). In practical terms, that status (as defined by the IRS--not specific to any one company or industry) means you may not be able to contribute as much as you'd like to your retirement 401k. If that happens, what can you do? To the degree it's practical (depending on your time, influence, and the size of your company), become a retirement savings proponent and do all you can to encourage lesser-paid employees to contribute more to the plan; the more they contribute, the more you may be able to as well. Go rally the troops!

Comment   |  Flag   |  Mar 08, 2012 from Orland, IN

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For the year 2012, a Highly Compensated Employee is anyone who was a “5-percent owner” at any time during 2011 or 2012 or anyone who received in excess of $110,000 in compensation during 2011 and, if elected by the employer, is in the top twenty percent of employees based upon compensation. These are limits determined by the IRS, and your 401(k) plan has to prove that there is no bias towards highly compensated employees or it could lose the tax breaks it gets for having a retirement package. This menas that you may be limited in how much you could contribute to your plan in any given year based on other employees who are not deemed non-highly compensated and their level of participation in the 401(k) plan.

Comment   |  Flag   |  Mar 08, 2012 from Atlanta, GA

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Michael brings up a great point about rallying the troops! About 20 years ago I worked for a company with about 200 employees. Most of these employees were "blue collar" and did not have savings mindset. Even with a great deal of education by our 401(k) plan provider, the participation rate was poor so I would always be limited on how much I could put in the plan for myself. If a young employee simply saves $50 per month for 40 years at 8%, they would have close to $200K at the end of the period. That sure is a better amount than zero! :-) As Michael said, go rally the troops and good luck!

Comment   |  Flag   |  Mar 08, 2012 from Atlanta, GA

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