2013 has been the first year I have been deemed an HCE thus limiting my 401k contributions. This is actually very frustrating to me as I budgeted very thoroughly to maximize contributions to my 401k annually with the goal of retiring in my mid-50s. All of the sudden, this goal seems highly unattainable and I'm also not happy my taxes will be based on an estimated $10k higher income because I CAN'T take advantage of my 401k. Lucky me, I'll get to work 10 extra years while paying higher taxes at the same time! So my question is, can someone please explain to me what the purpose of this limitation is because I certainly can't see the good in it.
I am happy to hear that you are taking full advantage of your 401(k) plan. Maximizing your deferrals will put you well on your way to a secure retirement financially. So the limits affect your retirement age.
For a retirement plan such as a 401(k) to continue to qualify to provide tax benefits it must pass tests designed to prevent benefit discrimination between employees; usually between the senior management and the subordinates. There are a number of tests every plan must pass annually. One is the “actual deferral percentage” or ADP test. Employees are broken into highly compensated and non-highly compensated groups. Then the average deferral percentage (an employee’s 401k contribution divided by their pay) of the highly compensated is compared with that of the non-highly compensated. If the percentage deferred by the highly compensated is too high relative to the non-highly compensated deferral rate then the plan will fail the test. The test is performed after the end of the plan year. If the plan fails this test (or others) your employer may come back to all of the highly compensated who had contributed during the plan year and make them take a refund of a part of their contribution. The refund would be W2 income in the year the refund occurs. So by limiting your contribution your employer is trying to avoid failing the ADP test. Another way to pass the test is for the employer to make an employer contribution to the non-highly paid employees.
This explanation probably doesn’t make you feel any better. And unfortunately there is a lot of talk in Washington of further reducing the contributions that can be made to a 401(k) plan. Apparently proponents of the lower limits are trying to raise our taxes and generate more money for the Government. My point is that things could be, and may be, worse. Best to just roll with the punches and take advantage of the limits available. Also consider saving and investing in a taxable investment account. At least you will be able to take advantage of the lower long-term capital gain tax rate in a taxable account. This tax rate is not available in a 401(k) plan or IRA so the news is not all bad.
Jennifer, If you are looking to shelter additional money from taxes and are more than 10 years from retirement, you may want to consider investing in an indexed or variable universal life insurance policy. Before I go any further, you should know that every time I make this recommendation, my colleagues express their displeasure by giving me "thumbs down" votes. Fortunately for you, their feelings about this recommendation will never negate the fact that the world's wealthiest families have used life insurance to grow and preserve their wealth over generations. When you examine all of the features and benefits available in a properly structured and managed life insurance policy, you will understand why we often refer to life insurance used as an investment as a "Roth IRA for the wealthy." With variable universal life, you can have unlimited tax-free growth potential, the ability to invest in stocks, bonds, commodities, Real Estate and other asset classes, the ability to adjust your asset allocation in accordance with changes in the economy or your financial situation, unlimited contributions and the ability to take withdrawals tax-free as a loan against your policy. For high income, high net worth individuals who have maxed out their retirement plan contributions and have adequate liquidity (savings and taxable investments), life insurance provides an excellent way to generate tax-free growth and income… in addition to a tax-free death benefit. Feel free to contact me directly if you would like to learn more about this strategy and whether it may be appropriate or beneficial for you.
Being classified as an HCE means that you are earning more than $115,000 which is a good income and does subject you to higher taxes. It is good that you also want to maximize your 401(k) plan contributions. For 2013 & 2014 you are able to contribute $17,500 and if over 50 years old you can contribute an additional $5,500 as a catch-up contribution. The only reason that your contributions may be limited is that your company’s retirement plan may not be designed properly and is a result of required testing formulas imposed by ERISA as mentioned by the other advisor that responded. There are various options in the design of a 401(k) plan, such as safe harbor contributions, cash balance features and tiered (group allocation) plans that could eliminate this problem. You should suggest to the owners or plan trustees that there may be other people in your organization that have the same frustration and ask that they look at options that could improve the overall plan design. If your company’s owner or trustees are not working with an experienced retirement plan advisor they should contact us to learn more about options available to them.
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As John said, it's for discrimination testing mandated by the IRS. Two ways around it: 1) become your company's biggest 401k cheerleader. The more money the non-HCEs put in, the more it helps your cause. 2) Encourage your company (if it's in their budget) to consider a safe harbor plan design, which mandates an employer contribution but would let HCEs be able to put more in. You could also approach your company's retirement plan advisor with these two requests as well!
Rich brings up a good point - there might be other ways to plan on a retirement in your mid-50s. Get with a good financial planner!
Jennifer, John’s answer explained the rules. Rich’s answer explained there are other options, and and Courtenay’s answer correctly explained what your company can do to make the plan better, specifically adopt a ‘safe harbor’ design and better education to encourage better participation of non-HCE’s. Courtenay, I don’t understand why someone gave you a negative vote. Fortunately a positive vote negates that.
Your employer could also adopt an auto-enroll plan, where all employees are automatically enrolled, but can of course, opt out. It would do, in my opinion two positive things. First, more of the rank and file would be contributing, but perhaps more importantly, it would allow for a ‘safe harbor’ with a slightly lesser contribution for employer, plus employer could utilize a ‘cliff’ vesting.
I will add that other than universal life or a conventional variable annuity, there are fee-based variable annuities with very low fees. You can invest after tax dollars and let it grow tax deferred. Good investment choices with no frills. Find a good financial planner in your area planner in your area, preferably a CFP®