Due to the nondiscrimination regulations for tax qualified plans, the IRS places a limit on the amount that a Highly Compensated Employee (HCE) may save in a 401(k) plan. This limit is based on the average rate of savings for employees who are not HCEs.
The IRS defines an HCE as an employee who is a 5% owner in the current or previous plan year, or an employee who earned over $115,000 in the previous plan year. Through attribution, certain family members of 5% owners may also be considered HCEs for testing purposes.
If the savings rate of the HCEs under your firm’s retirement plan exceeded the allowable limit and a portion of the 2012 plan year contributions and earnings were refunded to your HCEs in March, chances are you have some unhappy folks in your office. The good news is – there are changes you can make now to avoid or limit refunds in the future.
Even if the NHCE ADP percentage rose slightly due to upbeat market reports and employees taking the initiative to save, the testing may never pass at current rates of deferral and participation. That leaves you with several alternative plan design options:
Option #1 – Safe Harbor Matching or Nonelective Contributions
- Tiered Employer Match – 100% of the first 3% of deferrals plus 50% of the next 2% of deferrals for a total match of 4%.
- Nonelective Employer Contribution – 3% for all eligible employees regardless of whether or not they defer to the plan.
- All Safe Harbor contributions must be 100% vested and no allocation conditions may apply (e.g. last day employment, 1,000 hours of service).
- This option may not be added mid-year for an existing 401(k) plan. You must provide notice at least 30 days prior to the start of the next plan year.
- Exemption from ADP/ACP testing provided if all requirements are met.
Option #2 – Traditional Automatic Enrollment
- Start all newly eligible employees at 3% (or higher) rate of deferral by default.
- Notice must be given to employees before the commencement of the automatic enrollment feature and annually thereafter.
- An acceptable default investment must be available under the plan.
Note – a hybrid safe harbor/auto enroll design structure known as a “QACA” was created under the Pension Protection Act. This plan design should also be considered.
Option #3 – Implement a Cap on Elective Deferrals for HCEs
- Determine the level of HCE contributions that would enable the ADP test to pass. This is the lesser of two percentage points plus or two times the NHCE ADP percentage. For plans that use the prior year method for testing purposes, predicting the maximum allowable HCE rate of contribution is much easier.
- Issue an annual notice to HCEs before the start of each plan year to let them know what the limit will be for the upcoming year.
Option #4 – Plan ahead for Catch-up reclassification
- Let HCEs continue to defer the maximum amount each year (currently $17,500).
- For those over age 50, leave the catch-up source vacant so excess deferrals can be reclassified as catch-up contributions.
Regardless of the changes you decide to make in order to avoid or reduce refunds to your HCEs, you are obligated as the plan sponsor to offer ongoing education for your employees. Burke Group conducts semi-annual participant educational meetings for our clients. We are also offering our new “Your Retirement Matters” newsletter that can be distributed to plan participants four times a year as well as targeted singles for select groups of employees. We recommend that plan sponsors establish a meaningful educational campaign with lots of touches throughout the year. Please feel free to contact us to discuss our educational offerings at any time.