Unbalanced 401(k) Plans Mean Refunds for Some Employees

By Clifton Linton
Senior Writer, mPower

In this article: Discrimination Tests: Why? Who Qualifies How the Test Works Fixing a Non-Compliant Plan Government Help What To Do If You're Capped

"The check's in the mail." Usually, this expression shouldn't be taken seriously. But for hundreds of thousands of highly paid workers in 401(k) plans, it is serious -- and an unwelcome surprise.

Why? If so-called "highly compensated employees" (HCEs) contribute too much to a 401(k) plan compared with other workers in the same company, the plan could be in trouble with the IRS.

minute: read this article at a glance.

Every year the IRS subjects all of the nation’s 401(k) plans to discrimination tests. These exams ensure that each plan is offered equitably to all employees. Passing the test allows a plan to maintain its tax-deferred status.

Most plans, when they fail, rectify this by sending partial refunds to the highly paid workers. That means some employees receive checks -- usually between January and April — worth hundreds or thousands of taxable dollars.

At this time last year some 300,000 workers in the U.S. got refund checks from their employers, estimates Ted Benna, the creator of the first 401(k) plan. A similar number may get them this year, he said.

In 1998, about 16.1% of plans polled by the Profit Sharing/401(k) Council of America reported returning excess contributions

Non-Discrimination Tests: Why We Have Them

When the 401(k) plan was created, Congress devised non-discrimination tests to prevent the plans from becoming a tax-dodge for top employees.

"If the top people should put the max in without any tie to the lower-paid employees, there would be little or no incentive for employers to communicate the benefits of the plan" to all employees equally said Benna. "Congress wouldn't be happy with the result if you just had the higher people participating."

Who Qualifies

If you earned $80,000 or more in 1998, or you owned 5% or more of your business, the IRS will categorize you as a highly compensated employee for 1999. That $80,000 can be made up of payments such as salary, bonuses, commissions and relocation expenses, said Paul Neeson, manager, Human Capital Advisory Services with Deloitte & Touche LLP.

If your company failed to pass its non-discrimination test, you should be on the lookout for a check.

This rule might not apply to employers with a high number of highly compensated employees, like a brokerage firm. In that case the employer often names the top 20% of wage earners as highly-compensated workers who could be affected by an eventual contribution cap and resulting refund.

For 2000, the HCE income limit rose to $85,000. But that will only apply to contributions in 2001.

How the Test Works

The test works this way: highly compensated employees, as a group, can't contribute more than 2% of pay more than the lower-compensated employees contribute as a group. If they do and the company fails to correct it, the retirement plan could lose its status as a qualified tax-deferred plan. This would mean that everyone's money would be refunded and the plan would go out of operation. In addition to the 2% spread, the HCE contribution may not be more than two times the percentage of other employees' contributions.

Say XYZ Co. has 10 employees, three of whom are considered highly compensated. Suppose the other seven, as a group, contribute 5% of their pay to the retirement plan, while the three HCEs contribute, as a group, 8%. XYZ Co. would fail its non-discrimination test because the HCEs are putting 1% too much into the plan. (Since the lower-compensated employees contribute 5%, the HCEs should contribute no more than 7%.)

The average percentage of salary highly compensated employees contribute to 401(k) plans is controlled by the average percentage contributed by non-HCEs.

If non-HCE's contribute HCE's can contribute 1% 2% 2% 4% 3% 5% 4% 6% 5% 7% 6% 8% 7% 9% 8% 10% 9% 11.25% 10% 12.5% 11% 13.75% 10% 15%

Source: "Helping Employees Achieve Retirement Security," by R. Theodore Benna

Fixing a Non-Compliant Plan

There are a few techniques employers use to make sure their plans pass the test.

The most common remedy is for employers to refund the excess money to employees.

"About 99% of companies (that fail nondiscrimination tests) decide to give a refund." - Linda Kravchick Director of Operations Ceridian Retirement Plan Services

"About 99% of companies (that fail nondiscrimination tests) decide to give a refund," said Linda Kravchick, Director of Operations with Ceridian Retirement Plan Services, a retirement-plan record-keeping firm.

Refunds tend to be somewhat unpopular, though. First, the money is viewed as taxable income by the IRS, so it can increase your adjusted gross income. Further, you can lose the ability to invest the money tax-deferred. Plus, you might only get the refund after you file your tax return, since refunds can be made up until the tax filing date, so you may have to file an amended return.

Some plans try to avoid failing non-discrimination tests by slapping on contribution limits for HCEs. For instance, plans may limit contributions to 5% of salary.

Along those lines, some employers test their plans regularly through the year. If they find HCE contributions are getting too high, they impose contribution limits immediately. "A lot of companies have technology that tracks everything," said David Wray, president of the Profit Sharing/401(k) Council of America. "When you reach the critical point, the HCEs are cut off."

The option that is used most rarely is for the employer to make contributions to lower-paid employees' accounts to raise their percentage contributions.

Employers can also decide to make employees wait longer to become eligible to join the plan. Typically, workers with a longer time on the job have higher participation rates in employer-sponsored retirement plans. So the thought is that by lengthening the eligibility period, the plan will have higher participation levels and it won't fail the non-discrimination tests. The government allows a maximum waiting period of one year.

Over the long term, a good way to fix a contribution imbalance is to encourage wider participation by lower-paid workers in the plan.

Sometimes boosting education about the plan is all it takes, Kravchick says. Sometimes it takes adding a company match if one isn't currently offered. "There you are really encouraging people to defer money," she said. "That's a better incentive for employees."

Government Help

In the last few years, Congress has passed laws making it easier for employers to pass non-discrimination tests.

• A few years ago, as an incentive to include employees earlier in 401(k) plans, the government started allowing employers to exclude first-year workers in calculating non-discrimination tests. Many plans took advantage of this to more easily pass non-discrimination tests.
• In 1997, Congress passed a law making it easier for employers to calculate non-discrimination tests. That way employers could give their workers a heads up if they were in the HCE category and let them know how much they likely can contribute in the next year.
• In 1999, a law took effect defining a new plan called a "design-based safe harbor." One of the requirements of this type of plan is 100% vesting of employer contributions. Employers that change to this type of plan are exempt from the special non-discrimination tests that apply to 401(k) plans, Benna says.

What To Do If You're Capped

If you're worried you might get a refund, or if you already have, Neeson, of Deloitte and Touche offers these options to lessen the pain.

• Prepare yourself by asking your plan administrator what happens if the plan doesn't pass the non-discrimination test. Find out whether the company cuts off contributions at a certain point, refunds excess contributions, or is one of those rare firms that makes a contribution to the accounts of non-HCEs.
• See whether your plan permits after-tax contributions. That way, even if you can't take advantage of the reduction in your taxable income, you can still benefit from tax-deferred growth of the money once it's in the plan. Find our whether your employer offers a nonqualified pension plan. You might be able to put your refund in that plan.
• If you receive a refund for 1999, consider reducing your contribution this year in order to avoid an excess contribution refund. Check with your plan administrator to be sure that conditions warrant this.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Unbalanced 401(k) Plans Mean Refunds for Some Employees

By Clifton Linton
Senior Writer, mPower

In this article: Discrimination Tests: Why? Who Qualifies How the Test Works Fixing a Non-Compliant Plan Government Help What To Do If You're Capped

"The check's in the mail." Usually, this expression shouldn't be taken seriously. But for hundreds of thousands of highly paid workers in 401(k) plans, it is serious -- and an unwelcome surprise.

Why? If so-called "highly compensated employees" (HCEs) contribute too much to a 401(k) plan compared with other workers in the same company, the plan could be in trouble with the IRS.

minute: read this article at a glance.

Every year the IRS subjects all of the nation’s 401(k) plans to discrimination tests. These exams ensure that each plan is offered equitably to all employees. Passing the test allows a plan to maintain its tax-deferred status.

Most plans, when they fail, rectify this by sending partial refunds to the highly paid workers. That means some employees receive checks -- usually between January and April — worth hundreds or thousands of taxable dollars.

At this time last year some 300,000 workers in the U.S. got refund checks from their employers, estimates Ted Benna, the creator of the first 401(k) plan. A similar number may get them this year, he said.

In 1998, about 16.1% of plans polled by the Profit Sharing/401(k) Council of America reported returning excess contributions

Non-Discrimination Tests: Why We Have Them

When the 401(k) plan was created, Congress devised non-discrimination tests to prevent the plans from becoming a tax-dodge for top employees.

"If the top people should put the max in without any tie to the lower-paid employees, there would be little or no incentive for employers to communicate the benefits of the plan" to all employees equally said Benna. "Congress wouldn't be happy with the result if you just had the higher people participating."

Who Qualifies

If you earned $80,000 or more in 1998, or you owned 5% or more of your business, the IRS will categorize you as a highly compensated employee for 1999. That $80,000 can be made up of payments such as salary, bonuses, commissions and relocation expenses, said Paul Neeson, manager, Human Capital Advisory Services with Deloitte & Touche LLP.

If your company failed to pass its non-discrimination test, you should be on the lookout for a check.

This rule might not apply to employers with a high number of highly compensated employees, like a brokerage firm. In that case the employer often names the top 20% of wage earners as highly-compensated workers who could be affected by an eventual contribution cap and resulting refund.

For 2000, the HCE income limit rose to $85,000. But that will only apply to contributions in 2001.

How the Test Works

The test works this way: highly compensated employees, as a group, can't contribute more than 2% of pay more than the lower-compensated employees contribute as a group. If they do and the company fails to correct it, the retirement plan could lose its status as a qualified tax-deferred plan. This would mean that everyone's money would be refunded and the plan would go out of operation. In addition to the 2% spread, the HCE contribution may not be more than two times the percentage of other employees' contributions.

Say XYZ Co. has 10 employees, three of whom are considered highly compensated. Suppose the other seven, as a group, contribute 5% of their pay to the retirement plan, while the three HCEs contribute, as a group, 8%. XYZ Co. would fail its non-discrimination test because the HCEs are putting 1% too much into the plan. (Since the lower-compensated employees contribute 5%, the HCEs should contribute no more than 7%.)

The average percentage of salary highly compensated employees contribute to 401(k) plans is controlled by the average percentage contributed by non-HCEs.

If non-HCE's contribute HCE's can contribute 1% 2% 2% 4% 3% 5% 4% 6% 5% 7% 6% 8% 7% 9% 8% 10% 9% 11.25% 10% 12.5% 11% 13.75% 10% 15%

Source: "Helping Employees Achieve Retirement Security," by R. Theodore Benna

Fixing a Non-Compliant Plan

There are a few techniques employers use to make sure their plans pass the test.

The most common remedy is for employers to refund the excess money to employees.

"About 99% of companies (that fail nondiscrimination tests) decide to give a refund." - Linda Kravchick Director of Operations Ceridian Retirement Plan Services

"About 99% of companies (that fail nondiscrimination tests) decide to give a refund," said Linda Kravchick, Director of Operations with Ceridian Retirement Plan Services, a retirement-plan record-keeping firm.

Refunds tend to be somewhat unpopular, though. First, the money is viewed as taxable income by the IRS, so it can increase your adjusted gross income. Further, you can lose the ability to invest the money tax-deferred. Plus, you might only get the refund after you file your tax return, since refunds can be made up until the tax filing date, so you may have to file an amended return.

Some plans try to avoid failing non-discrimination tests by slapping on contribution limits for HCEs. For instance, plans may limit contributions to 5% of salary.

Along those lines, some employers test their plans regularly through the year. If they find HCE contributions are getting too high, they impose contribution limits immediately. "A lot of companies have technology that tracks everything," said David Wray, president of the Profit Sharing/401(k) Council of America. "When you reach the critical point, the HCEs are cut off."

The option that is used most rarely is for the employer to make contributions to lower-paid employees' accounts to raise their percentage contributions.

Employers can also decide to make employees wait longer to become eligible to join the plan. Typically, workers with a longer time on the job have higher participation rates in employer-sponsored retirement plans. So the thought is that by lengthening the eligibility period, the plan will have higher participation levels and it won't fail the non-discrimination tests. The government allows a maximum waiting period of one year.

Over the long term, a good way to fix a contribution imbalance is to encourage wider participation by lower-paid workers in the plan.

Sometimes boosting education about the plan is all it takes, Kravchick says. Sometimes it takes adding a company match if one isn't currently offered. "There you are really encouraging people to defer money," she said. "That's a better incentive for employees."

Government Help

In the last few years, Congress has passed laws making it easier for employers to pass non-discrimination tests.

• A few years ago, as an incentive to include employees earlier in 401(k) plans, the government started allowing employers to exclude first-year workers in calculating non-discrimination tests. Many plans took advantage of this to more easily pass non-discrimination tests.
• In 1997, Congress passed a law making it easier for employers to calculate non-discrimination tests. That way employers could give their workers a heads up if they were in the HCE category and let them know how much they likely can contribute in the next year.
• In 1999, a law took effect defining a new plan called a "design-based safe harbor." One of the requirements of this type of plan is 100% vesting of employer contributions. Employers that change to this type of plan are exempt from the special non-discrimination tests that apply to 401(k) plans, Benna says.

What To Do If You're Capped

If you're worried you might get a refund, or if you already have, Neeson, of Deloitte and Touche offers these options to lessen the pain.

• Prepare yourself by asking your plan administrator what happens if the plan doesn't pass the non-discrimination test. Find out whether the company cuts off contributions at a certain point, refunds excess contributions, or is one of those rare firms that makes a contribution to the accounts of non-HCEs.
• See whether your plan permits after-tax contributions. That way, even if you can't take advantage of the reduction in your taxable income, you can still benefit from tax-deferred growth of the money once it's in the plan. Find our whether your employer offers a nonqualified pension plan. You might be able to put your refund in that plan.
• If you receive a refund for 1999, consider reducing your contribution this year in order to avoid an excess contribution refund. Check with your plan administrator to be sure that conditions warrant this.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.