Unwanted Refunds for Highly Paid 401(k) Participants

By Brenda Watson Newmann
Managing Editor, mPower

The popularity of 401(k) plans has given rise to some unusual phenomena. Perhaps one of the strangest is the following scenario: a person receives a check in the mail for hundreds, or even thousands, of dollars…and is annoyed about it.

Why does this happen? Every year, some 401(k) plans don't pass mandatory IRS nondiscrimination tests. So every year - generally during the first quarter - the "highly compensated employees" (HCEs) in those plans get some of their contributions back.

They're none too happy about it, either. Getting a refund means having to pay tax on the money and losing the compounded interest on that amount which, over time, could be substantial. Also, for participants who have already filed their income tax returns, it generally means filing an amended return.

"This doesn't seem fair," one participant complained to mPower. "Is there anything I can do? Or am I just along for the ride?"

Well, for the 1998 plan year, unfortunately, the die has been cast and there's nothing you can do except take the refund and invest it the best way you know how. But there may be something you can do for future years, as you'll see later in this article.

Who Gets A Refund?

First, here's the nub of the issue: the IRS will only allow a 401(k) plan to have tax-deferred status (i.e. let participants make pretax contributions and avoid paying taxes on interest until withdrawal) if the plan benefits all employees similarly, no matter what their income. If higher-paid employees are allowed to contribute substantially more than their lower-paid colleagues, they will save more on taxes and may also get a higher amount in employer matching funds, and that is not allowed.

The "highly-paid" category has to start somewhere, and for the IRS it is at $80,000 a year or more in earnings, or ownership of at least 5% of the company. (It may surprise some people - single-salary parents living in a big city come to mind - to know that earning $80,000 a year makes them "highly compensated." Well, things could be worse. In 1995 it was $66,000.)

The calculations involved in nondiscrimination testing are complex, but essentially, HCEs as a group may not contribute more than 2 percentage points above their "non-HCE" colleagues.

So, if the non-HCEs on average contribute 4% of their salary over the year, the HCEs cannot, on average, contribute more than 6%.

If the HCE average turns out to be 8%, for example, the employer has to choose between depositing extra money in the account for the non-HCEs, to make up the difference, or refunding the difference to the HCEs.

It's not surprising that most employers choose the less expensive option of refunding the HCE's excess contributions.

That's when participants start receiving letters in the mail telling them that they contributed too much to their plan - even though their contributions were below the federal $10,000 ceiling.

Adding insult to injury is the fact that many people receive these letters AFTER they have filed their tax returns, and must therefore file an amended return listing the refund as income. If you received a refund before March 15, 1999 for last year, you have to declare the income on your 1998 tax form. However, if it came later, you can list the income on your 1999 return. (Most employers make the refunds before March 15 because if they don't, they have to pay a 10% penalty to the IRS.)

Receiving a refund out of the blue can be upsetting, to say the least. "I don't understand why they did not see this coming, and give those who contribute the maximum an opportunity to reduce their contributions," one irritated participant wrote to mPower.

Such feelings are justified, says Jennifer O'Reilly, Vice President of Western Pension, a 401(k) plan consultant and third party administrator. "Employers absolutely should see this coming," she says, because "a good consultant should do interim tests during the year and be able to warn them."

What You Can Do

To avoid receiving an unwanted refund again, a good strategy might be to encourage lower-paid employees at your company to start participating in the 401(k) plan, if they are not already doing so, or to increase their contributions. Remind them that the employer match is free money, so they should at least try to receive the full match.

Surveys have shown that a good way to encourage employees to participate in a 401(k) plan is to give them advice about how to invest their money. mPower is a company that contracts with plan sponsors to provide customized 401(k) investment advice to participants - you could consider telling your benefits representative about this service.

Also, you can urge your employer to pay attention to interim testing so that future refunds don't come out of the blue.

Safe Harbor Plans

There's another option, but your employer might not go for it.

An employer who wants to avoid the hassle and expense of nondiscrimination testing each year may set up a "safe harbor" 401(k) plan. Under such a plan, the employer has to pay a certain amount of money into the account for the non-highly compensated employees. There are various formulas for calculating the amount. Some employers might find this option expensive, especially since these contributions would have to be fully vested from the word go.

The deadline for setting up such a plan for 2000 is December 1, 1999.

Other Reasons for Refunds

In addition to the HCE limit, there are two other contribution limits that could result in unexpected and unwanted refunds.

1) One is the $10,000 annual contribution ceiling. People who contribute over this limit often have worked for more than one employer during the year and haven't kept track of their contributions - or have thought, mistakenly, that they could contribute up to $10,000 per employer. If you are in this situation, you should tell your employers immediately. If you didn't get a refund by April 15, you have to pay a 10% penalty on the money. 2) The second limit stipulates that the maximum amount that can be accumulated in any of your tax-qualified defined contribution plans - 401(k), thrift, profit-sharing, ESOP and money purchase - is limited to 25% of your gross pay or $30,000, whichever is less. If your 401(k) contributions in 1998 put you over this limit, you have to get a refund of the difference by December 31, 1999, and declare the amount on your 1999 tax form. If the refund comes late your employer has to pay a 10% penalty on the amount.

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.

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.

Unwanted Refunds for Highly Paid 401(k) Participants

By Brenda Watson Newmann
Managing Editor, mPower

The popularity of 401(k) plans has given rise to some unusual phenomena. Perhaps one of the strangest is the following scenario: a person receives a check in the mail for hundreds, or even thousands, of dollars…and is annoyed about it.

Why does this happen? Every year, some 401(k) plans don't pass mandatory IRS nondiscrimination tests. So every year - generally during the first quarter - the "highly compensated employees" (HCEs) in those plans get some of their contributions back.

They're none too happy about it, either. Getting a refund means having to pay tax on the money and losing the compounded interest on that amount which, over time, could be substantial. Also, for participants who have already filed their income tax returns, it generally means filing an amended return.

"This doesn't seem fair," one participant complained to mPower. "Is there anything I can do? Or am I just along for the ride?"

Well, for the 1998 plan year, unfortunately, the die has been cast and there's nothing you can do except take the refund and invest it the best way you know how. But there may be something you can do for future years, as you'll see later in this article.

Who Gets A Refund?

First, here's the nub of the issue: the IRS will only allow a 401(k) plan to have tax-deferred status (i.e. let participants make pretax contributions and avoid paying taxes on interest until withdrawal) if the plan benefits all employees similarly, no matter what their income. If higher-paid employees are allowed to contribute substantially more than their lower-paid colleagues, they will save more on taxes and may also get a higher amount in employer matching funds, and that is not allowed.

The "highly-paid" category has to start somewhere, and for the IRS it is at $80,000 a year or more in earnings, or ownership of at least 5% of the company. (It may surprise some people - single-salary parents living in a big city come to mind - to know that earning $80,000 a year makes them "highly compensated." Well, things could be worse. In 1995 it was $66,000.)

The calculations involved in nondiscrimination testing are complex, but essentially, HCEs as a group may not contribute more than 2 percentage points above their "non-HCE" colleagues.

So, if the non-HCEs on average contribute 4% of their salary over the year, the HCEs cannot, on average, contribute more than 6%.

If the HCE average turns out to be 8%, for example, the employer has to choose between depositing extra money in the account for the non-HCEs, to make up the difference, or refunding the difference to the HCEs.

It's not surprising that most employers choose the less expensive option of refunding the HCE's excess contributions.

That's when participants start receiving letters in the mail telling them that they contributed too much to their plan - even though their contributions were below the federal $10,000 ceiling.

Adding insult to injury is the fact that many people receive these letters AFTER they have filed their tax returns, and must therefore file an amended return listing the refund as income. If you received a refund before March 15, 1999 for last year, you have to declare the income on your 1998 tax form. However, if it came later, you can list the income on your 1999 return. (Most employers make the refunds before March 15 because if they don't, they have to pay a 10% penalty to the IRS.)

Receiving a refund out of the blue can be upsetting, to say the least. "I don't understand why they did not see this coming, and give those who contribute the maximum an opportunity to reduce their contributions," one irritated participant wrote to mPower.

Such feelings are justified, says Jennifer O'Reilly, Vice President of Western Pension, a 401(k) plan consultant and third party administrator. "Employers absolutely should see this coming," she says, because "a good consultant should do interim tests during the year and be able to warn them."

What You Can Do

To avoid receiving an unwanted refund again, a good strategy might be to encourage lower-paid employees at your company to start participating in the 401(k) plan, if they are not already doing so, or to increase their contributions. Remind them that the employer match is free money, so they should at least try to receive the full match.

Surveys have shown that a good way to encourage employees to participate in a 401(k) plan is to give them advice about how to invest their money. mPower is a company that contracts with plan sponsors to provide customized 401(k) investment advice to participants - you could consider telling your benefits representative about this service.

Also, you can urge your employer to pay attention to interim testing so that future refunds don't come out of the blue.

Safe Harbor Plans

There's another option, but your employer might not go for it.

An employer who wants to avoid the hassle and expense of nondiscrimination testing each year may set up a "safe harbor" 401(k) plan. Under such a plan, the employer has to pay a certain amount of money into the account for the non-highly compensated employees. There are various formulas for calculating the amount. Some employers might find this option expensive, especially since these contributions would have to be fully vested from the word go.

The deadline for setting up such a plan for 2000 is December 1, 1999.

Other Reasons for Refunds

In addition to the HCE limit, there are two other contribution limits that could result in unexpected and unwanted refunds.

1) One is the $10,000 annual contribution ceiling. People who contribute over this limit often have worked for more than one employer during the year and haven't kept track of their contributions - or have thought, mistakenly, that they could contribute up to $10,000 per employer. If you are in this situation, you should tell your employers immediately. If you didn't get a refund by April 15, you have to pay a 10% penalty on the money. 2) The second limit stipulates that the maximum amount that can be accumulated in any of your tax-qualified defined contribution plans - 401(k), thrift, profit-sharing, ESOP and money purchase - is limited to 25% of your gross pay or $30,000, whichever is less. If your 401(k) contributions in 1998 put you over this limit, you have to get a refund of the difference by December 31, 1999, and declare the amount on your 1999 tax form. If the refund comes late your employer has to pay a 10% penalty on the amount.

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.

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.