1. 401k plans must be tested
It’s pretty easy to max out your contributions to your 401k plan if you make a great income. For a refresher, the maximum contributions for 2015 are $18,000 plus an additional $6,000 “catch-up” contribution if you’re age 50 or older).
If your income is modest, or you have large financial obligations (think kids & family), it’s not nearly as easy to save the maximum amount into your 401k plan.
2. ERISA want’s 401k plans to benefit participants
Company owners typically have a pretty great income! They’re at the top of the heap, and it’s generally not too hard for them to max out their 401k plan accounts.
Their employees however, don’t always find it quite so simple. For this reason, the IRS imposed limits on the amount high income owners and key employees can save and invest into their 401k plan.
The IRS calls these high income individuals “HCE’s” or “Highly Compensated Employees”. The contribution limits are defined by what we call “discrimination testing”.
3. What is 401k discrimination testing?
Each year the IRS requires all 401k plans (with the exception of 401k safe harbor plans) to undergo a discrimination test. Doing this ensures that the highly compensated employees aren’t getting too great of a tax benefit from their 401k plan, while the “little guy” is struggling to save for retirement.
401k testing also does something very different – and highly beneficial – for everyone. Testing encourages the employer to incentivize their employees to contribute more to their retirement plan.
The discrimination test requires that employees are all split between HCE’s and non-HCE’s. To qualify as an HCE for 2015, an employee must have earned more than $120,000 in 2014 OR own more than 5% of the company in 2015.
Notice the compensation limit is for the prior year, and the ownership limit is for the current year. The income limits are indexed upwards periodically.
4. How does the 401 test work?
The actual test takes the average contributions of all highly compensated employees collectively as a group. That contribution for all HCE’s cannot exceed the average contribution percentage of all NON-HCE’s by more than 2%. Noteworthy is the fact that catch-up contributions are not included for this calculation.
So for example, if the ownership group making all the dough contributes an average of 10% of pay – and the rank-and-file contributes an average 5% of pay – the plan fails discrimination testing. If the 401k plan fails the test, the employer must fix it!
If they don’t fix it, the plan could lose it’s IRS qualified status and ALL monies would be returned to employees and taxed in the year received – NOT the year contributions were made. This would be quite financially painful!
In the example above, the group of highly compensated employees has a pretty big incentive to encourage the rank-and-file to contribute at least 8% of their pay. If they accomplish this, the spread between non-highly compensated and highly compensated is 2%, and within IRS limits.
All things considered, the government doesn’t want you relying on them for financial support in retirement. Rather, they want you to save on your own for your retirement, and they’ve given companies a great way to allow their employees to save on their own – the 401k plan.
Highly compensated employees must play by the rules however, and incentivize modest income employees to save as well – or simply add a Safe Harbor provision to their plan.