Highly Compensated Employee Rules Aim to Make 401(k)s Equitable

By Clifton Linton Senior Writer, mPower

When Mike Geersk steps out of his office he is often confronted by nervous colleagues asking, "Will I be getting money?" The funny thing is, they want him to answer "no."

You wouldn't think the prospect of getting money from an employer would be nerve-wracking. But those jittery co-workers are highly compensated employees (HCEs) concerned that they will receive a refund of excess 401(k) contributions because their plan failed its discrimination test. A refund means they will owe more income tax for 2001. Geersk (a pseudonym), who is also an HCE, is in information services and manages the computers that process his firm's 401(k) plan.

He says his honest answer of "I have no clue" to their questions fails to mollify them. "I don't know if I'm getting one," said Geersk, 39.

All he knows is that his New York-based employer failed the test last November and the human resources department has been scrambling to determine how much will have to be refunded, and to whom, so that the plan can keep operating.

	"Congress didn't want these considerable tax breaks to be only enjoyed by the HCEs. This is the way they encourage employers to let everyone play in the pool." Martha Priddy Patterson, analyst with Deloitte & Touche LLP's Human Capital Advisory Services group

Other employers whose plans failed the discrimination test will also likely be sending refunds to some or all of their HCEs by the March 15 deadline. Employers who miss this deadline must pay the IRS a 10 percent penalty, based on the amount that must be refunded. Plans that fail the test and don't take action to fix the situation would come under government review and could ultimately lose their qualified status, meaning all money in the plan will have to be refunded to all employees.

Highly compensated workers receiving refunds will find themselves with hundreds or thousands of dollars of extra taxable income at a time they are about to file, or have already filed, their tax returns for 2001. (This income, even though received physically in 2002, is counted as 2001 income for tax purposes.) If you think you might receive an excess contribution refund, hold off on filing your taxes until after March 15. If you've already filed your taxes and you receive a refund, you will have to file an amended return including the refund as taxable income.

Annual Test

Every year, the IRS requires all 401(k) plans (except safe-harbor plans, as described below) to take a discrimination test. Most easily pass it. Still, just under 40 percent of plans polled by the Profit Sharing/401(k) Council of America reported refunding or restricting HCE contributions in order to pass the test in 2000. And, 16.7 percent of plans reported returning excess contributions.

The reason for the test is "Congress didn't want these considerable tax breaks to be only enjoyed by the HCEs. This is the way they encourage employers to let everyone play in the pool," said Martha Priddy Patterson, analyst with Deloitte & Touche LLP's Human Capital Advisory Services group.

The test requires that employees be split into two groups: highly compensated and nonhighly compensated. For the 2001 tax year, highly compensated employees are those who earned more than $85,000 in 2000, or owned more than 5 percent of the business in 2000 or 2001. (The compensation limit is based on the previous year's compensation, while the ownership limit is based on the previous or current year.) You are considered highly compensated in 2002 if you earned more than $85,000 in 2001. You will be considered highly compensated in 2003 if you earn more than $90,000 this year (2002).

The test is as follows: the average contributions of highly compensated employees, as a group, cannot exceed the average contributions of nonhighly compensated employees, as a group, by more than about 2 percent. (Age-50 catch-up contributions are not included in discrimination testing.) If the HCEs exceed this threshold and the employer fails to correct the imbalance, the plan could lose its tax-qualified status and all contributions and earnings would have to be distributed to all plan participants. In addition to the 2 percent spread, the contributions of all HCEs as a group may not be more than two times the percentage of other employees' contributions.

Consequently, HCE contribution levels are based on the contributions of non-HCEs. By setting up this carrot-and-stick system, Congress made it in the best interest of highly compensated employees to encourage non-HCEs to contribute to the plan.

Resolving Plan Imbalances

If HCEs contribute too much, an employer can choose among several strategies to bring its plan in compliance with the law. Here are some of the most common:

First, an employer may set a percent-of-pay limit within the plan document that HCE contributions may not exceed. The advantage of this strategy is that it removes all doubt about whether a plan will pass its test. The disadvantage is that HCEs could miss out on savings opportunities if the cap ends up being lower than necessary.

Second, an employer may restrict HCE contributions when they reach the maximum allowed by the test. In this case, the employer often runs discrimination test projections in the middle of the year, looking for signs that contribution rates will become unbalanced. The advantage of this strategy is that HCEs will be able to contribute the most allowed given the constraints affecting their plan.

Geersk is upset that his employer didn't run mid-year projections. A coworker in his department ran the test on his computer "for fun" during the summer and found the plan was likely to fail the test. This information was passed to the benefits office, which didn't act on it then, Geersk said, comparing the office to the bumbling Keystone Kops.

Running the test midyear can also show if HCEs can be allowed to increase their contributions above the set percentage limit (if non-HCEs are contributing more than expected, for example).

	"The (HCE) refunds are to be made to the highly compensated participant or participants who made the largest contributions." Ted Benna, creator of the first 401(k) plan

Third, an employer may choose to refund excess contributions after determining at year-end how much needs to be refunded. Companies using this strategy generally notify their HCEs early on that a refund is likely, and explain why the plan works this way. Some plans deliberately choose this strategy because "you are actually maximizing the amount HCEs can put into the plan," said Rob Vetere, vice president, compliance services, with Diversified Investment Advisors.

How is it decided which HCEs get refunds, and how much they get? "The refunds are to be made to the highly compensated participant or participants who made the largest contributions," said Ted Benna, creator of the first 401(k) plan. "This order is to be followed regardless of the compensation levels or individual contribution percentages of the HCEs."

For example, suppose a company has 50 employees and five are HCEs. One (employee A) contributed $10,000, another (employee B) $5,000 and the remaining three (employees C, D and E), each contributed $4,000. Further suppose the plan needed to refund $10,000 to comply with the discrimination test. The refunds would be calculated as follows: the plan would first refund $5,000 to employee A (to bring her in line with the next-highest contributor). Next, employee A and employee B will be refunded $1,000 each, bringing them to the level of the next-highest contributors. But, the plan still needs to refund an additional $3,000. That will be spread among employees A, B, C, D and E, with each receiving a refund of $600.

Boosting Non-HCE Participation

The best way for employers to pass the discrimination test is to encourage greater participation by nonhighly compensated employees. But how?

Roger Brown, a 50-percent owner of a chain of pizza parlors, has been mulling over this question. The low participation rate of his employees in the 401(k) plan prevents him from contributing the full $11,000 allowed in 2002, because as a 50-percent owner he qualifies as an HCE.

He plans to boost enrollment in two ways: publicizing the plan more, and implementing an automatic enrollment program, in which new employees are automatically signed up for the plan unless they opt out when hired.

One of the most effective methods of boosting 401(k) enrollment is with an employer match, Benna said. "When you have a plan without a match, it is tough to get above 50 percent participation," he added.

Employers can also set up what is known as a "safe harbor" 401(k) plan. This is the one type of 401(k) plan not subject to discrimination tests. But it can be expensive for employers, requiring them to make a fully vested gift contribution to all employees or a matching contribution to plan participants.

Finally, Vetere predicts that the new 401(k) rules contained in the Economic Growth & Tax Relief Reconciliation Act (EGTRRA) will make it easier for plans to pass the test. These rules, such as offering a tax credit for low-income savers and raising the percent-of-pay limit to 100 percent from 25 percent, should encourage more non-HCEs to participate.

"We see fewer and fewer plans failing. Under EGTRRA that should drop" even further, he said.

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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.
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