What does it mean to be labeled a "highly compensated employee" in terms of 401k?
John M. Level 11
Being labeled a "Highly Compensated Employee" or HCE is a double-edged sword. It’s great that you're among the top earners at your firm, but now you are subject to certain limits when contributing to your 401(k). You can find the definition of a HCE in the Internal Revenue Code Section 414(q)(1)(B). And no, it isn’t specific to your company.
To be considered an HCE for 2012, unless you or your family has ownership in the company, you will need to have earned at least $110,000 in 2011. This amount can be increased based on cost of living adjustments on an annual basis.
The HCE designation is important when it comes to the nondiscrimination tests that a 401(k) plan needs to take every year. There are 3 major tests: The Average Deferral Percentage (ADP) test, the Average Contribution Percentage (ACP) test, and the Top Heavy Test. The ADP and ACP test look at HCEs and Non HCEs while the Top Heavy Test looks at "Key Employees" and "Non Key Employees".
I've heard many horror stories of bad administrators (mostly the payroll companies) that actually ask the employer "Who are your Highly Compensated Employees?" Naturally, not being versed in the code, the employer sends back who they consider highly compensated without regard to the IRS' definition. Sometime employees are included that shouldn't be, and more often employees that should be are left out (especially family members of the owner, even if they have no ownership stake). This puts the employer in jeopardy if the DOL or IRS ever rolls in to audit the plan.
Any good Third Party Administrator (TPA) will not have to ask the employer but
simply look at the census of employees and their compensation and run the calculations. What are they calculating? Whether or not the plan will pass or fail the "nondiscrimination tests".
Unfortunately, a bad administrator will put garbage in and get garbage out. A plan may fail testing because the administrator is not sophisticated enough to know how to use different testing methods to help a plan pass. Good advisors and TPAs will serve as consultants offering advice on how to restructure the plan to make sure it passes now and in the future. I've heard of some brilliantly creative ideas used to help plans pass.
The bottom line for you, Everett, is that if you are indeed a HCE, you will want to make sure the calculation was done correctly, and make sure the plan passes the testing. Failing to pass could mean refunds for you. That is, money you socked away in your 401(k) account will be returned to you and you will have to amend your tax returns to make sure it is accounted for as income. I've seen refunds in the tens of thousands of dollars. You might even consider holding off filing your personal tax returns until you get a clear indication from your employer as to whether or not you will be getting a refund. Also, make sure your firm is working with a reputable TPA and Advisor.
Lastly, some employers opt to implement a Safe Harbor provision which allows them to escape these tests as long as they meet certain requirements which I won't bore you with here. I hope this is helpful and good luck to you!
Comment | Flag | Mar 09, 2012 from Concord, CASource: www.brightscope.com