What’s the Gift? 401(k) “kickbacks”
With the holiday season far in the rear view, the IRS has one more gift to give some folks: a lump of coal in their stockings: a “corrective distributions” resulting from 401(k) compliance test failures.
Who Gets It? “HCEs”
What we’re talking about here: money contributed to the 401(k) by higher paid employees that has to be “kicked out” of the plan because “rank & file” employees didn’t contribute enough. This is the “ADP” (Annual Deferral Percentage) test – potentially impacting the “HCE” (Highly Compensated Employee) population in a not-so-jolly way. (Generally speaking, HCEs are defined as earning over $115,000, business owners, and family members thereof)
Why Did They Get It? “Failed ADP test”
Here’s the basic idea of the ADP test: if the average contribution of the HCEs is too far above the average deferred by rank & file, then a portion of the HCEs contributions will be refunded out of the plan back to the HCEs – recorded as taxable income! The issue generally occurs in plans with low participation & contribution rates among rank & file employees – particularly problematic in blue-collar businesses.
How Can Companies Avoid It?
There’s a number of ways companies look to combat the ADP test. The first attempt is often looking “free” remedies – or, more accurately, those whose only cost is time & energy (but not necessarily a hardcost). What we’re talking about here: employee education initiatives to drive participation & contribution rates and/or the installation of “automatic” enrollment & contribution escalation features.
What Other Options To Look At?
As “they” say: often you “get what you pay for” and the “free” remedies are often challenged to move the needle effectively. So, then there are really 3 options companies are left with…
- Do nothing
- Institute a 401(k) Safe Harbor provision
- Utilize nonqualified deferred compensation (“NQDC”) as an alternative for those HCEs
And, to be clear telling employees to cut back on their contributions to remain under the testing threshold isn’t a good answer! Let’s take a quick peek at each of these 3 alternatives…
Do nothing: yes, it is an option. But this is accepting that the most key employees to the organization (in the highest tax brackets) won’t be able to enjoy full tax advantages in their retirement savings. In short, they will be left to save too little & tax too much.
401(k) Safe Harbor provision: generally the solution of choice for companies who are more altruistically minded and/or have fewer than 100 employees. Premise: if you give a contribution (typically ~3% of pay) to everybody, you are exempted from the ADP test. Sounds simple BUT can get expensive with lots of employees i.e., a little contribution for everyone can add up fast when you’ve got a lot of “everyones”!
Nonqualified Deferred Compensation: often the “answer of choice” for companies with 100+ total employees. Basic idea: rather than doing a 401(k) Safe Harbor election to give a broad-based contribution, instead put in a “makeup” NQDC plan just for those handful of HCEs impacted. Concept: create a “401(k)-like” plan with no contribution limits & no discrimination tests – and limit availability only to a select group of key players. Admittedly sounds simple, but there’s much more to it than that with tax, accounting, IRC 409A, and asset ownership considerations – so working with a truly knowledgeable consultant & legal counsel is important.
Author:Ben Hall, ChFC, AIF®
VP & Managing Director – JKJ Retirement Services