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Tough Times May Turn 401(k)s Discriminatory

It’s bad enough that many 401(k) plan participants are hurting in the current economy. But now, if you’re an owner of a small business that sponsors a 401(k), you may face another problem. When lower-income workers reduce or eliminate their retirement-plan contributions, those plans could find themselves flunking the nondiscrimination rules for tax-qualified plans. In that case, you as the employer must either curtail contributions on behalf of highly compensated employees (HCEs) or refund some of what they’ve already contributed. Either way, the top echelon in your company could suffer.

A 401(k) plan lets employees defer part of their salary, on a pre-tax basis, to a personal account that can be tapped during retirement. Employers may also make a contribution, matching worker deferrals up to a stated percentage of compensation. All of the money in the account grows tax-deferred until it’s withdrawn.

The retirement plan limits for 2010 are the same as they were in 2009. Thus, for 2010, an employee’s elective deferrals to a 401(k) plan normally can’t exceed $16,500. But participants age 50 or over may be allowed to salt away an extra $5,500. That adds up to a per-worker maximum for 2010 of $22,000, with the employer permitted to make its own contribution so that the combined employer-employee contribution doesn’t exceed $49,000 for 2010, not counting the catch-up opportunity.

There are strict rules, however, to ensure a 401(k) plan doesn’t favor HCEs over other workers. For this purpose, an HCE is defined as any employee who owns 5% or more of the company or who earns at least $110,000 for 2010. The primary nondiscrimination test for 401(k)s requires that the average percentage of salary contributed by HCEs not exceed the greater of the following:

  • 125% of the average contribution percentage for lower-paid employees
  • Twice the average contribution percentage for lower-paid employees, but not more than two percentage points higher than the lower average

In other words, if the average compensation percentage of non-HCEs is 2% of salary, highly compensated employees may contribute no more than 4%. If the lower-paid workers average a 4% contribution, HCEs may put a maximum of 6% into the plan. In practical terms, that could limit contributions for HCEs to much less than the normal maximum.

Suppose an executive who is 55 years old earns $150,000 a year and wants to contribute the $22,000 maximum to your company’s 401(k) in 2010. But your lower-paid workers, hurt by the struggling economy, have cut back their contributions and as a group they now set aside an average of just 4% of compensation. Your executive will be allowed to contribute only 6% of his salary—just $9,000.

This problem is likely to increase in coming months. A recent survey of baby boomers by the AARP found that a third have already stopped funding their 401(k)s, other tax-qualified retirement plans, and IRAs. That trend could put many 401(k)s at risk of failing nondiscrimination rules.

But your company doesn’t have to wait to see whether your plan falls out of compliance. You can take steps to ensure you’re not hampered by the nondiscrimination rules. The most efficient approach may be to modify your plan so that it meets one of the tax law’s “safe harbor” rules. For instance, a plan will be deemed to have satisfied the average deferral percentage test if the employer contributes at least 3% of compensation for every rank-and-file employee eligible to participate in the plan. But that really means contributing for everybody, including those who choose not to make their own elective deferrals.

A second safe harbor is available to employers that establish an “automatic enrollment” feature that signs up all employees for a 401(k), then lets individuals opt out of participating. This arrangement generally encourages higher participation. Still other approaches sweeten the rate of matching contributions or speed up vesting provisions so that recently hired employees can quickly benefit from the plan. Another option is to set up a supplemental, nonqualified retirement plan for HCEs.

As a last resort, if your plan fails the nondiscrimination tests, you could increase contributions for lower-paid employees or refund contributions for HCEs at the end of the year. But employees are taxed on the money they’re forced to take back, and their retirement accounts will suffer. It’s much better to head off problems, steering your plan into a safe harbor if you find lower-paid workers decreasing their contributions. Also, educate your employees on the importance of maximizing ongoing contributions to their 401(k) plans, especially in a down economy with depressed stock market prices.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.

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