Overcoming 401(k) Plan Nondiscrimination Rules

by | May 3, 2021

Question:   My company sponsors a 401(k) plan to which many of our highly paid employees are unable to contribute as much as they would like. What alternatives are available to avoid or minimize this problem?

Answer:   There are various tools available to you as the plan sponsor which can alleviate or circumvent the 401(k) plan restrictions. The most common options involve you as the employer making additional contributions to the plan to enable the plan to satisfy or avoid the applicability of the statutory non-discrimination test. These steps can overcome the requirements limiting the salary reduction or 401(k) contributions made to the plan by highly compensated employees (“HCEs”) based on the plan contributions made by the non-highly compensated employees (“NHCEs”).

One means of correcting the problem is for the company to make additional plan contributions on behalf of NHCEs, so-called qualified non-elective contributions or “QNECs”.  QNECs made by the company on behalf of NHCEs are treated as if they were made to the plan by NHCEs and must be fully vested.  Because QNECs are classified as 401(k) contributions by NHCEs, they serve to increase the deferral percentages of the NHCEs, thereby permitting HCEs to contribute a larger amount to the plan.

Safe harbor contributions are another remedial tool which enable 401(k) plans to satisfy the non-discrimination test.  Employers can contribute 3% of each NHCE’s compensation to the plan which will automatically permit a plan to satisfy the statutory non-discrimination test.  An alternative safe harbor test entails a company making a matching contribution to the plan of 100% of the first 3% of each NHCE’s 401(k) contributions and 50% of the ensuing 2% of each NHCE’s plan contributions.  As with QNECs, the safe harbor contributions must be fully vested in employees. By adopting either of these safe harbors, HCEs can contribute the maximum allowable amount to the plan without regard for the statutory restrictions.

You might also consider adopting a separate deferred compensation arrangement available only to a select group of highly compensated employees.  As a plan not subject to the 401(k) statutory non-discrimination testing, HCEs can contribute to the plan whatever amounts they wish, subject of course to any limitations the plan may impose. You should be mindful that a plan of this nature which does not constitute nor satisfy the 401(k) plan rules falls outside of the rules of conventional retirement plans. Accordingly, adopting employers are not entitled to a current income tax deduction for contributions made to these plans; employer deductions will only be available when benefits are paid from the plan to participants, usually upon termination of employment. Non-qualified plans are also less favorable for contributing employees as benefits are fully taxable when paid to the plan participants with no opportunity to roll over plan distributions to Individual Retirement Accounts which is a common tax deferral technique utilized by retiring employees. Also, unlike assets held in a 401(k) plan, non-qualified plan assets are generally subject to the claims of company creditors.

If none of these alternatives is viable, your company’s HCEs should consider their own, personal retirement plan options.  Participants can fund an Individual Retirement Account on their own behalf and/or on behalf of their spouses.  The IRA contributions may or may not be deductible but even if not deductible, assets held in IRAs can accumulate on a tax deferred basis for a lengthy period of time.  Your employees might also explore some of the investment products that are available for retirement plan assets such as deferred annuities and life insurance products with savings features.

Many 401(k) plan sponsors face the same hurdles that you are facing and have employees that are frustrated by the statutory rules limiting the 401(k) contributions of HCEs.  Nevertheless, some creative planning can provide an effective means of accumulating funds on a tax-deferred basis for retirement purposes.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfbbg.com.