Why Did I Get A Check From My 401(k) Plan?

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Did you recently get a check from your 401(k) plan that you didn’t request Whether this is the first time it has happened to you or it is a regular annual occurrence, it can be confusing. It might even leave you wondering why this happens, will it happen again, and what you can do about it. The answer is that every 401(k) plan must go through “nondiscrimination testing” on an annual basis. If the IRS considers you a Highly Compensated Employee (HCE), you could be affected.  

The Why of Nondiscrimination Testing

Each year, 401(k) plans must perform nondiscrimination testing. Per the IRS, this process ensures 401(k) and other workplace retirement plans “provide substantive benefits for rank-and-file employees, not only for business owners and managers.” There are many layers to this process but specifically, two tests must be run:

  1. Average Deferral Percentage (ADP) test which relates to employee salary deferrals
  2. Average Contribution Percentage (ACP) Tests which primarily relates to employer matching contributions.

The short version of these tests is they compare the 401(k) contribution rates in the prior plan year of Highly Compensated Employees (HCEs) to those of Nonhighly Compensated Employees (NHCEs).  For the year 2018, the IRS considers you an HCE if you meet any of these conditions:

  • Earned $120,000 or more in the prior year (2017 for the 2018 testing year)
  • Owned 5% or more of the business at any point during the year
  • Related to a 5% or more owner

An NHCE is someone who does not meet any of the three conditions. To keep this manageable, we are going to focus on the ADP portion of the tests. 

Once your 401(k) administrator determines the HCEs and NHCEs, they compare the salary contributions each group made to the plan.  It is not unusual and even expected that the HCE group will have contributed more as a percentage of their salary on average than the NHCEs.  However, if the “gap”, or difference in the average contribution rates exceeds certain guidelines, then your company is deemed to have failed nondiscrimination testing. Of note, when calculating the group averages the test includes “zeros” for those employees who are eligible and not participating in the 401(k) plan. This is one of many reasons most employers pay close attention to their plan participation rate. 

To illustrate the concept, if the HCE group contributes 6% of their salary on average and the NHCE group contributes 3% of their salary on average the gap between them is too large. At that range the gap is only allowed to be a 2% difference.  Thus the ADP portion of the test will fail.  Your employer now has two options to close the gap between HCEs and NHCEs and pass the test:

  1. Raise the NHCE average, or
  2. Lower the HCE average

A common way employers raise the NHCE average is through a Qualified Non-Elective Contribution (QNEC).  However, this can be very expensive for your employer so it not frequently done.  The more common method to close the gap is to lower the HCE average by returning what have been deemed to be excesses contributions to HCEs.  If you recently received a check and money reversed out of your 401(k) account, then your company chose option number two.

The check you received is a mix of your contributions and any earnings (or losses) associated with your account for the year.  In addition to the check, you will eventually get a Form 1099R for the same amount. You will need to report that amount as income in the year you receive it, not retroactively to the plan year the contributions were made.

Sometimes when you get a check in the mail, it is a good thing.  For obvious reasons, this is not.  While you are now free to use the money as you like, you will be taxed on the amount and it doesn’t help your journey to retirement.

Will It Happen Again?

Nondiscrimination testing must be performed every year.  If your company failed testing this year, there is a reasonable chance they will fail next year and in the future.  Most of this will depend on the type of company you work for and the demographics.  For example, nondiscrimination testing is challenging for companies with few employees who are “executives” or are considered HCEs but have a large percentage of their workforce that are NHCEs. Classic examples are retailers, restaurants, manufacturers or other similar groups.  The 401(k) participant data consistently show that younger, lower-paid workers are not as likely to participate and save smaller percentages of their pay  in company retirement plans than older, higher paid employees. 

Whether this is the first time you had money reversed out of  your 401(k) account and returned to you, or it has happened consistently over the years, you can take action to improve results in the future and keep more money in your plan for your retirement.  

What Can You Do?

There are several options you may discuss with your employer to help your plan pass or improve nondiscrimination testing results in the future.  Keep in mind, many of these may add expense to the company, require plan changes, disrupt your fellow employees or all of the above.  

Safe Harbor Plan – If your employer changes your plan to a safe harbor plan, your company is considered exempt from nondiscrimination testing.  There are three variations of a safe harbor plan but the most common version requires that an employer matches 100% of the first 3% and 50% of the next 2% of compensation employees contribute to the plan. It also requires that all safe harbor matching contributions be 100% vested.  The good news is that as an employee, if you contribute 5%, you get a 4% match from the company that is 100% yours.  The bad news, depending on the current match your employer provides and the vesting schedule, this is a very expensive way to fix a nondiscrimination testing problem.  However, it is the only way to automatically pass the ADP portion of nondiscrimination testing every year which would allow HCEs to keep their 401(k) contributions in the plan.  

Increase participation and contribution rates – If your employer does not elect to make your plan a safe harbor plan, the next option is to increase the participation and contribution rates of the NHCEs.  Historically this has been done through education meetings or lunch and learn presentations.  More recently, employers have been adding plan features such as automatic enrollment.  This means that either all new hires or all employees who are not currently making salary contributions are enrolled in the 401(k) plan at a designated percentage of their income; unless they opt out.  Some employers will also pair this concept with annual automatic contribution increases.

For example, if someone is automatically enrolled at 4%, their 401(k) contribution would increase by 1% every year they are employed until they hit a 10% contribution, or they choose to stop the automatic increases.  What we have learned, is that about 90% of employees who are automatically enrolled in the plan will stay in the plan and have their contributions increased every year. This is a very effective option, but can be disruptive.  While it may be a big help to improve nondiscrimination testing results, it does not guarantee your company will pass.  Finally, keep in mind that if your company provides a matching contribution it will also increase their employer matching costs as more employees join the plan.  

Stretch The Match – If your employer offers a matching contribution, the way it is designed could impact testing.  If your company match is currently 100% of the first 3% then many employees will only contribute 3% to the 401(k) plan.  This is due to some rule of thumb guidance employees have heard over the years to save up to the amount their employer matches. You company could use conventional wisdom and research in behavioral finance to improve your testing results.  If they rephrase the match to 50% of the first 6% it could improve testing results. The actual company contribution does not change (still a maximum of 3%), but now employees must contribute 6% to get the full match. As a result, many employees will raise their contribution to the new 6% target to get the full match. This strategy helps employees save more money towards their retirement, doesn’t increase costs to the company and will likely improve nondiscrimination testing results.

Cap HCE Contribution Rates – Another strategy your company may take is to set a cap on HCE contribution rates.  Your employer should have the information on what your NHCEs have historically contributed to the plan.  Some employers will cap the contributions of their HCEs so that they do not receive “refunds” or a return of contributions each year because of a failed nondiscrimination test.  While this is an option, it does not guarantee they will pass the test.  This strategy may also potentially mean that you are leaving money on the table that you could have kept in your 401(k) plan. 

For example, what if your employer capped HCE contributions at 5% of salary and after the nondiscrimination tests were performed, you could have kept 5.5% of your salary in the plan?  Half of a percent difference, that might not sound like much. However, on a $150,000 salary, it is $750.  If your company matches employee contributions that might be another $750 for a total of $1,500 in contributions.  If that happens multiple times over the years and with some appreciation that could translate to tens of thousands of dollars.  

Testing Tricks

A few simple things can help your company’s nondiscrimination testing results and can help you keep more money into your 401(k).  Some of these may already be happening behind the scenes, others may not.

Catch-up contributions – For HCEs who are age 50 or older and contribute to the plan, and they fail nondiscrimination testing, a portion of their contributions may be recharacterized as catch-up contributions.  For example, if an HCE who is catch-up eligible contributes $15,000 during the year with no contributions already being designated as catch-up, their 401(k) administrator may reclassify those contributions up to the catch-up limit ($6,500 for 2018) as a catch-up contribution.  Then, in this example only the remaining $8,500 would count towards the ADP test.  This then lowers the percentage of income that the employee contributed to the plan.  It will also lower the average for the HCE group as a whole. In turn, it could help the plan pass testing or lower the overall return of excess contributions to HCEs in the plan.  

Remove Newly Hired  - A 401(k) plan administrator may also remove people who have not met certain plan eligibility conditions to improve testing results, even if they were eligible for or participated in the plan during the year. Using certain testing methods, employees who have not worked a full year, have not met a plan entry date or are not 21 years old may be removed from the nondiscrimination test. The logic is that having fewer newly hired employees who generally participate at lower rates than employees who have been with the company longer is better. By removing them from the test, it could raise NHCE average contributions, close the gap between the HCEs and improve nondiscrimination testing results.  

Top Paid Group – If a large percentage of the employees at your company are considered HCEs, they may elect the “Top Paid” method to determine who the HCEs in your plan are. Under this option, instead of designating all employees who have gross compensation over the IRS income threshold as HCEs, only the top 20% earners in the company will be considered HCEs for testing purposes.  This may be beneficial as it requires a lower percentage contribution for someone making a higher income to max out on their 401(k) contributions.

For example, someone earning $250,000 only needs to contribute 7.6% of their salary to reach the $19,000 IRS maximum 401(k) contribution for 2019.  While someone earring $120,000 must contribute 15.8% of their pay to “max out”.  By limiting the HCEs group to the “Top Paid” group, your company could improve testing results by taking advantage of the lower percentage of pay the highest earners contribute to hit the IRS maximums to close the gap with the NHCEs.

Current vs. Prior Year – Finally, your employer also has the option to designate whether they will look at the NHCE contribution rates for the year prior when they perform nondiscrimination testing, or whether they will look at the NHCE rates in the current year. As we sit here in 2019, testing is being performed on the 2018 plan year. However, if your employer is using the prior year testing method, they are actually looking back to the 2017 plan year to see what NHCEs contributed to determine what HCEs may contribute in 2018. Employers who are capping HCE contributions generally rely on this strategy. However, if your employer has taken steps to add automatic enrollment or automatic increases they should consider current year testing to capture the benefits of those strategies in their testing results sooner.  

The 401(k) nondiscrimination testing process is complex and involves a lot of math. For your employer, the trick is to understand how the math works and get it to work in their favor. If you received a check this year due to failed nondiscrimination testing, express your concerns, ask good questions and engage in a thoughtful dialogue. Mention a few of the points above and see what else they have considered or explored to improve results now or in the past.  Keep in mind, many plan changes that could improve nondiscrimination testing results may increase company expenses, require plan changes or disrupt employees. Who knows, you might walk away with a stronger appreciation for what your employer has already done to get the best possible testing outcome, or maybe they will explore a few of your ideas to improve results in the future.  

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