Question 290: I have just moved to a new company and have increased my salary to $175,000. I assume that makes me a highly compensated employee (HCE). Has does that impact 401(k) contributions?
Answer: Your assumption is not immediately correct. I'll first address your situation from the standpoint of what the Internal Revenue Code provides and then discuss briefly the effect of your plan's document. As I do, I'll provide references to the 4th edition of my book, Who's the Employer?. (Subscribers can click to view online the text of these references.)
There are two ways to become an HCE: ownership or compensation. [Q 23:3.] To be an HCE by virtue of ownership, you must own (or be deemed to own) more than 5% of the employer. [Q 23:4.]
An HCE by virtue of compensation for a given plan year is an employee whose compensation during the previous plan year exceeded a threshold in effect for that year. The threshold started at $80,000 in 1997 and has slowly increased with changes in the cost of living. [Q 23:8.]
Your compensation is now well above the threshold. But what matters is that your compensation during the last plan year from this employer was $0. Therefore, you are not an HCE for the current plan year.
Next year will you be an HCE? Maybe, or maybe not. Let's suppose your employer has a calendar year plan. Five months of $175,000 salary is roughly $73,000, not enough to make you an HCE. So, you may have more than a year outside of HCE status. Of course, I have no idea what the plan year is for your employer's plan. Incidentally, some plans use the calendar year for this determination, regardless of the plan year. [Q 23:10.]
What happens in 2009? Certainly you will be over the compensation limit in 2008. Will that make you an HCE in 2009? Maybe, or maybe not. An employer can make a top 20% election. If the employer makes the election then only those employees whose compensation is in the top 20% of all employees can be an HCE by virtue of compensation. [Q 23:11.] In other words, if your company has enough people who earn more than you do, you may still not be an HCE.
What affect does that have on your ability to defer? The Internal Revenue Code has detailed nondiscrimination rules to make sure "the little guy" (the nonhighly compensated employees, or NHCEs) is getting enough benefit out of the retirement plan to justify providing tax benefits for the HCEs. One way the Code does this is with a nondiscrimination test for deferrals. If the HCEs are deferring a lot more than the NHCEs, then the employer either has to kick in more money for the NHCEs, or the plan must give some of the deferrals back to the HCEs. A plan doesn't have to do this test if the employer makes "safe harbor" contributions for the NHCEs. How will this impact you? In depends on the terms of the plan and how much your fellow employees defer.
Speaking of the terms of the plan, everything I've said so far has dealt with the law, but employers have a great deal of latitude as they adopt plan documents. So, you'll want to check with your HR department or read the summary plan description to find out about your situation.
Some plans limit the percentage of compensation HCEs can defer in order to prevent nondiscrimination problems. For example, if the NHCEs regularly defer only 4% of pay, the plan may limit HCEs to deferring 6% of pay. The only way to know is to check your document.