One of the benefits that make tax-deferred retirement accounts like 401(k) plans so attractively is their high contribution limits. This becomes especially appealing when your company offers a 401(k) employer match. However, some plans restrict highly compensated employees (HCEs) from making the maximum contribution. Nonetheless, you can avoid these restrictions and find ways to maximize your retirement savings. But first, determine if you are a highly compensated employee in the first place. For help with saving and planning for retirement, consider working with a financial advisor.
Who Is a Highly Compensated Employee?
The IRS defines a highly compensated employee as someone who meets either of the two following criteria:
- A worker who received $130,000 or more in compensation from the employer that sponsors his or her 401(k) plan in 2021. For 2022, this threshold rises to $135,000.
- A person who owns more than 5% of interest in the business sponsoring the plan at any point during the last year, regardless of compensation.
Compensation doesn’t just cover what you get from your employer in the form of a recurring paycheck. It also includes overtime, bonuses, commissions and salary deferrals made toward cafeteria plans and 401(k)s. And according to the IRS, your employer can choose to designate you an HCE if you rank among the top 20% of employees when it comes to compensation.
That 5% rule can also be a bit vague. It’s based on the value of company shares. But it doesn’t just count what you own. It also covers ownership attributed to your spouse, children and grandchildren working for the same company. So if your holdings in the company are worth 3% and your son owns 2.2% in the same firm, you’re considered an HCE. That’s because your total ownership amounts to 5.2%.
401(k) Contribution Limits for Highly Compensated Employees
Before we explore how restrictions may apply to you, let’s get to know the maximum 401(k) contribution rules that apply to all. For 2021, a 401(k) participant filing single can contribute up to $19,500. For 2022, a 401(k) participant filing single can make up to $20,500 in contributions. If you’re at least age 50, you can also direct an additional $6,500 in “catch-up” contributions. Factor in an employer match and you could be looking at major tax-advantaged savings.
Each year, employers run the 401(k) plans they sponsor through non-discrimination tests. The IRS requires these to make sure plans don’t favor HCEs over the rest of the company.
So to pass the test, average contributions made by HCEs can’t be more than two percentage points higher than average contributions made by non-highly compensated employees. So if the average contribution that non-HCEs make equals 4% of their salaries, the average contribution HCEs make can’t exceed 6% of their salaries.
In addition, total HCE contributions can’t exceed the total contributions of non-HCEs by more than 2%. As you can see, how much you should contribute to your 401(k) depends heavily on how much non-HCEs are contributing and how many are even participating at all.
What to Do If You Maxed Out Your 401(k) Contributions
Companies have until March 15 to conduct this test for the previous year. So if you’re an HCE who maxed out your contributions in the previous year, you may not know if the company failed the test until the following year. If so, your firm would most likely refund you the excess contributions you made. This will count as taxable income. So it could increase your tax liability for the current year. Plus, the money coming back reduces the tax savings and earnings potential of your 401(k).
So you may want to set some cash aside to cover a potential tax hike. Or you can make an estimated tax payment. And at some points, it may be best to hold off on reaching your 401(k) maximum contribution until you know whether you will face restrictions.
Other Retirement Accounts HCEs Can Consider
When it comes to a 401(k), you can still contribute as much as your employer will allow HCEs to contribute without penalty. Nonetheless, you may want to look at ways to maximize your retirement savings beyond a 401(k). Let’s explore some options below.
Make Non-Deductible Contributions to a Traditional IRA
If you’re an HCE as described above and covered by an employer-sponsored retirement plan, you’re not eligible to make tax-deductible contributions toward a traditional IRA account. That benefit phases out after certain income thresholds. That starts to happen when your modified adjusted gross income (MAGI) reaches $66,000 (or $105,000 if married and filing jointly) in 2021 and $68,000 (or $109,000 if married and filing jointly) in 2022.
For 2021, the IRA deduction benefit is phased out completely when your income reaches more than $76,000 (or $125,000 if married and filing jointly). In 2022, the same happens when your income exceeds $78,000 (or $129,000 if married and filing jointly).
However, you can still open a traditional IRA and fund it. In addition, your earnings will grow tax-deferred. And you can contribute toward the full IRA contribution limit.
For 2021 and 2022, the contribution limit for an IRA stands at $6,000 and $12,000 for married couples filing jointly. If you’re at least age 50, you can again make additional catch-up contributions up to $1,000. Overall, you won’t get the full benefits of a traditional IRA. But it can serve as a nice supplement to your 401(k), especially when the plan puts some restraints on you.
Open a Roth IRA
Instead of using pre-tax dollars, a Roth IRA is funded with after-tax dollars. By paying taxes on the money upfront, your money grows tax-free.
For 2021, you can contribute at least partially toward a Roth IRA as long as you don’t earn more than $140,000 (filing single) or $208,000 (married filing jointly). However, you are subject to partial contribution limits once your income reaches $125,000 (single) or $198,000 (married filing jointly.)
For 2022, you can contribute toward a Roth IRA, at least partially, if you earn less than $144,000 (filing single) or $214,000 (married filing jointly). But partial contribution limits kick in once you earn $129,000 (single) or $204,000 (married filing jointly)
Despite income limitations, you can still enjoy some tax benefits using a Roth IRA. As long as you’ve had your Roth IRA for at least five years, you can make eligible withdrawals tax-free in retirement.
Open a Backdoor Roth IRA
HCEs may also be interested in going through a backdoor IRA. This process describes converting a nondeductible IRA into a Roth IRA. It can be very tricky. So your best bet is to find a financial advisor to guide you through the process. But we’ll cover the basics to see if it piques your interest.
For starters, it’s important to keep in mind that in order to make the most out of a backdoor Roth IRA and avoid major tax penalties, you can’t have another IRA. This covers SEP IRAs and SIMPLE IRAs.
Now here’s how it works. You open a traditional IRA and a Roth IRA at the same time, preferably with the same manager. Next, you contribute the $6,000 maximum to the traditional IRA. Afterward, you convert the traditional IRA to a Roth IRA and pay income taxes owed on the money. This process helps you make maximum tax-deferred contributions that grow tax-free. Finally, you can withdraw these savings tax-free when you’re eligible.
So if this option appeals to you, we recommend you consult a financial advisor to guide you through the process so you won’t run into any major pitfalls that may be hidden along the way.
Open a Health Savings Account (HSA)
If you’re enrolled in an eligible high-deductible health plan (HDHP), you may be able to open a health savings account (HSA). These savings vehicles help Americans save for future medical expenses, which can leave you burdened with major bills.
They also offer a triple tax advantage. You fund these accounts with pre-tax dollars and your earnings grow shielded from taxes. As with 401(k) plans, you can invest these savings in securities like stocks, bonds and mutual funds. In addition, you can withdraw money from HSAs tax-free as long as they cover qualified medical expenses. So while not designed as a retirement plan, you can use these accounts to pay for health costs that you otherwise would have relied on 401(k) money to cover. In a sense, that money can keep growing in the plan.
Open a Taxable Account
You should still consider directing some money into taxable investments. Regardless of income, you can always open a brokerage account or invest in securities like mutual funds. You also won’t run into any contribution limits regardless of how much you earn. In addition, you’d have access to your investments as you need it.
Being a highly compensated employee obviously has a nice ring to it. This can also mean you will get a few chains put on your retirement nest egg, but thankful you have options. You can contribute to an IRA, a Roth IRA or a Backdoor Roth IRA. Opening an HSA can also give you some tax benefits and help you save for future medical expenses. Plus, you can always invest in taxable accounts regardless of income.
Tips for Highly Compensated Employees
- Navigating the retirement planning terrain can be a hassle when you’re a highly compensated employee. With all these rules and regulations, it can get complicated, but a financial advisor can help. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you end up working with a financial advisor, we devised a checklist of the five questions to ask when choosing a financial advisor.
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