One of the benefits that makes tax-deferred retirement accounts like 401(k) plans so attractive 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 regardless. But first, determine if you are a highly compensated employee in the first place. For help with any retirement questions, 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:
- Received $130,000 or more in compensation from the employer that sponsors his or her 401(k) plan in the previous year.
- 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 a highly compensated employee 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 a highly compensated employee. 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 maximum 401(k) contribution rules that apply to all. For 2021, a 401(k) participant filing single can contribute up to $19,500. If you’re at least age 50, you can 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 highly compensated employees over the rest of the company.
So to pass the test, average contributions made by HCEs can’t be more than 2% higher than average contributions made by non-highly compensated employees. So if the average contribution non-HCEs make equals 4% of their salaries, the average contribution HCEs make can’t exceed 6% of their salaries.
In addition, HCE contributions as a total can’t exceed 2% of the total contributions non-HCEs. 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 a highly compensated employee 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 out 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 would 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 a highly compensated employee as described above, you’re not eligible to make tax-deductible contributions toward a traditional IRA account. That benefit phases out after certain income thresholds. That happens when your modified adjusted gross income (MAGI) reaches $66,000 or $105,000 if married and filing jointly in 2021. For 2021, that benefit is phased out completely when your income reaches more than $76,000 or $125,000 if married filing jointly.
However, you can still open one and fund it with pre-tax dollars. In addition, your earnings will grow tax free. And you can contribute toward the full IRA contribution limit.
For 2021, the contribution maximum 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
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 begin undergoing contribution limits once your income reaches $125,000 (single) or $198,000 (married filing jointly.)
However, you can still enjoy some tax benefits. 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
Highly-compensated employees may be interested in going through a Backdoor IRA. This process describes converting a non-deductible 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 peaks your interest.
For starters, keep this in mind. 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. 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 savings to cover health costs that may otherwise have been taken care of by your 401(k) money. 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 obvious has a nice ring to it. But it can also mean you’d get a few chains put on your retirement nest egg. But 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 in 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.
Photo credit: ©iStock.com/baona, ©iStock.com/RgStudio, ©iStock.com/Deagreez