Administrator Notes: Limiting the Number of HCEs
By: Lynda Morrison, email lmorrison@cbginc.com
An employee’s status as a highly compensated employee (“HCE”) can have a dramatic impact on the ability of that employee to accrue benefits under a tax-qualified plan. An HCE’s 401(k) deferrals may be limited by the ADP test, matching contributions may be limited by the ACP test, and profit sharing allocations may be restricted if the plan uses a new comparability or tiered allocation formula.
While employers are familiar with the Code’s definition of a highly compensated employee, many employers are unaware that they can make an election to limit the number of HCEs. Assume, in a simple example, that a medical practice sponsors a 401(k) plan. There are 10 employees, including two partners. The partners earn $200,000, two managers earn $100,000, and the six remaining employees earn less than $90,000. Further assume that the owners and managers
each defer $13,000 to the 401(k) and the remaining employees average 4%. Assume further that each employee’s compensation is the same each year.
An HCE is any employee who: (1) was a 5% owner at any time during the year or the preceding year; or (2) for the preceding year, received compensation in excess of $95,000 (as adjusted for cost-of-living increases) and, if the employer elects, was in the top-paid group of employees for the preceding year.
Assuming the employer does not make the top-paid group election, this definition results in 4 HCEs (two owners and two managers). For ADP test purposes, the 401(k) percentages of the HCEs are 6.5%, 6.5%, 13% and 13%. Thus, the HCE average is 9.75%. Based upon the other employees’ average of 4%, the ADP test is not satisfied and refunds are required to all HCEs. Based on my calculations, refunds would be $4,000 to each HCE.
This client is a perfect candidate for the top-paid election. If the employer makes the necessary election in the plan document, an individual would be an HCE based upon compensation only if they were in the top 20% of employees ranked on the basis of compensation. The employer should seek the assistance of its administrator in making this calculation because certain employees can be disregarded. However, based upon our simple example, the two owners remain HCEs because they are 5% owners. The two managers, however, are not HCEs because they were not in the top 20% of employees ranked on the basis of compensation. Thus, the two managers are non-HCEs.
The impact on the ADP test is dramatic. Now, the 401(k) percentage contributions of HCEs average 6.5%. The 401(k) percentage contributions of non-HCEs total 50% (13% and 13% for the managers, and 24% for other 6 employees, 4% average). Thus, the non-HCEs ADP average is 6.25%, the ADP test is satisfied and no refunds are required.
If the plan provided a new comparability profit sharing allocation, the impact on the general test could be similar. Thus making the election could have a beneficial impact on the allowable profit sharing allocation for the owners and managers.
The top-paid group election was beneficial in this situation. Any employer whose HCEs include more than 20% of its employees should consider making the election. However, the election should not be automatic. Based upon the specific group of employees, the impact of such election could do more harm than good (consider, for example, if the managers in the example set forth above had elected not to contribute to the 401(k)). As always, an employer should seek competent advice in this determination.