Determining if you have highly compensated employees (HCEs) isn’t hard. The Internal Revenue Service (IRS) is clear on who qualifies as an HCE. An HCE is an individual who:
- Owned more than 5% interest in the business during the current or preceding tax year.
- Received more than $125,000 in compensation or is in the top 20% of employees ranked by compensation.
What can be more difficult is how those HCEs impact your business’ 401(k) retirement plan. A little history is needed to understand the impact.
401K History
Did you ever wonder where the 401(k) concept came from? The Revenue Act of 1978 laid the groundwork for 401k retirement plans. The Act was designed to provide equal opportunities for employees to save for retirement. With no cap on the annual amount an employee could save, it became apparent that there was inequity in the initial concept. Enter the annual nondiscrimination test for all companies offering a 401K plan.
Nondiscrimination Test
The nondiscrimination test divides employees into two groups: the highly compensated and the non-highly compensated (NHCE). The tests look at the contributions of the two groups to make sure that the plan is not masquerading as a tax-deferred plan for HCEs. The IRS wants to ensure that NHCEs have access to a comparable retirement plan. As a result, they examine the contributions to determine if they are proportionate across all groups. Failure to comply comes with significant consequences to HCEs.
Failing the Test
The IRS gives a company 12 months from the year of infraction to correct any problems with a 401(k) plan. In most cases, the company can increase the amount it contributes to NHCEs, or it can return some of the contributions to the HCEs. These contributions are then taxable.
To find a 401(k) plan for your small business that will pass the annual nondiscrimination test, contact us, or request a proposal.