Advanced Underwriting Consultants

Ask the Experts – May 14

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: I have a client who is a small-business owner looking to set up a 401(k) plan for himself and his employees. He’s the only “highly compensated employee.” Should he be worried about contributing too much to his own plan as elective deferrals?

Answer: Your client should be aware of the rules against discrimination in favor of highly compensated employees.

The general rule is that if a 401(k) plan meets one of the following tests, it doesn’t discriminate in favor of highly compensated employees (HCEs):

    • The actual deferral percentage (ADP) for all HCEs does not exceed 125% of the ADP for all other eligible employees; or
    •  The ADP for eligible HCEs does not exceed twice the ADP for all other eligible employees, and the ADP for eligible HCEs does not exceed the other employees’ ADP by more than two percentage points.

ADP is the ratio of the amount of employee deferrals to the employee’s salary. The maximum salary taken into account for HCEs is $260,000 in 2014.

Let’s say your client’s workforce consists of the following employees, including your client:

Employee Deferral Salary ADP
Larry $2,000 $40,000 5%
Curly $0 $35,000 0%
Moe $7,000 $100,000 7%
Your client $17,500 $260,000 6.7%

 

Also assume your client made no matching or nonelective employer contributions to any employees, including himself.

Larry, Curly and Moe, the non-highly compensated employees, have an average ADP of 4% (the average of 5%, 0% and 7%). The first ADP test is failed because your client’s ADP exceeds 5% (i.e. 125% of 4%). The second test is also failed because your client’s ADP is more than two percentage points higher than his non-highly compensated employees’ average ADP.

Since both the ADP tests failed, your client’s 401(k) plan discriminated in favor of HCEs, and your client would need to withdraw the excess contributions—that is, distribute $1,900, which brings his ADP down to 6% and passes the second ADP test.

If he withdraws excess contributions after 2 ½ months from the close of the plan year, he incurs a 10% excise tax. He must also withdraw the excess contributions within 12 months from the close of the plan year or the plan will be disqualified.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.