Category: Retirement Plan Consulting

Refunds to the highly compensated employees (HCE) in a qualified retirement plan can be frustrating to the participants and a challenge to the plan administrator.  Various options exist to improve this situation.  These include:

• More effectively manage the deferral and refund process
• Eliminate the issue of refunds caused by testing
• Allow the participant to continue to individual retirement accounts

This article will discuss these options.

1. More Effective Management 

If a plan is using the “current year” testing method, consideration could be given to using “prior year” testing.  Under the “current year” option, the data is not finalized until after the end of the year and the HCEs do not know the amount they can contribute until after the testing is completed.

Under the “prior year” option, the data from the previous year is used to provide the maximum deferral amount for each HCE.  This should eliminate excess deferrals that require refunds.

Another option is to notify the HCE at the beginning of the year regarding the estimated maximum deferral.  This is based on the prior year average deferral of the non-highly compensated employees (NHCE) and a review of the current deferrals of each of the HCE.  Of course, this amount may change during the year due to changes in the deferrals of either group.

2. Consider a Safe Harbor Plan

A safe harbor plan allows the HCE to contribute the maximum allowable deferrals without regard to the average deferrals of the NHCE. There are various safe harbor options that a plan could consider.  These include:

• Basic Safe Harbor Match (equal to 100% of amount contributed up to 3% of pay, plus 50% of amount contributed, up to the next 2% of pay);
• Enhanced Safe Harbor Match (must be at least as generous as the basic formula, normally equal to 100% of amount contributed up to 4% of pay);
• 3% Non-Elective Contribution (NEC); and
• Qualified Automatic Contribution Arrangement (QACA):
  • QACA Match (equal to 100% of amount contributed up to 1% of pay, plus 50% of amount contributed, up to the next 5% of pay) or
  • QACA 3% NEC.

3. Options for the Participant

Each HCE has several options to contribute to retirement accounts outside of the qualified plan.  These include:

• IRA Deductible Contributions:  In most cases, HCEs do not qualify to make deductible IRA contributions.
• Non-Deductible IRA Contributions:  Most HCEs qualify to make non-deductible IRA contributions.  The maximum contributions to IRA accounts for 2022 is $6,000 plus $1,000 for employees 50 and older. 
• IRA to Roth IRA Conversions:  Each HCE should carefully consider the strategy of making non-deductible IRA contributions followed by a Roth conversion.  This works extremely well with participants who do not have an existing IRA account.  The non-deductible contribution is made, and the account is immediately converted to a Roth IRA.  The result of this process is that the money ends up in a Roth IRA growing income tax free just as it would have if the HCE elected to defer to the Roth 401(k) account inside the qualified plan.  If the participant has existing IRA accounts with zero basis, this option does not work as well.  In this case, the conversion would create additional taxable income.  This may or may not be an issue based on the current tax bracket and the projected future tax brackets. 

• Some HCEs have outside businesses that generate taxable income.  In some cases, the HCE has the option of opening a SEP plan and deferring money to the SEP account.
• Annuity contracts often allow investors to contribute unlimited amounts.  These contributions are after tax and form the basis in the annuity contract.  All the accumulated growth and earnings in the contract grow tax deferred.  Caution should be taken to avoid buying an annuity that has high internal fees and pays high commissions to the salesperson.  Always inquire as to the commissions to be paid, total expenses of the plan, and withdrawal options and penalties. 

Plan administrators should carefully consider the plan design to determine if changes could be made to manage this process more effectively.  HCE should seek guidance from qualified advisors to examine the various options available to assist them in making the critical long-term decisions regarding their retirement planning. 

by: Anthony McCallister, AIF®, J.D.

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Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice.