The Impact of Being a Highly Compensated Employee

Some of your employees may have recently received a letter in the mail notifying them that they are considered an HCE – highly compensated employee.

The good news is that being an HCE means a nice paycheck, since the employee would have made at least $110,000 in 2010. The bad news is that because of their HCE status, their ability to contribute to the company 401(k) may be limited.

For a highly-compensated employee, the total of their salary deferrals and employer contributions to a 401(k) plan can be no more than 125 percent of the average deferral percentage (ADP) of all eligible non-highly compensated employees in a calendar year. So if the majority of your workforce is not taking full advantage of the retirement plan, it could put a damper on the ability of your highly paid employees to save for retirement.

I have seen some companies having to limit their HCEs to as little as 7 percent salary deferral due to a low overall deferral rate, which may be much less than the typical $16,500 limit normally allowed by the IRS. Even worse, some employers notify HCEs at year-end, so their total deferral already contributed to the plan could end up being more than allowed under the ADP test, and then any excess contribution must be distributed back to the employee and ends up becoming taxable income for the year.

So how can this be avoided? For any HCE age 50 or over, the catch-up provision will enable them to defer an extra $5,500 regardless of the ADP.

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But what about everyone else? The best answer is to encourage ALL employees to take advantage of participating in the retirement plan, and not just at the minimum deferral to get the company match. I have seen some recent success from a few employers who have rolled out an auto escalation feature that automatically increases employee deferral rates until they hit a 10 percent savings rate. Employees have the ability to opt out, but most don’t. This has the effect of increasing the company’s ADP and raising the HCE limitation.

Another solution is to provide financial education that can combat the obstacles to saving for retirement such as cash flow issues and high debt loads. A retirement workshop may fall on deaf ears but a money management class that focuses on budgeting and debt control may be just the thing your employees need, especially if they DIDN’T get the HCE letter and make much less.

This was originally published on the Financial Finesse blog for Workplace Financial Planning and Education

Linda Robertson is an experienced financial planner with, the nation’s leading provider of unbiased financial education programs to corporations, credit unions and municipalities with over 400 clients across the country. Her focus is on retirement and tax planning, and her background includes positions with NationsBank, H & R Block, and Metropolitan Life. Contact her at .