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HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Mon Jan 16, 2017 4:06 pm
by icedtea
I'm now considered a Highly Compensated Employee HCE by the IRS and my employer's 401k only has a small number of participants, most of which are also HCEs. So, I expect for the 2016 FY we are going to get letters mid-2017 stating that we over-contributed to our 401ks, in comparison to the non-HCEs in the company. I max'd my 401k in 2016.

What can I expect and what should I plan to do with the excess? Does the money in the 401k get taken out with earnings or losses or just the raw excess contribution amount? Do I then receive a check that's taxable? And should I plan to put that money in my taxable investment account? I don't know where else I could put it as a tax haven. I don't run a side business.

By the way, if the only participants in a 401k plan are all HCEs, would that mean all the money contributed to the plan would be deemed excess contributions? Looks like now the only participants in my company are HCEs and unless we hire some non-HCEs who participate, it'll remain just HCE participants this year.

Iced Tea

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Mon Jan 16, 2017 5:48 pm
by Spirit Rider
It will be must sooner than mid-year. IRS regulations require the 401k plan to refund excess contributions due to testing failure by March 15th.

You will receive a check for the excess contribution and earnings. The contribution will be taxable unless it was a Roth deferral. The earnings are always taxable.

If there are only HCEs, you have nothing to worry about. They are anti-discrimination rules. If no NHCEs, no testing is required and no possible return of contributions.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Mon Jan 16, 2017 5:52 pm
by icedtea
Spirit Rider wrote:It will be must sooner than mid-year. IRS regulations require the 401k plan to refund excess contributions due to testing failure by March 15th.

You will receive a check for the excess contribution and earnings. The contribution will be taxable unless it was a Roth deferral. The earnings are always taxable.

If there are only HCEs, you have nothing to worry about. They are anti-discrimination rules. If no NHCEs, no testing is required and no possible return of contributions.
Thanks, so is the excess contribution and earnings deducted from the 401k balance on a given day, sometime by March 15th?

Interesting that if all the participants are HCEs, there's nothing to worry about. I assumed the opposite.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Mon Jan 16, 2017 6:55 pm
by Spirit Rider
icedtea wrote:Thanks, so is the excess contribution and earnings deducted from the 401k balance on a given day, sometime by March 15th?

Interesting that if all the participants are HCEs, there's nothing to worry about. I assumed the opposite.
Yes, it will be some day before March 15th, if it occurs.

The purpose of the anti-discrimination rules are just that. To prevent those with higher incomes (especially the owners) from contributing at a higher rate than those with lower incomes. If there is no one with lower incomes, there is no one who can be discriminated against.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Mon Jan 16, 2017 7:29 pm
by icedtea
Spirit Rider wrote: Yes, it will be some day before March 15th, if it occurs.

The purpose of the anti-discrimination rules are just that. To prevent those with higher incomes (especially the owners) from contributing at a higher rate than those with lower incomes. If there is no one with lower incomes, there is no one who can be discriminated against.
Is there a minimum investment that NonHCEs need to make in order to require the tests?

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Mon Jan 16, 2017 9:08 pm
by Spirit Rider
icedtea wrote:
Spirit Rider wrote: Yes, it will be some day before March 15th, if it occurs.

The purpose of the anti-discrimination rules are just that. To prevent those with higher incomes (especially the owners) from contributing at a higher rate than those with lower incomes. If there is no one with lower incomes, there is no one who can be discriminated against.
Is there a minimum investment that NonHCEs need to make in order to require the tests?
I do not know the specifics of how the testing is actually performed and what the specific rules are. There is a member of the forum (ERISAStone) that might know the answer to that question.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Mon Jan 16, 2017 10:30 pm
by ERISA Stone
FYI - the employer could give the NHCEs a Qualified Nonelective Contribution (QNEC) to bring the plan into compliance, but that rarely happens. The amount depends on how badly the nondiscrimination test fails. The plan would have to allow for it, but there's no reason not to have the option. You mentioned there are a small number of participants. Perhaps you have the owner's ear?

Also, refunds can be made after 3/15, but then the employer would be on the hook for an additional excise tax for not processing the refunds timely. I've had clients in the past that do this strategically, although I never quite understood the logic.

ETA: on the testing, long story short, the average of the aggregate HCE average deferral rate must generally be within 2% of the aggregate NHCE average. So if the NHCE average deferral rate were 5%, the limit for the average HCE rate would be 7%. There are a lot of rules that determine which participants are included in the test, but that's a summary.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Thu Jan 19, 2017 10:18 am
by icedtea
ERISA Stone wrote:FYI - the employer could give the NHCEs a Qualified Nonelective Contribution (QNEC) to bring the plan into compliance, but that rarely happens. The amount depends on how badly the nondiscrimination test fails. The plan would have to allow for it, but there's no reason not to have the option. You mentioned there are a small number of participants. Perhaps you have the owner's ear?

Also, refunds can be made after 3/15, but then the employer would be on the hook for an additional excise tax for not processing the refunds timely. I've had clients in the past that do this strategically, although I never quite understood the logic.

ETA: on the testing, long story short, the average of the aggregate HCE average deferral rate must generally be within 2% of the aggregate NHCE average. So if the NHCE average deferral rate were 5%, the limit for the average HCE rate would be 7%. There are a lot of rules that determine which participants are included in the test, but that's a summary.
Thanks ERISA Stone. I have the owner's ear but the owner doesn't care to listen. This info is in line with what I've read elsewhere. I don't know what percentages our participants have contributed but I imagine HCE's will exceed the 2% easily. Do you know any reference information online that can shed light on what happens if say HCEs are 5% over vs 3%? And how the employer allocates the refunds across the HCEs? Maybe it's too complex and not worth the energy...

Iced Tea

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Thu Jan 19, 2017 10:49 am
by Bwise1
In 2015 our 401k failed the discrimination test. We only had 2 Employees out of 50 contribute to the plan and both were HCE. The money was refunded early 2016 with an additional $200 penalty.

For 2016 we put a 4% company match which put the 401k back into good standing. Still only 2 people contributing...

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Fri Jan 27, 2017 12:02 pm
by icedtea
The OP here. Another group of questions and I could use help with.

How is HCE and compliance handled if you are with a company for only say 2 months of a calendar year, and in that period you contribute say $10k into the 401k. Does the HCE calculation to determine any penalties based your contribution against the income you receive from that employer in those 2 months or based on the expected income if you had stayed with the employer for the full calendar year?

And if it's just based on those 2 months, and you're talking $10k contributed and say gross pay of $25k in those 2 months, are you still considered an HCE?

Thanks,
Iced Tea

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Fri Jan 27, 2017 1:48 pm
by ERISA Stone
icedtea wrote:The OP here. Another group of questions and I could use help with.

How is HCE and compliance handled if you are with a company for only say 2 months of a calendar year, and in that period you contribute say $10k into the 401k. Does the HCE calculation to determine any penalties based your contribution against the income you receive from that employer in those 2 months or based on the expected income if you had stayed with the employer for the full calendar year?

And if it's just based on those 2 months, and you're talking $10k contributed and say gross pay of $25k in those 2 months, are you still considered an HCE?

Thanks,
Iced Tea
If you are an HCE and you contribute $10k on $25k compensation, your deferral rate is 40%. So the test would most certainly fail based on that. However, the actual refund amounts go first to the HCEs with the highest dollar deferral amounts. Suppose there are two HCEs - you and another person who contributes $18k. The first $8k refunded (adjusted for earnings) will go to the other HCE. Your refund won't start until the dollar amount is reduced to your level.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Fri Jan 27, 2017 3:04 pm
by Spirit Rider
icedtea wrote:How is HCE and compliance handled if you are with a company for only say 2 months of a calendar year, and in that period you contribute say $10k into the 401k. Does the HCE calculation to determine any penalties based your contribution against the income you receive from that employer in those 2 months or based on the expected income if you had stayed with the employer for the full calendar year?
ERISA Stone's response was about the specific's, if you are determined to be an HCE. This can happen at lower compensation if the owner or through attribution (family member) of the owner.

The compensation determination is based on the actual (not prorated) amount of compensation received as an employee of that plan. Compensation received before, during, or after employment from a different employer is not counted.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Fri Jan 27, 2017 3:18 pm
by icedtea
ERISA Stone wrote:
icedtea wrote:The OP here. Another group of questions and I could use help with.

How is HCE and compliance handled if you are with a company for only say 2 months of a calendar year, and in that period you contribute say $10k into the 401k. Does the HCE calculation to determine any penalties based your contribution against the income you receive from that employer in those 2 months or based on the expected income if you had stayed with the employer for the full calendar year?

And if it's just based on those 2 months, and you're talking $10k contributed and say gross pay of $25k in those 2 months, are you still considered an HCE?

Thanks,
Iced Tea
If you are an HCE and you contribute $10k on $25k compensation, your deferral rate is 40%. So the test would most certainly fail based on that. However, the actual refund amounts go first to the HCEs with the highest dollar deferral amounts. Suppose there are two HCEs - you and another person who contributes $18k. The first $8k refunded (adjusted for earnings) will go to the other HCE. Your refund won't start until the dollar amount is reduced to your level.
Thanks, so in my case I planned to contribute $8k for the January paycheck. I'm going to be leaving my firm at the end of March, so compensation from them for the year, including a recent bonus, before taxes will be about $37k. That's 21.6% contribution rate. Right now no non-HCEs contribute to the 401k and a few HCEs do. Maybe some non-HCEs will contribute later, but it's unclear. So, it sounds like that $8k is likely to come back in a refund, maybe completely. Right?

If that's the case, then am I better off trying to change my contribution to something much smaller (or nothing at all), since there is a chance that my new employer could end up offering a 401k (with or without a match)?

It might be too late to change contributions but I'll try.

Iced Tea

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Fri Jan 27, 2017 3:22 pm
by ERISA Stone
If no NHCEs contribute and they aren't excluded in the test, then all of the deferrals HCEs contribute would be refunded.

ETA: it is possible that an HCE could reclassify part of his/her refund amount as a catch-up contribution if he/she met the requirements for catch-up.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Fri Jan 27, 2017 3:28 pm
by nisiprius
I was once an HCE in your situation.

I innocently overcontributed in year X.

Either in year X or early in year X + 1 I got a letter about it from Human Resources.

Early in year X + 1 I simply got a check in the mail from the plan administrator, for the amount of my excess contributions. I think this was maybe in February or March.

Early in year X + 2 I got a 1099-R corresponding to that check. Unfortunately that form is used for about a dozen different situations, so the instructions for it are quite a thick booklet, but I found the part dealing with excess contributions to a 401(k) and followed the directions.

The check I received in year X + 1 was taxable income for year X + 1 and I paid taxes on it in year X + 2. Not a big deal and not a lot of money--apart from the nuisance, in part due to it taking two years to get everything completely squared away.

Before year X, the company had matched half (!) the contributions up to the first 1% (!) of income. Stingy, but apparently enough to motivate enough participation. Year X was the year they eliminated the match.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Fri Jan 27, 2017 4:05 pm
by icedtea
ERISA Stone wrote:If no NHCEs contribute and they aren't excluded in the test, then all of the deferrals HCEs contribute would be refunded.

ETA: it is possible that an HCE could reclassify part of his/her refund amount as a catch-up contribution if he/she met the requirements for catch-up.

I just read somewhere that "Eligible employees who don’t participate in the plan are included with a zero deferral percentage." for the testing. So that would mean all the nonHCE nonparticipants are going to lower the nonHCE averages even further, and more likely we'll fail the tests (for 2016 and 2017). Sounds like reason to not contribute to the 401k this year at all, right? I mean, since I'm leaving in the first few months, contributing $8k now means contributing a huge percentage, and it's pretty much a lock that it'll all get refunded anyway.

I called the payroll provider and payroll has already been set for the month, so my only shot is getting my employer to not send my contribution to the 401k company, Ubiquity, and then have my employer issue another paycheck for me for the $8k to be processed and taxed.

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Thu Mar 14, 2019 1:05 am
by zeugmite
What about the 10% early withdrawal penalty? Does it apply to these forced distributions?

Re: HCE: What to expect when having to pay tax on excess 401k contributions

Posted: Thu Mar 14, 2019 8:59 am
by icefr
zeugmite wrote:
Thu Mar 14, 2019 1:05 am
What about the 10% early withdrawal penalty? Does it apply to these forced distributions?
No, it is treated as wages on the 1040, since it is a return of contribution, which would have been wages had you not contributed to the 401(k).