Why did I have to take back some of my deferral money?

Each retirement plan must pass several IRS imposed tests for discrimination each year. The test that caused you to get money back may have been the Average Deferral Percentage (ADP) test.  This test limits highly compensated employees to a certain level of elective deferrals – as a percentage of compensation – that is not excessively above the level chosen by non-highly compensated employees.

A highly compensated employee for the 2013 plan year is a participant who earned $115,000 or more in the 2012 plan year, owns at least 5% of the company, or is directly related to someone who owns more than 5% of the company. A non-highly compensated employee is any employee who does not meet the criteria above. An employee could be highly compensated one year and non-highly compensated the next year. Certain stockholder employees can be highly compensated regardless of earnings.

In general, assuming the non-highly compensated group defers on average at least 2% of their compensation, the average deferral percentage of the highly compensated group can be no more than 2% more than the average deferral of the non-highly compensated group.

Example:

                               Salary     Deferral     Deferral Percent

Non-Highly

Employee A           $ 25,000      $ 1,000                4%

Employee B           $ 50,000      $ 1,000                2%

Average Deferral Percentage                               3%   (4%+2%)/2 employees

 

Highly Compensated

Employee C           $120,000     $ 4,800                4 %

Employee D           $ 120,000    $ 12,000              10%

Average Deferral Percentage                                7% (4%+10%)/2 employees

The highly compensated group can only do 2% more than the average deferral percent of the non-highly compensated group. In this example, the highly compensated group can only do 5% (Non-Highly average percent of 3% plus 2%), so employee D must take back enough money until the average deferral percent of the highly compensated group is 5%. Employee D would only be allowed to defer 6% of his pay ($7,200) so he must take back $4,800 ($12,000-$7,200). After he has taken this back, the Average Deferral Percent of the highly compensated group is 5%, and the 401(k) plan passes the test.

*** If the plan is a Safe Harbor Plan, there is no testing and the plan is deemed to pass this test. Therefore, in a safe harbor plan, the highly compensated employees are allowed to defer the maximum allowed by law. For more information on whether a safe harbor design is right for you, please contact us.