Congratulations! You’ve moved up the corporate ladder, steadily increasing your income. The bad news, you’ve been designated a highly compensated employee. Although it’s good for your bottom line, a highly compensated employee is subject to reduced 401(k) contribution limits. There are ways to overcome the highly compensated employee label. Unfortunately, none are as beneficial as just contributing to the 401(k).
Who is a highly compensated employee?
A highly compensated employee (HCE), as defined by the IRS, is an individual who:
- Officers making over $215,000 for 2023 (up from $200,000 for 2022)
- Owners holding more than 5% of the stock or capital
- Owners earning over $150,000, not adjusted for inflation (up from $135,000 for 2022) and holding more than 1% stock or capital
- Your employer can designate you an HCE if you rank among the top 20% of employees in compensation.
Let’s put a little more detail into the IRS’s definition. The 5% interest rule doesn’t just count what *you* own. It also includes the ownership of your spouse, children, and grandchildren working for the same company. If you own 2% of the company, your wife owns 2%, your son owns 1%, and your granddaughter owns 2%, you’re a highly compensated employee because the total ownership equals 7%.
Regarding the top 20% rule, once made, the election applies until your employer revokes it. Compensation includes overtime, bonuses, commissions, and salary deferrals toward cafeteria plans and 401(k)s. I’m sure you thought the HCE threshold was slightly higher than $150,000. The reality is most HCEs have incomes much higher than $150,000. My unscientific analysis indicates most HCEs have income over $250,000.
What’s the point of the HCE?
Each year, the IRS requires employers to ensure pre-tax benefit plans don’t favor highly compensated employees through non-discrimination testing. For example, someone earning $300,000 can contribute more than someone earning $30,000.
Although somewhat more complicated, for this purpose, we can generally say the average contribution rate of all HCEs cannot be more than 2% above the average contribution rate of non-highly compensated employees.
For example, if the average contribution of non-HCEs is 3% of their compensation, the average contribution of the HCEs cannot exceed 5% of their compensation.
401(k) & the HCE
The 401(k) contribution limit is $22,500 (2023). Those 50 and older are allowed a catch-up contribution of $7,500. There is usually some form of employer match as well. All in all, it’s a pretty sweet savings vehicle unless your employer has designated you an HCE. Then things get complicated.
For example, if your compensation is $250,000, and you plan to max out your 401(k) contribution of $22,500, but you’re a designated HCE and limited to 5%, that would limit your contribution to $12,500.
How to minimize the HCE pain
There are alternatives for the HCE regarding saving and reducing taxable income.
1. Catch-up contribution
One significant exception to the HCE 401(k) restriction is that if you’re 50 or older, the catch-up provision allowing you to contribute an extra $7,500 per year IS NOT LIMITED BY BEING AN HCE.
2. Contribute to a Health Savings Account (HSA)
An HSA is a medical expense account only available to those enrolled in a high-deductible health plan (HDHP). Individuals can contribute up to $3,850 (2023), and families, $7,750, plus an additional $1,000 a year if you’re 55 or older.
An HSA is like the holy grail of savings. Tax-free contributions, tax-free growth, and tax-free distributions when used for health care expenses. Can you tell I love HSAs? Learn more about why I like them in our post 7 Ways an HSA Can Help You Now and In Retirement.
3. Make Non-Deductible Traditional IRA Contributions
If an employer retirement plan covers you and your income is above certain limits, you cannot deduct your contributions to a traditional IRA. The deduction phases out in 2023, when your modified adjusted gross income is between $73,000 and $83,000 (single) or $116,000 and $136,000 (married filing jointly). When your income exceeds those figures, the ability to deduct contributions is wholly eliminated.
That doesn’t prevent you from opening a traditional IRA and making contributions, but they are considered after-tax contributions. All earnings/growth are still tax-free. The contribution maximum for an IRA is $6,500 (2023), and if you’re 50 or older, you can make a $1,000 catch-up contribution.
4. The Backdoor Roth IRA strategy
Highly compensated employees may be interested in employing the backdoor IRA strategy – converting a non-deductible IRA (mentioned above) into a Roth IRA.
Here’s how it works. After you open your traditional IRA and make nondeductible contributions, open a Roth and then convert the traditional IRA to a Roth IRA. The best part is that since the non-deductible IRA funds are after-tax, you don’t have to pay tax on the conversion.
However, to fully realize the benefit of a backdoor Roth IRA, you can’t have other traditional, SEP, or SIMPLE IRAs. Otherwise, those other accounts dilute the tax advantage, and the conversion will not be completely tax-free.
This strategy can be an annual occurrence but is a complicated process. To learn more, check out our blog, How to Grow more Tax-Free Retirement Assets with a Backdoor Roth IRA.
5. Deferred Compensation
Many companies offer a deferred compensation plan. The plan allows you to defer a set percentage or amount of your salary and taxes on that salary until a later date, typically after you retire or quit. You can opt in during the open enrollment period, and there are no limits to the amount you can defer.
Although there is no matching, investment options are similar to a 401(k). That means there is a potential for gain and a risk of loss.
There are other caveats. First, this deferred comp account is an asset of the company. If they go bankrupt, you will get nothing, unlike a 401(k), which is yours to keep. Secondly, you need to review the plan rules to determine the payout schedule once you leave or retire, which is usually paid out over 5, 7, or 10 years, or something similar and is considered taxable income at that time.
A deferred comp plan is a powerful tool for long-term financial planning. Check out our post 7 Questions to Consider before participating in a Deferred Compensation Plan to learn more.
6. Open a Taxable Account
A taxable account may be an option. Unlike retirement accounts, there are no contribution limits, but also no tax deferral on earnings or tax avoidance on capital gains. On the flip side, distributions are not considered taxable income.
I think a taxable account gets shortchanged when discussing savings and retirement. It’s another bucket of potential income in retirement, and that’s not a bad thing. Don’t discount it.
7. Deferred variable annuity
Although I’m not a big fan of annuities, they have their place in retirement planning. One of those places is for an HCE. An excellent low-cost deferred variable annuity can in many respects, be similar to a non-deductible IRA but without the contribution limits.
Distributions will be taxable and tax-free (return of principal) monies. It can be another valuable retirement income bucket like the taxable account above.
8. Spouse max out benefits
Your spouse can max out their contributions to a 401(k) as long as they aren’t also designated an HCE. Although this is the easiest solution, it may not be enough.
Highly compensated employee blues
You’re labeled a highly compensated employee when you can afford to sock away more. You can’t win. It’s a good problem to have, and you can get creative to work around these restrictions and find ways to maximize your savings potential.
If you need assistance navigating the possibilities and determining the best course of action, feel free to contact us.