Maximizing Retirement Savings for Highly Compensated Employees in 401(k) Plans

401(k) plans play a pivotal role in retirement planning for American workers, offering a valuable tactic to save for the future. However, for highly compensated employees (HCEs), navigating the path to retirement readiness within an employer 401(k) plan can be challenging due to regulatory constraints. In this article, Meghan Hannon, CRPS®, explores a problem-solving framework that can help plan sponsors and financial professionals address the specific needs and limitations faced by HCEs within 401(k) plans.

Assessing HCE Retirement Readiness

A crucial step in addressing the retirement needs of HCEs is to assess their readiness for retirement. One common metric used to assess retirement readiness is the projected income replacement ratio at retirement, typically set at 70 to 85 percent in plan-level analyses. By evaluating how well HCEs measure up to this benchmark based on their current 401(k) balances and contribution rates, sponsors can gain insights into their preparedness.

Exploring Contribution Limits

HCEs may find themselves constrained by the contribution limits set by the IRS. To address this, it’s essential to analyze how much each HCE participant and the plan sponsor are currently contributing on a tax-advantaged basis. This involves comparing employee pretax or Roth 401(k) deferrals to the yearly IRS employee contribution limit, which is $22,500 in 2023 (or $30,000 for those aged 50 or older). Additionally, sponsors should consider the maximum contribution limit for employer contributions, which is $66,000 (or $73,500 for those aged 50 or older) in 2023. Encouraging higher deferrals or increasing employer funding can be viable strategies to address shortfalls, depending on the plan’s nondiscrimination testing.

Considering Supplemental Plans

Another avenue to bolster HCEs’ retirement assets is to explore the addition of supplemental plans. Nonqualified deferred compensation plans (NQDC) or cash balance plans can be offered alongside the existing employer 401(k) plan, providing a means for HCEs to accumulate retirement assets without mandatory contributions from their side. While these options may be more complex to implement than traditional 401(k) contributions, they are worth considering, particularly if HCEs are limited by IRS caps or if competitors offer similar benefits. It’s important to note that NQDC plans come with specific eligibility rules.

Evaluating Nondiscrimination Testing

Nondiscrimination testing is an integral part of employer 401(k) plan compliance. It’s essential to assess the plan’s testing history, especially focusing on actual deferral percentage (ADP) and actual contribution percentage (ACP) testing results. If HCEs receive disproportionately high contributions compared to non-highly compensated employees (NHCEs), the excess amounts must be returned, impacting HCEs’ retirement savings and triggering income tax liability. Alternative testing strategies, such as a top-paid group election or cross-testing, can be explored to provide more flexibility for HCEs while maintaining compliance.

Reviewing Safe Harbor Plans

For plans with a safe harbor design, additional consideration is necessary. Safe harbor 401(k) plans allow HCEs to save up to the annual IRS contribution limit without risking nondiscrimination testing failure. However, evaluating how effectively this strategy benefits the target group is essential. While safe harbor plans offer advantages, they may not fully meet the retirement readiness goals of all HCEs, making it crucial to explore alternative testing methods and supplemental plans.

Helping You Get There…

Navigating the complexities of retirement planning for highly compensated employees within an employer 401(k) plan requires a multifaceted approach. By utilizing the framework outlined above, plan sponsors can enhance retirement planning opportunities for HCEs, ensuring they have the means to achieve their retirement income objectives within their elected plan.

Working with a trusted advisor and problem-solver in the realm of employer 401(k) plans can add significant value to your retirement programs and strengthen your employees’ retirement readiness. For plan sponsors deciding the right next steps, Boulay’s retirement plan advisors are committed to helping you get there. Connect with us today to learn more.