Options for Highly Compensated Individuals with 401(k) Limitations
If you are lucky enough to be a highly compensated employee (HCE), you’ll quickly learn that there are restrictions on how much you can contribute to your 401(k) account. The IRS does this so there is a more even contribution across all pay ranges. It is part of what’s called an annual nondiscrimination testing of retirement plans.
While there aren’t direct ways HCEs can contribute more to their 401(k), there are things that can be done as workarounds. In this article, you’ll learn what they are, starting with the most straightforward to those that are more complex and require more effort.
Per the IRS definition, you are a highly compensated employee if you meet any of the following:
Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
For the preceding year, received compensation from the business of more than $115,000 (if the preceding year is 2014; $120,000 if the preceding year is 2015, 2016, 2017 or 2018), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
If you make over $120K, you’re an HCE. It doesn’t seem like much compared to all the CEOs making millions per year. But like most things in the IRS, it hasn’t caught up to modern times, which means many average people get penalized.
Compensation is defined as including bonuses, overtime, commissions, and salary deferrals for 401(k) or cafeteria plan benefits.
For 2018, contributions into 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan increased from $18,000 to $18,500. In simple terms, HCEs max out at $18,500.
Roth IRAs are a great option for retirement. The main difference from a 401(k) is that money going into them is after-tax money. When you begin taking distributions, there are no taxes due since you already paid them. Gains are tax-free as well if they are qualified.
HCEs will have already hit phaseout levels for Roths at $120K. They become ineligible at $135,000. That means there’s only a small window of opportunity available. For married couples, phaseout starts at $189,000 and they are ineligible at $199,000.
Since many HCEs are likely to be ineligible for Roths, most will end up with taxable accounts as a workaround. This simply means depositing funds into a brokerage or mutual fund account as after-tax dollars that would have otherwise gone into a 401(k).
Money in the account can be withdrawn tax-free since it is simply a brokerage account. Taxes will apply to any gains but this is where things get interesting. Let’s say after 15 years; you have a gain of $50,000. Because it is a long-term gain, you only pay long-term capital gains taxes. That’s 15% if you are filing single making $38,600 to $425,800 or married filing jointly and earning $77,200 to $479,000. A 20% rate will apply if you are filing single and earning $77,200 to $479,000 or married filing jointly and earning over $479,000.
Since we are discussing HCEs, there is also a surcharge of 3.8% applied to higher-income earners. This is called the net investment income tax and applies to single filers earning $200,000+ or married and filing jointly earning $250,000.
HSAs are another strategy used by HCEs. They simply max out these accounts. HSAs are often used with high-deductible health plans. If you are the only one contributing to the plan, the limit is $3,450. If you are a family, the limit is $6,900.
One of the best parts of using an HSA is that there’s no income limitation on contributions. Using funds for medical expenses are also tax-free.
This option can get complex and depends on a number of factors specific to your situation. It’s best to speak with your accountant if you’re planning to use it.
A backdoor Roth starts life as a traditional IRA. After-tax money is deposited into the traditional IRA. Then the traditional IRA is converted into a Roth. This assumes you do not already have an IRA. The conversion will often not cost much in the way of taxes if there are any at all.
If you do have an IRA, converting a traditional IRA into a Roth can trigger tax consequences. You can learn more about the pros and cons of this strategy here.
For HCEs, it can feel as though you are leaving money on the proverbial retirement table. Knowing that you might not get the best deal on taxes, there are still viable options available to you. In this article, you’ve learned about a few that are certainly worth exploring.