If you're a 'highly compensated employee,' pay attention during open enrollment

  • If you're set to earn more than $120,000 from a company in 2018, you fit the IRS definition of a "highly compensated employee."
  • So-called HCEs may be subject to caps on their retirement contributions or may have excess contributions refunded to them.
  • Experts say open enrollment is a key time for highly paid employees to plan around such limits.
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There's a magic number that can complicate your open enrollment process: $120,000.

If you earned that much or more in 2018 from a business, the IRS considers you a "highly compensated employee," or HCE, of that company. (In 2019, the threshold will rise to $125,000.) That HCE designation also automatically applies if you owned more than 5 percent of the business at any time in that preceding year.

Further, employers can elect to consider you a highly compensated employee if your pay puts you among the top 20 percent of employees.

Becoming an HCE, however, can require extra planning at open enrollment.

Highly compensated workers are often subject to reduced contribution limits or access to certain pre-tax benefits — notably, 401(k) plans and dependent care flexible spending accounts. They may also have an opportunity during open enrollment to sign up for something called a deferred compensation arrangement, whereby the company holds a portion of their salary to be paid out at a later date.

"Don't just assume your open enrollment choices are the same as last year," said certified financial planner Carolyn McClanahan, director of financial planning for Life Planning Partners in Jacksonville, Florida.

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Restrictions on highly compensated workers stem from so-called non-discrimination tests, which the IRS requires retirement plans and certain benefit offerings to pass every year to maintain their tax advantages. Broadly speaking, the tests compare how HCEs and non-HCEs are making use of those programs, to ensure the highly paid workers aren't disproportionately benefiting, said Nicole Wruck, national health leader at benefits administrator Alight.

"The burden is on the plan sponsor to make sure they pass those IRS tests," she said.

Roughly 15 percent to 20 percent of companies curb highly compensated employees' 401(k) contributions in some way to keep their plans from failing those nondiscrimination tests, said Rob Austin, head of research for Alight.

"What is kind of an interesting angle is, these people who are newly highly compensated," he said. "Crossing over the threshold, it can be jarring to see the percentage of pay you can contribute drop."

How companies handle that cutoff varies. Some plans cap highly paid workers' contributions either upfront or at some point during the year, Austin said. About 12 percent return excess pre-tax contributions to workers as taxable pay after the plan year ends, according to the Plan Sponsor Council of America's annual survey of profit sharing and 401(k) plans.

401(k) average deferral percentage (ADP) non-discrimination test results*

ADP test results
1-49 participants
50-199 participants
200-999 participants
1,000-4,999 participants
5,000+ participants
All plans
Passed because of safe harbor plan design 59.1% 43.7% 34.4% 33.0% 38.6% 42.3%
Non-safe habor, passed without adjustment to elections of highly paid participants or return of excess contributions 26.0% 35.6% 40.8% 39.2% 36.6% 35.4%
Elections of highly paid participants limited when contributions reached the maximum allowed by test 4.7% 5.7% 9.6% 7.2% 6.9% 6.9%
Elections of highly paid participants limited by plan design 3.1% 6.9% 12.0% 13.4% 13.9% 9.7%
Excess contributions returned to participants after plan year ended 7.1% 14.9% 13.6% 16.5% 8.9% 11.9%
Excess 401(k) amounts deposited into a nonqualified arrangement 0.8% 0.0% 2.4% 2.1% 4.0% 1.9%
Other 2.4% 1.1% 0.8% 2.1% 4.0% 2.0%
SOURCE: Plan Sponsor Council of America, for plan year 2016. *Some plans use more than one approach to pass the ADP test.

HCEs are even more likely to see reduced contribution limits on benefits where enrollment is low, such as dependent care flexible spending accounts. (Health flexible spending accounts aren't subject to testing.)

Only 3 percent to 5 percent of eligible employees use dependent care FSAs, which let workers set aside pre-tax dollars to use for qualified care, Wruck said. The IRS allows families to contribute up to $5,000 per year; depending on how much lesser-paid employees are socking away, HCEs could be allowed just a fraction of that max.

"Because there's such a small enrollment there, a few people can make a difference between [the plan] failing or passing," she said.

Unless you're told outright your limits have been reduced as an HCE, make benefit elections as you normally would, said Jody Dietel, chief compliance officer for benefits administrator WageWorks. Curtailed limits for highly paid workers aren't a given, and the worst-case scenario is that you'll later have extra taxable wages in your paycheck from a contribution cap or returned excess contributions.

"Commit to, whatever they can't put in your 401(k), you'll put somewhere else." -Carolyn McClanahan, CFP and director of financial planning for Life Planning Partners in Jacksonville, Flordia

"Until the testing is done, you don't know what you'll be reduced to," she said.

Families could do some preemptive planning around dependent care FSAs, by splitting contributions if both spouses have access to such accounts.

On the retirement front, check to see if your company offers a deferred compensation arrangement, McClanahan said. Those plans provide a workaround to caps on pre-tax retirement contributions by letting eligible employers defer a portion of their salary (and the taxes on that money) until a later date. There's typically an opportunity to opt in open enrollment.

But it's not an agreement to enter into lightly. You'll need to dig into plan rules on when and how you can eventually receive the money, and make elections accordingly, she said. And there's some risk in participating.

"It's technically always an asset of the company you're working for," she said. "If the company ever goes bankrupt, that money goes away."

If your company does cap retirement contributions or return the excess, look for opportunities to use that extra money in your paycheck to stay on track with retirement savings goals, McClanahan said. That might fund your individual retirement account for the year, for example, help boost your health savings account balance or round out your taxable retirement bucket in a brokerage account.

"Commit to, whatever they can't put in your 401(k), you'll put somewhere else," she said.