Maxing Out a 401(k) … or Not?

Maxing out a 401(k) is an article of faith for many higher-income workers. Unlike IRAs, where income limits may curb contributions, employees can generally contribute the maximum allowable amount to their 401(k)s regardless of how much they earn. In 2014, people under age 50 are able to contribute $17,500, and those over age 50 can make a $23,000 contribution. That's a significant amount that is eligible for the tax-deferred compounding that 401(k)s afford.

However, an IRS regulation referred to as nondiscrimination testing may limit the 401(k) contributions of highly paid workers, especially for smaller companies with a lot of executives and a small number of lower-level employees. Nondiscrimination testing is an IRS rule intended to ensure that highly compensated employees, or HCEs, aren't benefiting disproportionately from the tax breaks that come along with investing in 401(k) plans, while non-HCEs are not taking advantage of them. For 2014, an HCE is defined as someone who had compensation of more than $115,000 during the year or who owns 5% or more of the company. The tests are performed by the plan sponsors by counting contributions by both HCEs and non-HCEs and performing a few mathematical calculations. If, based on these numbers, a company's 401(k) plan fails the nondiscrimination tests, employees who are classified as HCEs may not be able to make the maximum allowable contribution.

When a 401(k) plan fails the nondiscrimination tests, the company needs to take corrective action. In most cases, the company chooses to return a portion of HCEs' contributions. The refund amount would be taxable in the year in which it was received, along with any investment earnings on that excess contribution amount. Unfortunately, some plans fail nondiscrimination testing year after year, meaning that some employees can't take full advantage of all of their tax-sheltered options. For employees in this situation, there are a few options to explore, including the following.

Work to Enact Change: It is important to make the higher-ups in the company aware that employees are not happy when their retirement contributions are being curtailed. The possibility exists that the benefits administrator isn't properly categorizing HCEs and non-HCEs, which in turn can affect the plan's ability to pass the nondiscrimination tests. Employees can also lobby for improved non-HCE participation. The benefits administrator can be asked to consider an auto-enrollment feature and to step up educational efforts in order to encourage participation.

Maximize Other Options: For participants who have gotten a refund of a 401(k) contribution due to the failure of a nondiscrimination test, the next step may be to put that money to work elsewhere. Funding an IRA is a place to start. Married employees may also want to make sure their spouse is taking maximum advantage of his or her options by fully funding a 401(k) and/or IRA. In addition, a reasonable level of tax efficiency may be obtained (albeit without the benefit of tax-deductible contributions) by investing in a taxable account.

Ask for a Heads-Up: If a company’s plan has a history of failing nondiscrimination testing, employees may want to ask the benefits administrator for midyear guidance on whether the plan is likely to pass or fail for that particular year. If it appears that the plan won't pass, it may be better to stop contributing preemptively rather than risk an excess contribution and refund. After all, participants might be paying an extra layer of fees to invest inside of the 401(k) and might not have tax-efficient investment choices within that 401(k).

401(k) and IRA plans are long-term retirement-savings vehicles. Withdrawal of pretax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Please consult with a financial or tax professional for advice specific to your situation.