Why You May Not Be Able to Max Out Your 401(k)

"Say what?"

That was my response when a friend recently told me that she had a portion of her 2012 401(k) contribution refunded back to her in March of this year.

How could that happen? Maxing out a 401(k) is an article of faith for many higher-income workers. Unlike traditional deductible and Roth 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 2013, people under age 50 are able to contribute $17,500, and those over age 50 can make a $23,000 contribution. That's a decent chunk of change that's eligible for the tax-deferred compounding that 401(k)s afford. Contributing to a Roth 401(k), if the option is available, helps high earners make an even higher effective contribution, because they're putting in aftertax dollars.

And then the Retirement Planning course in the certified financial planner curriculum came rushing back to me: So-called nondiscrimination testing may limit the 401(k) contributions of highly paid workers, especially if they hail from smaller companies with a lot of executives and not many rank-and-file employees. If a company's 401(k) plan fails the nondiscrimination tests, those workers who are classified as highly compensated employees, or HCEs, may not be able to make the maximum allowable contribution. For 2013, 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. (You can also be classified as an HCE if your spouse, parent, grandparent, or child is a 5% owner of the business that employs you, even if you yourself do not have an ownership stake.)

The goal of the nondiscrimination tests is a laudable one: to make sure that the HCEs aren't benefiting disproportionately from the tax breaks that come along with investing in the plan while the non-HCEs (NHCEs, in Internal Revenue Service lingo) are not taking advantage of them. The specifics of the tests, outlined on the IRS' site, are somewhat complex. But they basically compare the rates of salary deferral and contributions for the set of HCEs alongside those of rank-and-file employees. If the HCE participation rates are much higher than is the case for non-HCEs, the plan will fail the tests.

Assuming the 401(k) plan failed the nondiscrimination tests, the company would then need to take corrective action. One way to correct the problem is to return a portion of HCEs' contributions so that the plan would pass the nondiscrimination tests. Alternatively, the company could make a qualified nonelective contribution to the accounts of NHCEs, correcting the imbalance not by reducing HCE contributions but by boosting those of NHCEs. Not surprisingly, the former route is usually the most common, as it doesn't result in additional costs being borne by the employer.

That means that some HCEs, like my friend, may be confronted with a refund of a portion of their 401(k) contributions after a plan fails to satisfy nondiscrimination testing. The refund amount, assuming it went into a traditional 401(k), would be taxable in the year in which it was received, along with any investment earnings on that excess contribution amount. Excess Roth 401(k) contributions, because they were already taxed, would not be taxable when refunded, though any investment earnings on those excess contributions still would be.

Companies can circumvent such issues in the future by creating what's called a safe-harbor plan--essentially, contributing enough on behalf of employees to ensure that it doesn't have to go through nondiscrimination testing.

What You Can Do
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. If this is the case with your company's plan, you have a few options to explore, including the following.

Work to Enact Change--Job one is to make the higher-ups in your company know that you're not happy that your retirement contributions are being curtailed. Implementing a safe-harbor plan is the most straightforward way to fix the problem. There's also the possibility that your benefits administrator isn't properly categorizing HCEs and NHCEs, which in turn can affect your plan's ability to pass the nondiscrimination tests. You can also lobby for improved NHCE participation. Ask your benefits administrator to consider an auto-enrollment feature and to step up its educational efforts, while conducting your own grassroots work to encourage participation among other workers. (Of course, if people aren't contributing because your plan isn't very good, it's incumbent on everyone to complain to both the higher-ups and the benefits administrator.)

Maximize Other Options--If you've gotten a refund of a 401(k) contribution, the next step is to put that money to work elsewhere. Fully funding an IRA, if you're not doing so already, is the smartest place to start. If you're married, you'll also want to make sure your spouse is taking maximum advantage of his or her options by fully funding a 401(k) and IRA (including a spousal IRA for nonworking spouses). In addition, you can obtain a reasonable level of tax efficiency (albeit without the benefit of tax-deductible contributions) by investing in a taxable account; broad equity market exchange-traded funds and index funds, tax-managed funds, and municipal bonds are all tax-efficient mainstays. Aftertax 401(k) contributions are also sometimes advised in this instance, but it's hard to make the case for doing so rather than simply investing in a tax-efficient manner within a taxable account. (The ability to eventually convert 401(k) assets to Roth may be the sole good reason to make aftertax 401(k) contributions.)

Ask for a Heads-Up--If your plan has a history of failing nondiscrimination testing, ask your 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's better to stop contributing preemptively rather than risk an excess contribution and refund. After all, you might be paying an extra layer of fees to invest inside of the 401(k), and you may not have tax-efficient investment choices within your 401(k), either. You're likely to be better off investing in an IRA or in tax-efficient investments inside a taxable account than you are making excess contributions to a 401(k) that will eventually be returned.

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