If you earned a lot of money in 2019 ($125,000 or more), you may have received an unpleasant surprise from your Human Resources Department or 401(k) Plan Administrator, telling you that your 401(k) plan failed testing and you will be receiving some of your contributions back.
Not-so great Bonus: those contributions being returned to you will be taxable income next year (unless they were Roth contributions to start with).
You may be wondering, “what does this even mean?”
Great question. We’ll give you a high level overview of what failed testing means for you and give you some ideas on how to handle it.
What Does “Failed Testing” Mean For My 401(k) Plan?
If your 401(k) is not a Safe Harbor Plan, then each year it must undergo a series of non-discrimination tests. The Actual Deferral Percentage Test (ADP), Actual Contribution Test (ACP), and Top Heavy testing. What all three of these tests are trying to figure out is whether or not the 401(k) plan is disproportionately benefiting the firm owners and highly compensated employees.
Highly Compensated Employee: an employee who earned more than $125,000 in 2019 or $130,000 in 2020.
The testing is a little complicated, but essentially a 401(k) plan can fail testing if non-highly compensated employees don’t contribute enough money to the plan as compared to the highly compensated employees.. Or, if it’s the Top Heavy test that your firm’s 401(k) plan is failing it means that 60% or more of the assets in the plan belong to highly compensated employees.
In either scenario, highly compensated employees and business owners get some of their contributions returned.
Your 401(k) plan could fix this by becoming a “Safe Harbor” 401(k) plan which would require an employer match or contribution and some additional plan modifications around vesting. Frankly, most plans already meet many of the other requirements of a Safe Harbor plan – it really comes down to the match or non-discretionary contribution.
Why is it bad if my 401(k) plan fails testing?
If you are saving in a pre-tax 401(k) you lose the tax savings benefit and you also may lose the corresponding tax deferral on the money saved in the 401(k). Also, the earnings on your pre-tax savings that get returned to you are taxed as income as well.
Or, if you were saving in a Roth 401(k), your Roth IRA contributions are capped at either $6,000 or $7,000/yr. Depending on whether or not you are under age 50. This is far lower than the $19,500 ($26,500 with catch-up contributions) you could have saved in a 401(k) in 2020.
Finally, sometimes when people receive that money back they aren’t sure what to do with it and it doesn’t get put back into retirement savings after it leaves your 401(k). Over time, this can drastically reduce your wealth as you enter retirement.
This hits high income earners where it hurts because generally they need to save more of their money on a percentage basis to maintain their lifestyle in retirement.
What Can I Do If My 401(k) Plan Failed A Non-Discrimination Test?
The first thing you need to consider is whether or not you are eligible to make an HSA (Healthcare Savings Account) contribution. An HSA, used properly, can make a tremendous retirement account for high income earners. Next, are you eligible to make a Roth IRA contribution (or if you are a good candidate to pursue a Backdoor Roth IRA strategy)? If you are, then any money that is returned to you could go into a Roth IRA. If neither of those strategies work for you then a taxable investment account is a simple alternative. The key here is to keep your money invested for retirement as tax-efficiently as possible.
If you’re working with a fiduciary financial planner (such as Spark Financial Advisors) they can advise you on the appropriate strategy. At Spark Financial Advisors we help clients create tax-efficient portfolios using a strategy known as “Asset Location.” With asset location we are trying to squeeze out every last penny out of your investment accounts by paying as little in taxes as possible.
While we start with asset allocation (how much you need in stocks, bonds, and cash to meet your goals), we don’t stop there. We also layer asset location on top. Yes, this is a little more complicated but it’s worth it and can save clients quite a bit of money in taxes over time. Asset location is focused on putting more tax-inefficient assets into your tax-sheltered accounts. Factors we consider include yield, turnover, and expected return.
If you need to fund a taxable investment account to help you meet your goals (as most high income earners will) then it’s time to talk to a fiduciary.
How Can I Keep This From Happening Again?
As an employee, your options are limited. Talk to HR and try to determine what would be a prudent contribution rate to minimize the odds that you have money returned to you next year. Depending on your role within the organization, you may be able to lobby your 401(k) plan to be amended and turned into a Safe Harbor 401(k) Plan.
Safe Harbor 401(k) plans are automatically deemed to pass these non-discrimination tests. To become a Safe Harbor plan the employer would need to either make a non-discretionary contribution of 3% of pay to all eligible employees or make a matching contribution. There are two broad types of matching contributions but that’s really beyond the scope of this article.
Business Owners Looking for Help
If you are the business owner then talk to your plan administrator or an experienced 401(k) advisor for help evaluating whether or not it makes sense to amend your existing 401(k) plan to a Safe Harbor 401(k) plan so you can save more money in the plan each year.
Spark Financial Advisors offers Fee-Only 401(k) plans and can serve as a 3.16 fiduciary on your 401(k) plan. We can help you evaluate your plan to make sure your costs are low and your retirement benefit is maximized through professional plan design.
Want to Make Sure You Make the Right Choice?
There’s no way around it, this is a bit of a hassle. Particularly since high income earners need to save more of their money to insure their retirement lifestyle in the first place. Losing out on the convenience of a 401(k) makes that harder. Working with a fiduciary financial planner can help you stay on track so you achieve financial freedom faster.
Questions for Lauren?
Financial planner and advisor, Lauren Zangardi Haynes, CIMA®, CFP®, works with business owners and leaders in Richmond and Williamsburg, VA. She also works virtually with clients nationwide. As a fiduciary, she offers comprehensive Fee-Only financial planning and investment advisory services so you can live your dreams with confidence.