How Having a High Salary Can Affect Your Retirement Savings
Everyone wants a well-paying job, but you might be surprised to learn that being a "highly compensated employee," or HCE, has some significant drawbacks. When you reach the middle management stage of your career or have access to employee stock options, you're more likely to notice the disadvantages.Just because you make a lot of money doesn't guarantee you'll get the HCE label. The Internal Revenue Service uses this term to describe a tax situation (IRS). Here's what you need to know if you're classified as an HCE.
Important Points to Remember
Highly compensated employees (HCEs) are employees whose immediate family owns more than 5% of the company at any point during the current or previous year.
If you were given more than $130,000 in 2021 ($135,000 in 2022) and your income puts you in the top 20% of the company's earners, you qualify as an HCE.
Contributions to HCE 401(k)s are limited to 2% more than non-HCE contributions.
HCEs can compensate for 401(k) contributions by increasing their IRA contributions.
What Does Being a High-Paid Employee Entail?
You might think of an HCE as a generic term for executives or people who can only be seen by appointment, but an HCE isn't just a high-paid executive with a fancy title.Who is considered an HCE, according to the IRS, is defined very clearly. To get that label, you don't have to make a ridiculous amount of money. It is possible to be considered highly compensated in two ways.
Ownership
If you acquired more than 5% of a company's stock at any point this year or the previous year, you are a highly compensated employee. Take note of the part of the rule that says "more than." This means that the IRS does not consider you to be highly compensated if you own exactly 5% of a company based on your voting power. Stock ownership of 5.01 percent or more, on the other hand, counts.The 5% limit also applies to equity held by relatives, such as your spouse, parents, children, or grandchildren. Grandparents and siblings are not included in this calculation.You are considered highly compensated if you own 3 percent and your spouse owns 2.01 percent (3 + 2.01 = 5.01). It makes no difference how much money you made in that case. If the company is new, the owners may not be paid a salary or may be paid very little.
Salary and Position
If two things are true, you'll also be well compensated:
In 2021, a single company will pay you more than $130,000. In 2022, this will rise to $135,000 per year.
When individuals at that company are ranked according to how much money they make, you are in the top 20%.
You don't have to meet the ownership and salary requirements to get the HCE label. You're considered highly compensated if you own more than 5% of the company but only make $30,000 per year.
You can only be counted as an HCE if the company employs you. You can't be an HCE if you own 5.01 percent or more but aren't an employee.
What Impact Do HCE Rules Have on You?
The rules for highly compensated employees were put in place to protect those who did not belong to this small group. When retirement plans were first introduced, they allowed anyone to contribute a certain percentage of their earnings, regardless of income.As a result, those with a lot of money got huge tax breaks that workers with less money didn't get. This was interpreted as discrimination.The highly compensated employee rules were developed by the IRS to make retirement savings and tax breaks more equitable for all workers.
What Impact Will These Regulations Have on Your 401(k)?
When it comes to putting money into a 401(k), being a highly compensated employee can be problematic (k). Every year, a company must pass a series of tests to ensure that it's 401(k) plan remains nondiscriminatory. One of these tests involves looking at the company's employees' average contribution rate. If the average contribution is 4%, most HCEs can only contribute 6%. This is because the contributions of highly compensated employees cannot exceed those of non-HCEs by more than 2%.If the average worker contributes $7,000 to their 401(k), someone earning $150,000 per year can only contribute $9,000. It is significantly less than the IRS's allowance of $19,500 in 2021 (which will rise to $20,500 in 2022). Because lower-paid employees contribute so little, some HCEs report being able to contribute only 2% to their 401(k).In most parts of the United States, most workers would love to earn a six-figure salary. Others, particularly those who live in cities like San Francisco or New York City, may argue that $150,000 is only enough to live comfortably in the middle class.A $300,000 upper manager could almost double their contributions at 6%, but a lower six-figure earner could not. As a result, some argue that HCE rules harm middle managers trying to save as much money for retirement as possible.
What are the Alternatives to the HCE Rule?
Your employer has a few different options for structuring retirement packages. Otherwise, having other retirement accounts in which to invest is the best option. The simplest option is to open an IRA and contribute to it fully. In 2022, you can save up to $6,000 per year ($7,000 if you're 50 or older). If you're over 50, you could also contribute to a taxable investment account or make catch-up contributions.You can contribute to your 401(k) even if you are an HCE (k). You'll lose the tax benefit that a non-Roth 401(k) provides (k). Some companies take a different approach and offer a higher employer match. If they don't already have one, they might start one if enough employees are affected by the HCE rules.Note: Without an employer match, the incentive to contribute to a 401(k) plan may be insufficient for cash-strapped employees struggling to make ends meet.If the HCE rules apply to you, talk to your boss about how to make retirement savings more accessible to everyone at your workplace. You could also seek the advice of a financial advisor. Even if your 401(k) contributions are limited, retirement and tax professionals can advise you on how to continue saving for the future.
