Limits for High Income Earners
Limits for High Income Earners
All about Limits for High Income Earners – The 401k is one of the best retirement plans out there; it provides generous benefits and it can come paired with an employer contribution.
Besides, there are other subtle benefits such as tax reduction and your resources receive some level of evasion from debts.
But what highly paid workers should be aware of is that there are limits for your contributions depending on your wage.
- How the limits for High Income Earners work
- Definition of a High Income Earner
- Non-Discriminatory test
- ADP test
- ACP test
- What if your 401k plan fails the test
- How to check if there was a mistake in your test
- Strategies for Highly Paid Earners
- Contributions to IRA
How the limits for High Income Earners work
Highly Paid Employees or HPE for short suffer from some limitations in the 401k plan.
That is restraining because while low paid earners can contribute a good portion of their salaries, you cannot invest large portions of your salary.
Therefor, if you made your contributions for the year already, but were recently determined as an HPE, the excess contributions will be refunded to you.
The limitations imposed on HPE’s are based on the average contributions made by non-HPE’s.
Definition of a High Income Earner
The definitions for an High-Income Earner aren’t obvious. For example, you can be classified as a HPE based on your relatives.
Furthermore, an employee, whose first-degree relative is the owner of 5% or more of a business, is also considered an owner of the business.
According to the IRS (Internal Revenue Service) a High Income earner is someone who:
- Received a compensation of more than 120 thousand dollars in the preceding year, or was in the top 20% of employers ranked by compensation.
- Was the owner of at least 5% of interest in a business, regardless of how much compensation they received.
To qualify for the tax-favored status, a benefit plan such as the 401k plan must not discriminate workers in favor of Highly Compensated Workers.
However, there are regulations created by the Federal Government specifying the requirements for each kind of benefit.
The name “Non-Discriminatory” comes from exactly what the tests are being applied for, to check if the plans are complying in not discriminating workers.
The tests are made to see if the earnings for lower paid employees are proportional to those of Highly Paid Earners.
The non discriminatory test actually consists of two tests, the Actual Deferral Percentage (ADP) test and Actual Contribution Percentage (ACP) test.
In case you are an employee, this test is not important; your boss is the one responsible for it. However, this information is important if you own a business.
The ADP test includes both pre-tax and Roth 401 plans, but excludes catch-up contributions. It includes both non-HPE’s and HPE’s
The elective deferrals of both HPE’s and non-HPE’s are divided separately by their compensation, which creates the Actual Deferral Ratio or ADR.
The Actual Deferral Percentage for Highly Paid Earners can’t surpass:
- 125% of the APD for non-HPE’s
Or be less than:
- 200% of the ADP for non-HCEs or the ADP for the non-HCEs, plus 2%
The Actual Contribution Percentage (ACP) test, tests the contribution percentage of the workers, contrary to the ADP that tests the deferrals percentage.
The Actual Contribution Percentage for Highly Paid Earners can’t surpass:
- 125% of the ACD for non-HPE’s
Or be less than:
- 200% of the ACP for non-HCEs or the ACP for the non-HCEs, plus 2%
What if your 401k plan fails the test
If your 401k plan fails the test you are going to be given a second chance and a period of two and a half months to redo your test.
If you succeed during the period, your excess contribution will be returned to you, without tax reduction.
However, if you fail a second time, the entire plan will lose its tax qualified status.
How to check if there was a mistake in your test
Check again if your properly classified HPE and non-HPE, check all employees eligible to make a deferral, including those who don’t want to make one.
Strategies for Highly Paid Earners
There are strategies you can take advantage of to make your situation as a HPE better. None will completely change everything for you, but they will help.
You can make nondeductible contributions, you will pay some more taxes for your contributions but they will still generate tax-deferred income.
Provide Catch-up contributions; they allow you to contribute with a certain extra amount if you are 50 years old or older.
The amount you can contribute with in 2018 is 6,000 dollars, but pay attention, because this number may rise in the next few years.
Set up a Health Saving Account (HSA), that will provide you with tax-deferred savings.
The plan can only be used to pay for health costs, but that is important.
Contributions to IRA
If you are a Highly Paid Worker and you can’t contribute past a certain amount, making contributions to IRA can be of help.
Anyone, with any level of income can make a contribution to IRA. Contributions are nothing compared to what is possible to do with a 401k plan.
Nevertheless, a little bit is better than nothing.
Yearly contributions may not exceed 5,500 or 6,500 if you are 50 years old or older.
So, if you learn more about Social Security, click here.
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