Jeanne, the HR director for a law firm complained that the company was having a tough time passing their non-discrimination testing. Each year, they offered the same embarrassing excuse to their employees: “We failed our non-discrimination test again this year and we have to refund you a chunk of the money you put into the plan.”
“That refund became unexpected taxable income,” explained Jeanne, “and this didn’t do anything to improve company morale.”
“Then we asked our payroll provider, ‘Is there anything we can do to pass the non-discrimination testing?’ They had the nerve to suggest that we either encourage our lower-paid employees to put in more or encourage our higher paid people to put in less!”
After asking a few questions, I believed I had a solution to Jeanne’s problem that did not involve encouraging anyone to put in more or less into the plan. I asked her to send me a census to review and that confirmed my conclusion.
I explained to Jeanne that the Top-Paid Group rule (a.k.a the Top 20%) would make their plan pass non-discrimination testing moving forward, and that if they had applied this rule in the past, they probably would never have failed the test. “Unfortunately, your prior firm was either too inexperienced or too lazy to customize your plan.”
“What is the Top-Paid Group rule?” asked Jeanne.
“Instead of determining highly compensated employees (HCE) contributions based on compensation alone, you consider whether they are within the top 20% of employees based on income. Why will this work in your situation? Your law firm has a lot of highly compensated employees based on income only; over 50% of your workforce is highly compensated. However, once you apply the top-paid group rule, only 20% are considered highly compensated. Remember; non-discrimination testing is a comparison of the highly-compensated contribution rate with the non-highly-compensated contribution rates.”
“I think I understand,” said Jeanne. “The majority of our team were initially classified as highly compensated, but if we apply the Top-Paid Group Rule, all but the top 20% can be classified as non-highly compensated employees.”
“Exactly,” I assured her. “Those folks contribute at a high rate. Moving them from highly compensated to non-highly compensated status will lower the contribution rate for the high earners—which is a positive—while increasing the contribution rate for the non-high earners. And of course, you’ll pass your non-discrimination test!”
“Sounds like I’m going to pass the no-more-embarrassing-news test as well!” laughed Jeanne.
Too many businesses leave thousands of dollars on the table because they don’t get sound advice when they first start up a new retirement plan. Challenge a Professional Retirement Plan consultant to find those savings and set up the best plan for you.