401K Plans – Secure Act 2.0 from Bad to Worse Highly Compensated Employees (HCE)

(The short as I could make it version)

First the Bad.

If you’re one of the highly compensated employees HCE (wages over 135,000 in 2022), I would assume you’re already familiar with the non-discrimination testing and how it usually, at least in the automobile dealership world, limits your ability to reach the maximum 401K contribution of $20,500, 2022. Most of the car dealerships I see have non-discrimination tests that max out the HCE at about $4,500 or so. If you contribute over this test limit amount, you will have your excess contribution amount given back to you and form 1099 to file with your tax return. The 401K plan non-discrimination testing was designed by the DOL/IRS to put pressure on the business owners and HCE to make larger contributions for all of the regular employees, i.e., safe harbor contributions. However, I have not seen this occur too often because the contribution would be too high. This is primarily due to poor employee participation in the 401K plan. So, the highly compensated employee, the ones that usually can afford to put more away more for themselves, can’t contribute as much as they’d like. Well, at least if you are age 50 or older, you can still make the tax savings catch-up contribution without having to worry about the limit, but not for long!

If the top heavy testing limit wasn’t “Bad” enough for the HCE, the new Secure Act 2.0 only allows you to use your catch-up contribution for a Roth contribution, meaning no tax deduction, the “Worse” part. Really!!! Hopefully, you’re aware of the age 50 catch-up not being subject to the HCE top heavy limit and use it. You’ll have this tax savings available to you for 2023, but after that, the new Act kicks in. The wage amount would be $145,000 for the 2.0 Secure Act. The next question is, what if your 401K plan doesn’t have a “Roth” option as they are not required to have one, “worse” news again. Let’s hope the plan gets amended to include the Roth in time as we still have time and that your plan’s advisor, someone like me, hint hint, notices.

The catch-up contribution is going up, and if you are 60 to 63 years old in 2025, the catch-up contributions will be the greater of $10,000 or 50% more than the regular age 50 catch-up amount. If you’re not a highly compensated employee, then your treatment is the same as it’s been, pre-tax, with larger catch-up contributions available to you in the future, 2025, and beyond.

The employer could elect a “save harbor” provision for the 401K plan. The safe harbor employer contribution will bring the regular employees’ contributions up to 3% to 5%, depending. This avoids the non-discrimination testing but does cost the company in terms of higher employer contributions, and it’s vested 100% when made. Thus, it might not be a good fit for the company, cost-benefit rule. There are other alternatives, but that would have to be explained in another blog post.

NOTE:   The Secure Act 2.0 will be effective for 2024 for HCE for Roth-only catch-up contributions, an increased Catch-up contributions will be effective for 2025.

As always, seek the advice of your financial professionals before implementing any method on your own.