Over the past few years, the long-term impact of low individual retirement savings have been highly publicized as personal and household debt has soared. Individuals are continuing to shift less money to personal 401(k) accounts as discretionary spending and household debt has grown exponentially. This fact has only been amplified as the United States economy has struggled to recover from the recent recession. Individuals are struggling to keep up with growing living expenses, so the amount of money being saved in long-term retirement plans is often the first budgetary consideration to be negatively impacted. In addition, many employees who have traditionally contributed to their 401(k) accounts are electing to take hardship distributions to help pay for items such as the purchase of a primary residence, paying for college tuition or meeting medical expenses. The receipt of a hardship distribution requires that the employee be prohibited from deferring money to a 401(k) account for 6 months, thus further diminishing retirement savings and participation.
A hidden factor eroding account balances within 401(k) Plans is the ever-increasing need for corrective distributions related to failing annual Discrimination Testing. Annual Discrimination Testing compares the average deferral percentage of Owners and other Highly-Compensated Employees to the average percentage of employees who are not considered to be highly-compensated. This form of testing was originally instituted to ensure that 401(k) Plans were not unfairly benefitting upper-level employees.
As more non-highly compensated employees are reducing or completely eliminating their elective deferrals into 401(k) Plans, annual Discrimination Testing results are becoming more skewed, thus causing more retirement money to be distributed to Highly-Compensated Employees as corrective distributions. Many Highly-Compensated Employees are able to withstand the impact of recessionary economic periods, so the reduction in these individuals’ deferral amounts is less likely to occur. However, during these same recessionary periods, non-highly compensated employees are pulling back on contributing to 401(k) Plans in order to meet the growing costs of basic living expenses. This overall polarization of retirement plan contribution trends has directly contributed to increased corrective distributions for Highly-Compensated Employees.
As corrective distributions continue to grow from year to year, Plan Sponsors for 401(k) Plans often search for plan design methods that can be implemented to reduce or eliminate the need for these payouts. In addressing this issue, many Plan Administrators recommend two plan provisions which can help to eliminate or greatly mitigate corrective distributions related to failed Discrimination Testing:
- Implement as Safe Harbor Contribution Feature: Under ERISA regulations, implementing Safe Harbor Matching or Non-Elective provisions to a 401(K) Plan will allow Plan Sponsors to avoid having to perform annual Discrimination Testing, since these plans are automatically deemed to pass testing. Thus, Highly-Compensated Employees are allowed to defer as much as they prefer up to the annual deferral limits. While the implantation of a Safe Harbor contribution provision is greatly helpful to avoid corrective distribution payouts, Plan Sponsors must also understand that these contributions are mandatory and must be deposited as long as the safe harbor feature is in place.
- Require Automatic-Enrollment for Eligible Employees: For Plan Sponsors looking to improve Discrimination Testing results, who do not feel that they will be able to meet the mandatory annual Safe Harbor Contribution requirement, the implementation of an Automatic-Enrollment option may prove to be more appealing. Automatic Enrollment requires that all eligible employees make a minimum deferral to 401(k) accounts based on a pre-determined percentage, often ranging from 2-4% for each eligible participant. The requirement of each eligible employee to make a minimum deferral contribution will help to improve the Discrimination Testing results since the average deferral percentage for non-highly compensated employees will obviously increase. While this feature may not necessarily guarantee a passing result of the annual Discrimination Test, it will help to reduce the amount of money that will need to be distributed to Highly-Compensated Employees in order to bring the plan to a passing status.
Schneider Downs Wealth Management Advisors is proud to employee a team of retirement plan specialists who are ready to help any Plan Sponsor looking to improve or enhance their 401(k) Plans. Please contact Karl W. Kunkle (412-697-5401) or Jeff Acheson (614-586-7259) for any retirement plan need.
© 2013 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.