401k HCE and followup questions

My boss told me I am on the verge of being considered a "Highly Compensated Employee" (HCE) and I need to aware of the HCE guidelines. He went on to tell me that every year in February HR performs 401k testing which determines at what salary level a HCE is defined and how much a HCE may contribute. What confuses me is he said that the testing, which will happen in February 2007 will determine how much a HCE will be able to contribute to their 401k in 2006. This seems grossly incorrect since it would obviously affect your taxes if the testing determined that a person could only contribute $2000 and they all ready contributed the maximum of $15,000. Not to mention one would receive a check for $13,000 in February that could have been invested otherwise. This may see trivial for someone well within the HCE guideline, but, a person living in an expensive area of the country, who just falls within the HCE guideline, and throw in a kid or two, it is much more than just a trivial matter. (It seems to me that one should be aware of being classified as an HCE and contribution limit before or early into the contribution year . . . for example the testing in February 2007 should be for HCE definition and contribution limits for 2007 using 2006 data.)

After searching the web, I realize there are different guidelines, including defaulting to a static salary threshold of $100,000 for 2006 and 2007, depending on the chosen 401k provider/plan. Is the $100,000 threshold a "floor" which the annual testing may not fall below?

It seems incorrect that a person who is nearing the HCE threshold could out-of-the-blue receive a letter and a check saying that the previous year they were defined as an HCE and here is a check with your excess contribution. Can anyone confirm and/or elaborate on that?

In my opinion, the standard/core investment strategies include a savings account at some short-term emergency level, max out your 401k, max out an IRA (roth if you fall above the deduction limits), sliding in purchasing a home at some point, and purchasing some life insurance at some point. If one suddenly becomes classified as an HCE, assuming minimal maintenance, where should one divert these funds? Are there alternative plans available? Or, is the next step opening up a brokerage account and buying mutual funds?

Thanks, BLC

Reply to
BLC
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It seems unfair but unfortunately, those are the rules. There are two ways of correcting a top heavy plan: (1) return contributions to HCE employees or (2) give extra matching to non-HCEs to balanced out the plan. Guess what's cheaper for the company to do? So yes, it makes it a real hassle -- you will get a big portion of your contributions back. I'm sure they also return the gains on that portion for that year so the entire amount becomes taxable income. Basically, the rest of your coworkers suck by contributing little or nothing. Or your employer sucks by not offering enough matching to get them to contribute.

What are your options for 2006? None unfortunately. There's no retroactive tax shelter you can finagle to count for 2006. Only a traditional IRA but you won't qualify for it because you are "covered" by an employer retirement plan and your salary is too high.

For the future, taxable accounts or low-expense variable annuities. > It seems incorrect that a person who is nearing the HCE threshold could

Reply to
wyu

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