So my wife is considered a "highly compensated employee" and has been maxing out her 401k and 457b (as well as the HSA). We recently received a letter informing us that since other plan members didn't use their 401k, we can only contribute 2% greater than average. The refund will be taxable. Our combined income makes us ineligible for traditional IRA deductions.
So, what is the best option?
1. Making this an "after tax" contribution.
2. Contributing to a Roth.
3. Just putting it in a taxable account.
4. Other?
Text of the letter received is below:
Under the current IRS rules governing our 401k plan, you are considered a highly compensated employee or HCE. Each year the plan must be tested to assure the total of HCE’s in the 401k plan are not contributing at a percentage more than 2% above the total average contribution of the other employees in the plan. Unfortunately, upon completion of the compliance testing for 2017, finalized just this week, EPIC determined your annual contribution exceeded the limit. To satisfy the plan's nondiscrimination requirements you will be issued a refund check in the amount of $9655.48.
Please be advised this is taxable to you for 2018. However, you will not receive Form 1099-R until January 31, 2019 which will be coded to indicate to the IRS that the income is taxable in 2018. I have included an article from Good Financial Cents website that provides a greater explanation as to what happened and possible strategies to consider regarding what can be done with the refund.
To hopefully stop this from happening again, we will be instructing our compliance to complete mid-year testing that should provide a fairly clear indication as to whether your 401k deferral election is too high and if so, advise you to discontinue further deferrals before year end.
