Excess Contributions

Definition

Excess Contributions are contributions made to cash or deferred arrangements, such as 401(k) plans, by or for highly compensated employees that exceed the limits set under IRS nondiscrimination rules. These rules are designed to ensure that retirement plans do not disproportionately favor high-income employees over other employees.

The Internal Revenue Service (IRS) determines the maximum allowable contributions annually, and contributions above this limit are considered “excessive”. Such excess contributions must be corrected to avoid penalties and ensure the plan’s compliance with IRS regulations.

Examples

1. 401(k) Contributions: If a highly compensated employee contributes more to their 401(k) plan than is allowed by IRS rules, these additional amounts are considered excess contributions.

2. Deferred Compensation Plans: Contributions made by highly compensated employees above the plan’s limit in a deferred compensation plan, which defers income to a later date, are also regarded as excess contributions.

3. Employer Matching Contributions: If an employer contributes more on behalf of highly compensated employees than the non-discriminatory limits allow, these contributions can be considered excessive.

Frequently Asked Questions (FAQs)

1. What happens if excess contributions are not corrected?

   • Failure to correct excess contributions can result in penalties, taxation on the excess amounts, and potentially losing the plan’s tax-qualified status.

2. How are excess contributions corrected?

   • Excess contributions can be corrected by distributing the excess amount to the employee or recharacterizing them to comply with regulations.

3. Who is considered a ‘highly compensated employee’?

   • The IRS defines a ‘highly compensated employee’ based on factors such as compensation level, ownership interests, or classification based on plan year activities.

4. What are nondiscrimination rules?

   • Nondiscrimination rules are regulations ensuring that retirement and benefit plans do not disproportionately benefit high-income employees compared to other employees within the organization.

5. Can employers also make excess contributions?

   • Yes, employer contributions can exceed allowable limits, and these must be corrected similarly to employee contributions.

Related Terms

• Highly Compensated Employee (HCE): An employee who meets specific income and ownership thresholds set by the IRS.
• 401(k) Plan: A retirement savings plan sponsored by an employer that allows employees to save and invest a part of their paycheck before taxes are taken out.
• Non-Discrimination Testing (NDT): Tests the IRS requires employers to conduct annually to ensure their retirement plans do not favor highly compensated employees disproportionately.

Online References

• IRS: Retirement Topics - Highly Compensated Employee
• Department of Labor: Employee Retirement Income Security Act (ERISA)

Suggested Books for Further Studies

• Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches by Daniel Cassidy
• The 401(k) Handbook by Booke Seminars

Fundamentals of Excess Contributions: Tax Compliance Quiz