"My employer just sent me a letter stating that I could not contribute more than 10% to my 401(k) because I am a “highly paid” employee (as the letter states, I make more than $115,000). This doesn’t make any sense to me. I thought I could contribute up to $17,500 this year. Is this one of the new tax laws with the January tax changes? Please help me understand."
Thank you very much for your question as I am sure there may be other people out there that may face the same issue and have received similar letters. First of all, as you are already aware there were numerous tax changes made for high income earners in early January this year. These changes could be another post in and of themselves. Regardless, these new tax changes are not responsible for the limit that has been placed on your 401(k) contributions.
This letter is a result of the type of 401(k) that your employer has set-up. As some background, the intention of 401(k)’s was to provide a tax advantaged retirement savings plan to benefit all employees and not just owners and other highly paid (HP) employees. For this reason, the IRS requires that checks and balances need to be in place to make sure that a plan achieves this balance. One of those checks and balances limits the contribution percentage that HP employees can contribute over the NON-highly paid (NON HP) contribution percentage. To use your situation as an example, the HP employees in your company are limited to 10%. What that tells me is that the NON HP employees are contributing an average of 8% of their income. If the NON HP employees contributed a higher of lower percentage, then the limit placed on the HP employees’ contribution percentage would be higher or lower respectively.
I mentioned earlier that this letter was a result of the type of 401(k) that your employer has set-up. I made this clarification because not every 401(k) plan needs to satisfy these checks and balances. There are other plans that do not need to fulfill this particular requirement. Instead, they have other requirements to meet. I wanted to add this point, not to suggest one type of plan is better than another, rather to clarify that not everyone with a 401(k) is subject to the limitations that you face in your plan as a HP employee.
Thank you again for your question. It really dives into the specifics of 401(k)’s that I am willing to bet most people would share the same questions you do if they received a similar letter. Hopefully, now they will already understand the answers.