Do 401(k) retirement plan contribution limits make sense?

Jeff_MarzinskyEach year I work with a number of clients who are retirement plan sponsors for defined contribution (DC) plans, which include 401(k) plans. In order to help them complete their annual nondiscrimination testing, we have to take their employee payroll data and run it through a series of required tests—all to make sure that individual employees have not contributed more than the applicable limit of $16,500 to their plans (with a “catch-up” contribution of another $5,500 allowed for employees of age 50 and older), and that the total amount for each individual, including any employer contributions, doesn’t exceed $49,000 for each employee (again, more is allowed if the employee is over age 50).

Taking it a step further, qualified 401(k) retirement plans must also pass a test called the actual deferral percentage (ADP) test, which may further limit the amount of deferrals certain employees may contribute to the plan. A similar test is applied to the employer matching contributions, called the actual contribution percentage (ACP) test.

Granted, not many employees bump up against the limits each year, but plan sponsors do get questions from employees as to why their deferrals were arbitrarily stopped during the year (when it hit the $16,500 deferral limit), or worse, why they got a check back early in the following year with a letter saying, “Sorry, our plan failed the ADP test, here’s a refund for the excess amount you deferred to the plan.”

So why does the government place these limits on retirement plans? The short answer: so that the 401(k) plan doesn’t discriminate against (or favor) certain employees participating in the plan on the basis of contributions. Another factor may be tax revenue, as employees defer their salaries pre-tax, which means they are not paying income tax on the deferrals—a revenue loss for the government.

Sponsors and employees have questions about the present testing requirements. Channeling this perspective, here are some questions and considerations:

  • If the 401(k) plan was created as a vehicle to help employees save, why place limitations on the amount individuals can defer to the plan out of their own salaries? If an employee has a savings short-fall and needs to contribute more to their retirement savings, why arbitrarily stop them from saving more, at the current limit of $16,500 or ADP testing limits?  Is it really discrimination if one employee chooses to save more, in terms of dollars or a percentage of their salary than another employee?
  • Wouldn’t it make more sense to focus on limiting the amount of employer contributions to ensure that the plan (employer) does not favor certain individuals in the plan?
  • Perhaps the government could consider removing the ADP nondiscrimination test on employee deferrals to a 401(k) plan, allowing employees to defer up to the limit if they choose, or possibly removing the limits altogether for certain employees.
  • The government could consider nondiscrimination testing only on employer contributions that exceed a certain dollar or percentage amount. This would ensure that the employer does not provide more benefits to individuals or certain groups of employees within a plan.
  • Instead of allowing just those employees who are age 50 to utilize the catch-up, just consider increasing the 401(k) deferral limit to $22,000 ($16,500 + $5,500).

For more information, Milliman publishes an annual sheet on the retirement plan limits.

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