The higher $12,000 standard deduction for single filers has produced an incentive in some cases for business owners to put their kids on the payroll in an effort to shift income out of the owner’s high tax bracket into the children’s lower tax bracket. However, there was a non-Wojeski accountant that advised his clients not only to put his kids on the payroll but also to have their children put all of that W2 compensation in the company’s 401(k) plan as a Roth deferral.
At first look it would seem to be a dynamite tax strategy but this strategy blew up when the company got their year end discrimination testing back for the 401(k) plan and all of the executives, including the owner, were forced to distribute their pre-tax deferrals from the plan due to failed discrimination testing. It created a huge unexpected tax liability for the owners and all of the executives completely defeating the tax benefit of putting the kids on payroll. Not good!!
Why This Happened
If your client sponsors a 401(k) plan and they are not a “safe harbor plan”, then each year the plan is subject to “discrimination testing”. This discrimination testing is to ensure that the owners and “highly compensated employees” are not getting an unfair level of benefits in the 401(k) plan compared to the rest of the employees. They look at what each employee contributes to the plan as a percent of their total compensation for the year. For example, if you make $3,000 in employee deferrals and your W2 comp for the year is $60,000, your deferral percentage is 5%.
They run this calculation for each employee and then they separate the employees into two groups: “Highly Compensated Employees” (HCE) and “Non-Highly Compensation Employees” (NHCE). A highly compensated employee is any employee that in 2019:
- is a 5% or more owner, or
- Makes $125,000 or more in compensation
They put the employees in their two groups and take an average of each group. In most cases, the HCE’s average cannot be more than 2% higher than the NHCE average. If it is, then the HCE’s get pre-tax money kicked back to them out of the 401(k) plan that they have to pay tax on. It really ticks off the HCE’s when this happens because it’s an unexpected tax bill.
Little Known Attribution Rule
ATTRIBUTION RULE: Event though a child of an owner may not be a 5%+ owner or make more than $125,000 in compensation, they are automatically considered an HCE because they are related to the owner of the business. So in the case that I referred above, the accountant had the client pay the child $12,000 and defer $12,000 into the 401(k) plan as a Roth deferral making their deferral percentage 100% of compensation. That brought the average for the HCE way way up and caused the plan fail testing.
To make matters worse, when 401(k) refunds happen to the HCE’s they do not go back to the person that deferred the highest PERCENTAGE of pay, they go to the person that deferred the largest DOLLAR AMOUNT which was the owner and the other HCE’s that deferred over $18,000 in the plan each.
How To Avoid This Mistake
Before advising a client to put their children on payroll and having them defer that money into the 401(k) plan, ask them these questions:
- Does your company sponsor a 401(k) plan?
- If yes, is your plan a “safe harbor 401(k) plan?
If the company sponsors a 401(k) plan AND it’s a safe harbor plan, you are in the clear with using this strategy because there is no discrimination testing for the employee deferrals.
If the company sponsors a 401(k) plan AND it’s NOT a safe harbor plan, STOP!! The client should either consult with the TPA (third party administrator) of their 401(k) plan to determine how their kids deferring into the plan will impact testing or put the kids on payroll but make sure they don’t contribute to the plan.
Side note, if the company sponsors a Simple IRA, you don’t have to worry about this issue because Simple IRA’s do not have discrimination testing. The children can defer into the retirement plan without causing any issues for the rest of the HCE’s.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.