Deferred Compensation, Part IV: Non-Discrimination

According to §401(a)(4), a deferred compensation plan cannot discriminate in favor of highly compensated employees (HCEs), which is a person who either owned 5% of the business at any time during the year or made more than $80,000 (inflation-adjusted) during the preceding year.

The regulations provide two safe-harbor tests for defined contribution plans (which comprise the vast bulk of 401ks). 


The first is a “unified allocation formula,” which requires all plan contributions to be allocated in one of three ways:

  • the same percentage of plan year compensation,
  • the same dollar amount, or
  • the same dollar amount for each uniform unit of service (not to exceed one week) performed by the employee during the plan year.

While the rules do allow a C-Suite executive to benefit from the plan based on their status within the company, it doesn’t allow them to benefit more than their status would allow.

The second method uses a “uniform points method” which are determined by summing “the employee’s points for age, service, and units of plan year compensation for the plan year.”

The main point that advisers should take from these rules is that the regulations contain very rigid, mechanical rules that prevent the top of the employee ranks from rigging the retirement plan to their benefit at the expense of the rank-and-file.

Have a question? Contact Hale Stewart. Your comments are always welcome!

Mr. Stewart has a masters in both domestic (US) and international taxation from the Thomas Jefferson School of Law where he graduated magna cum laude. Is currently working on his doctoral dissertation. He has written a book titled US Captive Insurance Law, which is the leading text in this area.

He forms and manages captive insurance companies and helps clients in international tax matters, US entity structuring, estate planning and asset protection.

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