More money, more problems: What to do if you’re a highly compensated employee
So you’ve finally begun earning more at your job. While making more money can definitely have its perks, there are a few things to watch out for. This is especially true if you decide to buy stock where you work.
Be Smart About Making More
The IRS considers some people “highly compensated employees.” Many of the people in this category are not raking in exorbitant salaries.
So what exactly makes you a highly compensated employee, and what moves should you make if you fall into this category?
The Highly Compensated Employee
Employees are considered highly compensated by the IRS if they own more than 5% interest in the company they work for during the current or preceding year. You’re safe at 5%, but even 5.01% will put you in the highly compensated employee category. The 5% rule includes any equity owned by your spouse, parents, children, and grandchildren. Family members such as grandparents and siblings don’t count toward this percentage.
No matter your salary, if you surpass the 5% equity rule, the IRS will consider you highly compensated. If you were paid more than $120,000 in the current or preceding year and if you’re in the top 20% of employees when it comes to compensation, you’ll also fall into this category.
The Work Around
Basically, if you are considered a highly compensated employee, your 401(k) contributions will be capped at no more than 2% of the average employee contribution at your company. This can create problems, as you may be prohibited from contributing the maximum allowed by the IRS each year. Luckily, there is a way around this annoying rule.
The easiest way around the highly compensated employee rule is to start an IRA and max it out. This way, you can still save for retirement without being burdened by your salary or equity. While a lot of people don’t fall into the highly compensated employee category, it’s good to know what to do if you happen to find yourself there.