How NoNDiscrimiNatioN testiNg affects You

Saving for Retirement as a“Highly Compensated Employee”

Your plan may offer:

• An array of benefits—such as tax-deferred growth, professional money management, a diverse investment lineup and multiple distribution options—which offer participants a convenient vehicle for retirement investing

• Communication initiatives—such as informational seminars and re-enrollment meetings—to educate employees about the importance of plan participation and make it easy to participate

• Features—such as auto-enrollment and auto-deferral increases—that bring employees into the plan and help them to contribute to the plan automatically

It’s obvious that a decision to participate in the plan affects individual employees and impacts their retirement.

What may be less obvious is that these individual decisions about joining the plan and how much to save can impact all participants.

This impact is created by certain mathematical tests—called nondiscrimination tests—mandated by the Internal Revenue Service (“IRS”) code. The IRS requires these tests to ensure that highly compensated employees (“HCEs”) are benefiting from the plan within a certain proportion to non-highly compensated employees (“NHCEs”).

The ImporTance of plan parTIcIpaTIonYour 401(k) retirement savings plan may be designed to encourage all eligible employees to become plan participants and to invest for a financially secure retirement.

2 Saving for retirement aS a HigHlY CompenSated emploYee

categorization of employeesWhen performing nondiscrimination tests, the plan places employees into one of two categories as defined by the IRS code:

• Highly Compensated Employees or “HCEs” are defined as those who own more than 5% of the business at any time during the current or prior year, or whose compensation exceeded $110,000 in the prior year .* The plan sponsor can elect to limit the number of HCEs earning over $110,000 to those HCEs who are in the top 20% of all employees ranked by compensation. Certain family members of highly compensated employees may also be considered HCEs due to rules that attribute stock ownership to family members.

• Non-Highly Compensated Employees or “NHCEs” are those employees who do not fall into the HCE category through stock ownership or compensation.

Testing proceduresThere are two nondiscrimination tests required by the IRS.

The actual deferral percentage (“ADP”) test calculates and compares the deferral ratio (deferral amount divided by compensation) of HCEs and NHCEs in the plan.

The actual contribution percentage (“ACP”) test calculates and compares the contribution ratio (the sum of voluntary employee after-tax contributions and employer matching contributions divided by compensation) of HCEs and NHCEs in the plan.

Generally, if the HCE’s ADP or ACP exceeds the NHCE’s ADP or ACP, respectively, by a certain amount, then the ADP test or ACP test is not satisfied.

passing the TestsPlan sponsors can use a number of strategies to help the plan pass the ADP and ACP nondiscrimination tests. They may:

• Make special employer contributions called qualified nonelective contributions (“QNECs” or “QNCs”) to balance the HCE and NHCE deferral and contri-bution levels or may also make refunds to HCEs

• Amend the plan to include a safe-harbor provision that includes certain provisions that may exempt the plan from discrimination testing or ensure that certain nondiscrimination rules are satisfied

• Expand employee education and communication initiatives and/or add plan features designed to encourage participation, including auto enrollment, matching contributions, loans and hardship withdrawals

When a plan fails nondiscrimination TestingIf the plan does not satisfy the ADP or ACP nondiscrim-ination tests, corrections must be made to maintain the plan’s tax-qualified status, thereby allowing participants to continue to save pretax dollars. These corrections often take the form of taxable distributions to HCE participants.

*in 2011, the $110,000 limit references the amount of compensation paid in 2010.

Saving for retirement aS a HigHlY CompenSated emploYee 3

Importance of plan participation to YouWhen you defer money from your paycheck to your retirement savings plan, you are taking an important step to meet critical retirement objectives for you and your family. You also:

• Are saving pretax dollars automatically and benefiting from the power of compounding over time

• Can take advantage of professional fund management in a range of diversified investment options

• May benefit from convenience and accessibility of plan and account information

• Are generally able to select from a number of distri-bution choices

When you defer the maximum permissible contribution, you are also maximizing all the benefits of the plan.

Testing procedures and YouAs a Highly Compensated Employee, you have a stake in the level of plan participation by all employees. If the deferral/contribution rate for HCEs is disproportionate to that of NHCEs, your plan may not meet the criteria for IRS-mandated, nondiscrimination testing. In that event, you may receive a refund of a portion of your retirement savings deferral or the match contributions made on your behalf.

As a result of this refund, there will be tax consequences for you. Under current tax law, you may face two alternatives—filing a delayed tax return or filing an amended tax return. The IRS Code may permit you to incur the tax liability in the year the refund is distributed, rather than the year originally contributed.

As a result of this refund, there will also be consequences to your retirement strategy and potential for reaching your retirement savings goals.

refund SolutionsHCEs receiving a refund are often looking to minimize its tax-liability impact and maximize its retirement-savings potential. You may have a number of options, including the purchase of an annuity, tax-efficient investing through exchange traded funds (“ETFs”) or a Traditional or Roth Individual Retirement Account (IRA).

next StepYour plan’s Financial Advisor may be a good source of information on alternative investment vehicles to facilitate retirement savings outside your 401(k) plan. You should plan to spend some time exploring strategies that will complement your entire retirement portfolio and offer tax-deferred benefits similar to your employer-sponsored retirement savings plan. Care should be taken to calibrate these strategies to work effectively within your overall financial plan.

tax laws are complex and subject to change. morgan Stanley Smith Barney llC, its affiliates and morgan Stanley Smith Barney financial advisors do not provide tax or legal advice and are not “fiduciaries” (under eriSa, the internal revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by morgan Stanley Smith Barney. this material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. individuals are urged to consult their tax or legal advisors before establishing a retirement plan and to understand the tax, eriSa and related consequences of any investments made under such plan.

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