Compliance Testing Required for 401(k) Plans

Qualified retirement plans must provide benefits to plan participants in a non-discriminatory manner. Current required anti-discrimination testing involves Top-Heavy Determination, 401(k)/401(m) Discrimination Testing and 410(b) Coverage Testing. Top-Heavy Determination Test focuses on the definition of a Key Employee while 401(k)/401(m) and 410(b) testing focuses on the definition of a Highly Compensated Employee. While these concepts are similar in some respects, their actual definitions and applications are uniquely different.

Key Employee Defined

  • A 5% owner without regard to compensation, or
  • 1% owner whose annual compensation is over $150,000, or
  • Officers with annual compensation in excess of $170,000 (in 2014).

Highly Compensated Employee (HCE) defined:

  • A 5% owner of the Employer or an Affiliate in the current or the immediately preceding plan year, or
  • Any employee that earned more than $115,000 in the 2013 plan year will be considered an HCE for the 2014 plan year.

Constructive ownership rules apply attributing ownership to spouses and lineal ascendants and descendants (parents, grandparents, children and grandchildren) of the owner in both of the above employee definitions.

Top Heavy Determination and Top Heavy Requirements:

The purpose of the Top Heavy Requirements is to ensure that qualified plans do not unfairly benefit the Key Employees of the employer. If, on the Determination Date, the total of the account values for the Key Employees exceeds 60% of the account values for all employees, it will be determined to be Top Heavy. A minimum Top Heavy Contribution will be required for the initial plan year and/or the following plan year if the Key Employees receive any contribution allocation. This contribution must be 3% of the Non-Key employee’s total annual compensation or if less, the highest percentage of compensation that any Key Employee receives. The Top Heavy Contribution is allocated to the eligible Non-Key employees who are employed on the last day of the plan year without regard to the number of hours worked. Key Employees may receive a Top Heavy Contribution if elected in the Plan Document.

401(k) / 401(m) Discrimination Testing:

The purpose of the discrimination test is to ensure that Highly Compensated Employees do not receive contributions on average that are substantially greater than Non-Highly Compensated Employees. A general description of the test follows:

The discrimination test divides participants into two groups, Highly Compensated and Non-Highly Compensated. Once the groups are separated, contribution ratios are developed for salary deferrals and employer matching contributions for each participant. The ratios are averaged for both the Highly Compensated Group and Non-Highly Compensated Group. This creates the ADP (Actual Deferral Percentage) and the ACP (Actual Contribution Percentage), which are compared to the following table to see if the plan is within passing guidelines.

ADP or ACP of the NHCE Group

Maximum ADP or ACP of the HCE Group

0% - 2%

0% - 4% (i.e. x2)

2.1% - 8%

4.1% - 10% (i.e. +2)

>8%

x1.25

If the plan is outside of these guidelines, corrective measures are required. The most common method of correction is issuing corrective distributions to the Highly Compensated Employees. If corrective distributions, including earnings, are not made by 2½ months after the plan year-end, a penalty tax will be imposed on the employer equal to 10% of the excess contributions. If the corrective distributions are not returned by the end of the plan year following the plan year in which the test failed, plan qualification may be jeopardized.

Participation of Non-Highly Compensated Employees is important. Since the maximum ADP permitted for the Highly Compensated Group of employees is dependent upon the ADP for the Non-highly Compensated Group of employees, participation by NHCEs is key to any successful 401(k) plan. Matching contributions are also an important factor. If the employer contributes an amount only when the employee defers, the employee may be more inclined to participate.

410(b) Coverage Testing:

A retirement plan must satisfy coverage testing in order to qualify for favorable tax treatment. The purpose of the test is to ensure that the plan does not discriminate in favor of highly compensated employees in regards to eligibility for benefits. The ratio percentage test is the most commonly used coverage test. Under this testing method, the percentage of the NHCEs who benefit under the plan (including terminees with more than 500 hours of service) must equal at least 70 percent of the percentage of the HCEs who benefit under the plan.

Generally, if a plan excludes no employee groups other than non-resident aliens or union employees, the 410(b) test is passed. If there are affiliated or commonly controlled companies in the employer group and a segment of the companies is not included in the retirement plan then particular attention should be placed on this test.

Maximum Limit on Elective Deferral Contributions:

Effective January 1, 2014, a participant’s elective deferral contributions under all retirement plans in which he or she participates during any taxable year is limited to $17,500. Plans may permit participants who have reached age 50 by the end of the plan year to make annual catch-up contributions of an additional $5,500 once the annual dollar limit or a plan-imposed limit on elective deferrals has been reached.

The limitation on elective deferrals applies to the participant’s tax year, which is usually a calendar year. For participants who exceed the limitations, corrective distributions should be made no later than April 15th following the close of the taxable year. If excess deferrals are not timely corrected, double taxation will occur: the amount of the excess will be included in the participant’s income for the taxable year in which the excess arose and again in the year of the distribution.

Maximum Annual Additions:

The Internal Revenue Code sets limits on contributions made to a participant’s account. The Code uses the term “annual additions” which represents both employee and employer contributions as well as reallocated forfeitures. Effective January 1, 2014, the annual dollar limit is the lesser of 100% of compensation or $52,000.

Excluded Compensation Testing:

If the Plan excludes certain types of compensation, for instance: bonuses or overtime, additional testing must be done to ensure that the exclusion does not discriminate in favor of the HCEs. In general, the average of the ratio of included compensation to total compensation for the HCE group may not be more than a de minimis amount higher than the average of the ration of included compensation to total compensation for the NHCE group. The IRS has used 3%-5% as a safeguard, but each plan is viewed on a facts and circumstances basis.

In summary:

This has been a broad overview of the general testing requirements for 401(k) plans and is not meant to be comprehensive. To learn more about the testing requirements for your specific plan, please contact us.Contact us today

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Important 401(k) Testing Deadlines to Remember

Happy New Year! With the New Year, the annual cycle of most retirement plans begins again. In general, 401(k) plans must be tested annually to demonstrate that they do not discriminate in favor of highly compensated employees, or provide benefits that exceed certain statutory or regulatory limits. If a plan “fails” any of the required tests, the plan sponsor must take corrective actions, and there are established deadlines for correcting certain failures. The following is a brief summary of these deadlines:

Note: Since most 401(k) plans are on a calendar plan year end, deadlines are based on a calendar year.

  • March 15th-Deadline for issuing corrective distributions to correct ADP/ACP testing failures for traditional 401(k) plans.

In general, corrective distributions must be issued within 2 ½ months following the close of the plan year (March 15th) to avoid a 10% excise tax imposed on the excess amounts. Plan sponsors of 401(k) plans that include an “eligible automatic contribution arrangement” have up to 6 months (June 30th) to issue corrective distributions without incurring the excise tax.

In either situation, corrective distributions must be issued no later than the last day of the plan year following the plan year in which the testing failure occurred in order to protect the qualified status of the plan.

  • April 15th – Due date for issuing corrective distributions for excess deferrals (i.e. participant deferrals made in excess of 402(g) limit – ($17,500, or $23,000 for individuals age 50 or over, in 2013). If the excess amount, plus earnings, is not distributed by this date, the participant is taxed on the excess amount both in the year the excess occurred and the year of the corrective distribution. (Note: This deadline is the same, regardless of plan year).
  • June 30th – Extended due date for issuing corrective distributions for ADP/ACP testing failures under “eligible automatic contribution arrangement” 401(k) plans; the 10% excise tax applies to distributions made after this date.
  • October 15th – Deadline for adopting a retroactive plan amendment to correct a coverage testing failure (if applicable). The amendment must be adopted no later than 9 ½ months following the close of the plan year in which the failure occurred.
  • December 31st – Final deadline for issuing corrective distributions for ADP/ACP testing failures for the prior year (or for making a QNEC/QMAC to correct the failure).

The deadlines 401(k) plan sponsors must observe are numerous and complex; the deadlines listed above are not meant to be comprehensive, but rather, represent critical dates related to the correction of specific plan testing failures. EJReynolds is available to help you understand your Fiduciary deadlines. For a more detailed calendar, please see our Compliance Guide and Calendar

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