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.
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.
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.
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)
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.
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.
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.
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.
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.
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