Month: January 2020

Since it’s time for most 401(k) plans to perform annual nondiscrimination testing, it makes sense to review the requirements for the Average Deferral Percentage/Average Contribution Percentage (ADP/ACP) tests and the options for plans that fail one or both tests.

Note: Plans that provide for safe harbor matching or safe harbor nonelective contributions are generally deemed to satisfy both tests.

What are the ADP and ACP tests?

The ADP/ACP tests are performed to demonstrate that the plan does not discriminate in favor of highly compensated employees (HCEs) with respect to 401(k)/Roth deferrals and employer matching contributions. The ADP test compares the average deferral rates of the HCEs to that of the non-highly compensated employees (NHCEs); the ACP test does the same for matching contributions. Plans may use either the current year or prior year average of the NHCEs for this purpose; however, the method selected must be specified in the plan document.

In general, a plan passes these tests if the average of the HCEs does not exceed the lesser of (1) the NHCE average plus 2%, or (2) 2 times the average of the NHCEs.

Do catch-up contributions get counted in the ADP test?

No. If a participant makes catch-up contributions by either exceeding the statutory limit ($19,000 for 2019/$19,500 for 2020) or a plan-imposed limit, the amounts are excluded from the ADP test.

What happens if a plan fails these tests?

The plan sponsor must take corrective actions which typically involves issuing corrective distributions to certain HCEs. Although this is the most common way to correct failures, many plans also allow for the employer to make an additional contribution to the plan on behalf of certain NHCEs. These amounts, known as QNECs (Qualified Nonelective Contributions) and QMACs (Qualified Matching Contributions), must be 100% vested and are subject to certain distribution restrictions.

Note: It may be possible to correct or reduce the impact of an ADP testing failure by “reclassifying” deferrals of eligible HCEs as catch-up contributions. When this occurs, corrective distributions are reduced by the reclassified amounts to the extent they do not exceed the catch-up limit ($6,000 for 2019, $6,500 for 2020).

Is there a deadline for correcting failures?

Yes. Generally, corrective distributions must be issued within 2 ½ months following the close of the plan year 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 to issue corrective distributions without incurring excise taxes.

Regardless of the method chosen (i.e. corrective distributions or QNEC/QMACs), corrections must be made no later than the last day of the plan year following the plan year in which the testing failure occurred.

What happens if a plan doesn’t correct the failure in a timely manner?

In short, the qualified status of the plan may be jeopardized, and “late” corrections are much costlier for the employer. The IRS provides two methods for making late corrections under its Employee Plans Compliance Resolution System (EPCRS). Under the first option, the employer must make a QNEC on behalf of the NHCEs. This method is often more expensive than making a “normal” QNEC because the contribution must be made on behalf of all eligible NHCEs. Under the second option (the “one-to-one” correction method), the plan sponsor must issue corrective distributions and must make a QNEC in an amount equal to the corrective distributions. The QNEC is then allocated to the NHCEs.

Can a plan do anything to prevent failures?

Yes. As mentioned above, plans that provide for either safe harbor matching or safe harbor nonelective are generally deemed to pass these required tests. Additionally, there are other options available that may help reduce or eliminate ADP/ACP testing failures such as adding automatic enrollment, making a top-paid group election, or adding a plan-imposed limit for HCEs.

If you would like to learn more about these options or if you have any questions, please contact us.

Several tests must be performed each year to demonstrate that 401(k) plans do not discriminate in favor of highly compensated employees and that contributions do not exceed certain limitations. Since many 401(k) plans are on a calendar year basis, your clients are probably working on these tests now or in the next few weeks. It is probably a good idea to review some of the most common tests, including:

• ADP/ACP Tests
• Annual Deferral Limit
• Annual Additions Limit
• Coverage Test
• Top Heavy Determination

Highly Compensated and Key Employees

For purposes of all these tests, it is important to understand two basic definitions.

• Highly Compensated Employees (HCEs) are employees who (1) own more than 5% of the company*, or (2) earned compensation in excess of an annual dollar amount in the prior year (for example, earning over $180,000 in 2018 makes for an HCE in 2019, while earning over $125,000 in 2019 makes for an HCE in 2020). Some plans limit the number of employees considered to be highly compensated by making a “top paid group” election. Whether this is beneficial for a given plan depends on several factors including the demographics of the workforce.
• Key Employees are employees who at any time during the plan year (1) owned more than 5% of the company*, (2) owned more than 1% of the company* and had compensation in excess of $150,000, or (3) were officers of the company with compensation greater than a certain dollar amount ($180,000 for 2019, $185,000 for 2020).

*Stock attribution rules apply when determining ownership. This means direct relatives of the owner(s) are generally considered to “own” the same percentage for purposes of determining highly compensated and key employee status.

ADP/ACP Tests

The Average Deferral Percentage/Average Contribution Percentage (ADP/ACP) tests are performed to demonstrate that the plan does not discriminate in favor of highly compensated employees with respect to 401(k)/Roth deferrals and employer matching contributions. If the plan fails one or both tests, corrective actions must be taken which often includes issuing corrective distributions, generally by March 15^th of the following year. Note: Plans that provide for safe harbor matching or safe harbor nonelective contributions are generally deemed to satisfy both tests. Eligible Automatic Contribution Arrangements have until June 30^th to make these corrections.

Annual Deferral Limit

The annual deferral limit ($19,000 for 2019 plus $6,000 for participants age 50 or older, or $19,500 and $6,500 respectively for 2020) is a limit placed on the amount a participant may contribute through pre-tax deferrals and/or Roth contributions. This combined limit is always measured on a calendar year basis and applies to the individual. As a result, the participant has the responsibility of informing the plan administrator if they made excess deferrals and participated in an unrelated employer’s plan. The excess amount, along with related earnings, must be distributed no later than April 15th of the following year. If this deadline is not met the participant will be taxed on the excess amount in both the year of the deferral and the year of distribution.

Annual Additions Limit

Participants are also subject to an overall contribution limit known as the “415 limit” (the lesser of 100% of gross compensation or $56,000 for 2019, $57,000 for 2020). This limit generally includes all contributions made to the plan for a plan year; however, it does not include rollover contributions or catch-up contributions. If the limit is exceeded, corrective actions must be taken which normally involves issuing corrective distributions or forfeiting the excess amounts, adjusted for related earnings.

Coverage Test

The coverage test is performed to demonstrate that the plan meets the minimum coverage standards required by law. This test must be run separately for each contribution type or component of the plan (e.g. 401(k), match, and profit sharing). In general, the test is satisfied if the plan covers at least 70% of all the employees who have met the minimum statutory age and service requirements (i.e. age 21 and 1 year of service). In the event of a failure, the employer typically must make an additional contribution to the plan on behalf of non-highly compensated employees.

Top Heavy Determination

In general, a 401(k) plan is top heavy when more than 60% of plan assets are attributable to key employees as of the last day of the prior plan year. Top heavy plans are subject certain minimum contribution and vesting requirements.

Other Required Tests

This is a broad overview of the general testing requirements for 401(k) plans and is not meant to be comprehensive. Other tests may be required depending upon a plan’s design and its features. For example, plans that exclude certain types of compensation, such as commissions, or allocate profit sharing contributions to different groups of participants are subject to additional testing requirements.

To learn more about the testing requirements for your specific plan, please contact us.

On December 20, 2019, President Trump signed into law the Setting Every Community Up for Retirement Enhancement Act of 2019 (the SECURE Act) as part of a compromise bill to avoid a potential government shutdown. The SECURE Act contains many changes to retirement savings accounts in general. Although IRS guidelines have not yet been established, plan sponsors may take advantage of some of the changes in 2020. Following is a summary of new rules that current and potential 401(k) plan sponsors need to know:

• For Existing Plans
  • Safe Harbor Plans Have New Flexibility – The IRS requires that 401(k) plans conduct and pass compliance testing to ensure a plan does not discriminate against Non-Highly Compensated Employees. However, a plan sponsor can satisfy the testing requirements by implementing a Safe Harbor 401(k) Plan. Under the SECURE act, the following Safe Harbor plan designs have been given more flexibility:

• • • • Safe Harbor Nonelective (“SHNEC”): With this design, a plan sponsor can satisfy discrimination testing by making an employer contribution of at least 3% of compensation to all eligible employees. Under prior law, a sponsor can adopt a SHNEC 401(k) plan provided a notice was distributed to plan participants 30 days before the beginning of the plan year.  The SECURE Act eliminates the notice requirement in general and permits a plan sponsor to decide to have a nonelective safe harbor plan mid-year, provided they decide prior to 30 days before the end of the plan year. They may decide even later than that, potentially after the end of the plan year, provided they make a safe harbor contribution of at least 4% of compensation.  The notice requirement remains the same for plans that use the Safe Harbor Match design.

• • • • Safe Harbor Qualified Automatic Contribution Arrangement: Under this plan design, an eligible employee is automatically enrolled in the plan with a pre-set deferral deduction that automatically escalates the employee’s contributions each year. The cap on the automatic escalation will increase from 10% to 15%.

• • Part-Time Employees Must Be Covered in All 401(k) Plans – Currently, plans may exclude employees who don’t complete at least 1,000 hours of service in a 12-month eligibility computation period. This allowed a plan sponsor to exclude a part-time employee from the plan, if they worked less than 1,000 hours in a year. In 2021, the SECURE Act, will require that part-time employees who complete more than 500 hours of service in three consecutive eligibility years be permitted to contribute to 401(k) plans. They will not be required to receive employer contributions and will be excluded from non-discrimination testing but must be given the opportunity to contribute.

• • For Plans that have participant loans – Effective immediately, 401(k) plans are not permitted to make plan loans available by credit card. Existing programs using this form of payment must be discontinued.

• • Mandatory Distribution Date – Under current law, an owner or related employee, or any terminated participant must begin taking minimum distributions by April 1^st after turning age 70 ½, or face penalties of a 50% excise tax. The SECURE Act increases that age to age 72. This applies to individuals attaining age 70 ½ after December 31, 2019. This means that if you turn 70 in 2019 but were born on or before June 30, 1949, the age is still 70 ½, and you must take a distribution by April 1, 2020. However, anyone born July 1, 1949 or later can wait until April 1, 2023 before taking their first distribution.

• For Employers Considering Adopting a Plan
  • Higher Tax Credits May Be Available – The tax credit for small employers who start new retirement plans increases from $500 per year to as much as $5,000 per year for three years. There is also a new $500/year tax credit for up to three years for small employers that adopt new plans that include automatic enrollment. Small employers are considered those that had no more than 100 employees who earned at least $5,000 in the preceding year.

• • More Time to Adopt – Under current law, qualified plans must be adopted by the last day of the year for employers to make deductible contributions for that year. For Tax Years beginning in 2020, qualified plans can be adopted after the end of the tax year and up until the tax return due date. This will provide much needed flexibility to employers considering qualified plans but will not permit employees to make retroactive 401(k) contributions.

• • New Options under Multiple Employer Plans – The SECURE Act will make open multiple employer plans, called Pooled Employer Plans, or PEPs, available as an option beginning in 2021. These will be professionally managed plans that permit unrelated employers to participate.  Adopting employers will be relieved of much (but not all) of their fiduciary responsibilities. PEPs are a major step towards increasing small employer plan coverage, and they will be the subject of a separate upcoming post.

There are several other sections, including a tenfold increase in penalties for failure to file Form 5500 and certain other returns timely and easing the in-service distribution rules for the birth or adoption of a child that we will discuss in greater detail in future articles. For now, contact your EJReynolds’ Plan Consultant with any specific questions as to how the SECURE Act may affect your plan.

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