A number 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. Some of the most common tests include:
• ADP/ACP Tests
• Annual Deferral Limit
• Annual Additions Limit
• Coverage Test
• Top Heavy Determination
Highly Compensated and Key Employees
For purposes of these tests, it is important to understand two basic definitions. Highly compensated employees are employees who (1) own more than 5% of the company*, or (2) earned compensation in excess of a certain dollar amount in the prior year ($120,000 for 2018). 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 a number of 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 ($175,000 for 2018).
*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.
The 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 of these tests, corrective actions must be taken which often includes issuing corrective distributions.
Note: Plans that provide for safe harbor matching or safe harbor nonelective contributions are generally deemed to satisfy both tests.
Annual Deferral Limit
The annual deferral limit ($18,500 for 2018 plus $6,000 for participants age 50 or older) 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 $55,000 for 2018). This limit generally includes all contributions made to the plan for a particular 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.
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 of 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 considered to be 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 has been 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 particular 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.