The 401(k) plan has
emerged as the most popular form of retirement plan in the United
States. This trend will likely continue for some time for a number
of reasons. One is the cost savings to employers, since deferral
contributions are paid by employees. Another is the fact that 401(k)
plans are more easily understood than traditional retirement plans
and consequently more appreciated by employees.
One aspect of 401(k) plans that is not so easily understood is
the annual contribution nondiscrimination testing. This article will
review the mechanics of this required testing and correction methods
for failed tests.
Highly Compensated Employees
Every 401(k) plan, other than "SIMPLE" plans, "Safe Harbor" plans
or "Qualified Automatic Contribution Arrangements," requires an
annual test to prevent discrimination in favor of the group of
employees referred to as "highly compensated employees" (HCEs).
Employees who fall into the following two categories are considered
to be HCEs:
- An owner of more than 5% of the employer in the testing year
or the previous year (family stock attribution rules apply which
treat an individual as owning stock owned by his spouse, children,
grandchildren or parents), or
- An employee who received compensation in excess of a specified
limit from the employer in the previous year (e.g., employees who
earned more than $100,000 in 2007 will be considered HCEs in
2008). The employer may elect that this group be limited to the
top 20% of employees based on compensation.
401(k) Nondiscrimination Testing
The nondiscrimination rules require average deferrals and average
contributions for the HCE group to be within a certain range of the
average deferrals and contributions for the "non-highly compensated
employee" (NHCE) group.
Testing of employee deferrals is referred to as the ADP test
(Average Deferral Percentage). The ACP test (Average Contribution
Percentage) includes the employer match contributions, employee
voluntary after-tax contributions and certain forfeitures allocated
on the basis of deferrals or matching contributions.
Each participant’s deferral or contribution percentage is
determined by dividing the applicable deferral or contributions by
the compensation defined in the plan document. Averages are then
determined for the HCE and NHCE groups by dividing the sum of the
deferral or contribution percentages by the number of employees in
the group. Below is an example of the ADP determination:
| Employee |
Compensation |
Deferral |
ADP |
| HCE 1 |
$200,000 |
$12,000 |
6.00% |
| HCE 2 |
110,000 |
5,500 |
5.00% |
| HCE Total: |
11.00% |
| HCE Average
(11.00% ÷ 2): |
5.50% |
| NHCE 1 |
50,000 |
4,000 |
8.00% |
| NHCE 2 |
40,000 |
2,000 |
5.00% |
| NHCE 3 |
30,000 |
0 |
0.00% |
| NHCE 4 |
20,000 |
800 |
4.00% |
| NHCE Total: |
17.00% |
| NHCE Average
(17.00% ÷ 4): |
4.25% |
The HCEs’ average may only exceed the NHCEs’ average (for both
the ADP and ACP tests) by specific limits summarized as follows:
NHCE
Percentage |
|
Maximum
HCE Percentage |
| 2% or less |
|
NHCE % x 2 |
| 2% - 8% |
|
NHCE % + 2 |
| more than 8% |
|
NHCE % x 1.25 |
In the above example, the maximum ADP of the HCE group is 6.25%
(the NHCE average of 4.25% plus 2%). The test passes since the ADP
of the HCE group is 5.50% which is less than the 6.25% maximum.
Catch-up contributions (available to participants who are age 50
or older if permitted by the plan) that exceed a statutory limit or
plan-imposed limit are not included in performing the ADP test.
Also, compensation for plan purposes is subject to an annual limit
($225,000 for 2007 and $230,000 for 2008). For example, assume Harry
earned $300,000 in 2007 and deferred $20,500 (the maximum deferral
of $15,500 for 2007 plus the maximum catch-up contribution of
$5,000). His deferral percentage is calculated by dividing $15,500
(his deferral without the catch-up contribution) by $225,000 (the
compensation limit for 2007).
Employees Included in Testing
In performing the ADP test, all active and terminated employees
eligible to defer at any time during the plan year are included,
whether or not they actually made a deferral.
The following employees are included in the ACP test, regardless
of whether they received matching contributions or made after-tax
contributions:
- Active employees who have met the plan’s requirements to
receive a match as of the plan year-end being tested (e.g., if the
plan requires active employees to have more than 500 hours of
service during the plan year in order to receive matching
contributions, employees with less than 501 hours are not
included);
- Employees who terminated during the plan year being tested if
they met the plan’s requirements to receive a match (e.g., if the
plan requires 1,000 hours of service and/or employment on the last
day of the plan year, employees who have not met these
requirements are not included); and
- All employees eligible to make voluntary after-tax
contributions at any time during the plan year.
Plans that allow employees to participate before they reach age
21 or complete one year of service are permitted to exclude such
employees from the test if they are NHCEs.
If the plan covers both union and non-union employees, each group
must be tested separately.
Related Companies
Employees who work for a "related" company may also have to be
considered. Related companies are either part of a "controlled group
of corporations" or an "affiliated service group." Whenever an
individual who owns any portion of the sponsoring employer buys into
another business, the plan’s advisors should be notified so a
controlled group determination can be made. The same applies if
another company works together with the employer to provide services
to each other or to third parties which could constitute an
affiliated service group. These circumstances create important
issues that could affect the qualification of the plan.
Testing Methods
Two testing methods are permitted. The first method is current
year testing where current year deferral and contribution
percentages are used to compare the percentages of both HCEs and
NHCEs.
The other method is prior year testing where the deferral and
contribution percentages for NHCEs in the prior year are compared
with HCE deferral and contribution percentages in the current year.
The prior year testing method gives employers the ADP and ACP limits
for the HCEs in advance, which reduces the chance of a failed test
at year-end and the need for taxable refunds or other corrective
measures.
Whichever testing method is chosen, regulations require it to be
specified in the plan document. The testing method may only be
changed by amendment, subject to certain restrictions on changing
from current year to prior year testing.
Mechanics of Prior Year Testing
In the first year of a 401(k) plan, or the first year 401(k)
provisions are effective in an existing plan, a special rule applies
since there are no prior year percentages to use for the test. The
employer can assume a prior year percentage for the NHCEs of 3% for
both the ADP and ACP tests or use the actual results of the first
year’s test.
The second year, the maximum HCE percentage will be based on the
NHCE percentage from the first year. At the end of the second year
the test will be performed which will be used for two purposes:
- The average HCE percentage will be compared to the maximum
permitted average percentage (based on the NHCE percentage from
the first year) to verify that the maximum was not exceeded, and
- The NHCE average percentage will be used to determine the
maximum average HCE percentage for the third year.
Correcting Test Failures
Plans that do not pass the ADP and/or ACP tests must take some
action, such as making corrective distributions or additional
employer contributions.
Refund Deferrals/Matching Contributions
The most common method used to correct a failed ADP or ACP test
is to make corrective distributions of the excess deferrals or
contributions, plus earnings (in some cases, forfeiture of matching
contributions may be required).
Corrective distribution amounts (determined by a required
leveling method) are allocated among the HCEs based on the dollar
amount of their deferrals or contributions. If the plan permits
catch-up contributions and the participant is 50 or older and has
unused catch-up contributions remaining, the ADP refund is first
offset by the unused catch-up contributions.
These distributions must be made within 2½ months of the plan
year-end in order to avoid a 10% penalty (this deadline is extended
to six months for plans that meet the eligible automatic
contribution arrangement requirements). The final deadline for
making corrective distributions with the penalty is the last day of
the following plan year. For plan years beginning on or after
January 1, 2008, these distributions are taxable in the year in
which they are distributed (for plan years prior to 2008,
distributions made before the 2½-month period are taxable in the
prior year).
QNECs and QMACs
In some situations, a failed nondiscrimination test can be
corrected by having the employer make a "qualified nonelective
contribution" (QNEC) or "qualified matching contribution" (QMAC).
These additional employer contributions are made to NHCEs to
increase their ADP or ACP to the level needed for the HCEs to pass
the test. QNECs and QMACs are required to be immediately 100% vested
and subject to withdrawal restrictions. These contributions must be
deposited by the last day of the following plan year.
Conclusion
Nondiscrimination testing sounds complex--and it is. Gaining a
better understanding of this testing should help plan sponsors
appreciate the importance of providing complete and accurate census
data to their advisors.
Census information, including all employees, should be compiled
as soon as possible after the plan year ends so that
nondiscrimination testing can be performed accurately and any
corrective distributions can be made in a timely manner in order to
avoid the 10% penalty.
It is also important for business owners to be aware that related
companies may impact nondiscrimination testing and to disclose to
their advisors any and all ownership interests or service
affiliations. This will help ensure that the plan maintains its
qualified status.
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