401k plan testing may create extra paperwork, but it is essential in order to keep the plan qualified. If you are a plan fiduciary you will want to be familiar with the different compliance tests, what they measure, how to avoid failing the tests, and what the consequences are for failing compliance testing.
The government actually created these tests with fairness in mind. But they didn’t make the rules all that easy to follow. Compliance testing is full of nuances and important definitions. However, you shouldn’t worry or be overwhelmed. You can avoid problems by being proactive or by hiring an expert Third Party Administrator to perform the tests for you.
The reason you want to have at least a minimal working knowledge of the testing process is that the consequences for failing the testing could include penalties, fees, plan disqualification, and possibly refunds of plan contributions made to certain employees (including yourself). Those are all financially painful penalties!
If you don’t pay attention to the 401k testing process you could find yourself in a very expensive and stressful mess!
In addition to knowing that you can receive help with performing 401k compliance tests, you should also know that you automatically pass many of the required tests (ADP/ACP and top-heavy tests) by establishing a Safe Harbor 401(k) plan.
Employees Are Classified Differently
Before diving into the testing, let’s make sure to define the different players that will be the subject of the testing.
A key employee is an employee that, at any time during the plan year (even if deceased now):
- Owned 5% or more of the company
- Owned 1% or of the company and had actual compensation of more than $150,000/yr
- Is an officer and makes over $180,000/yr for 2019
HCEs-Highly Compensated Employees
Is determined from ownership status and/or income. An HCE is an employee that at any time during the plan year:
- Owns 5% or more of the company that sponsors the workplace retirement plan, regardless of actual compensation
- Makes more than $125,000 in 2019
- Is designated by the employer to be in the top 20% of employees in terms of compensation (even if actual compensation is below $125,000)
When it comes to determining ownership (for both key employees and HCEs), aggregation rules must be considered. IRS aggregation rules treat anyone that is a “spouse, child, grandparent or parent of someone who is a 5% owner, or who, together with that individual, would own more than 5% of a company’s stock as a 5% owner.”
As you can see, it is possible that a person covered under the plan is both an HCE and a key employee. Or, an employee could be an NHCE and key employee through aggregation ownership.
NHCEs-Non-Highly Compensated Employees
An employee that does not meet HCE status.
Non-Discrimination & Compliance Testing
What Is The Purpose Of 401k Discrimination Testing?
Each of the 401k compliance tests has a specific purpose and goal. But more generally, the tests are designed to see if the majority of employees covered by a given plan is benefitting, or only a select few (namely those that make more money). In other words, does the plan discriminate against the more rank-and-file employees? Part of the testing is literally called non-discrimination tests, and it’s all about the money.
The government wants to make sure that the “little guys” are encouraged to save and contribute to their retirement savings. It’s easy to see how well-compensated employees could max-out contributions to their plan. But what about the NHCEs?
It’s much more challenging to sock away money when compensation is low and life’s expenses are calling. Historically, HCEs had a much easier time making contributions to a plan and received larger tax breaks. The solution? The IRS installed rules and regulations as well as developed tests to calculate how much HCEs and NHCEs contribute to their 401k.
In fact, if NHCEs have low participation in a workplace 401k, the results of the test will be such that the contributions of HCEs could be forced to be reduced to below the yearly 401k maximum contribution limit allowed by the IRS.
Why Would NHCEs Not Participate?
NHCEs may have low participation in retirement plans because they lack knowledge about the plan or the importance of saving for retirement. They may think retirement is too far away to worry about now, think that saving is futile, or generally not care very much about it.
401k plan testing does something very highly beneficial for everyone. Testing encourages the employer to incentivize their employees to contribute more to their retirement plan. With higher NHCE participation, HCEs may enjoy larger contributions and the employer will get to keep a qualified plan and enjoy the associated tax breaks.
Nondiscrimination tests include the ADP, ACP, and top heavy tests. Limit tests include the coverage tests and participant limit tests. In short, these tests help to ensure that the plan meets all of the legal standards, protecting both plan sponsors and the plan participants.
401k Plan Coverage Testing
Purpose: To ensure that an adequate number of NHCEs are covered by the 401k plan. Coverage will be compared to HCEs.
|Minimum Coverage Test|
# of NHCEs benefited by 401k __________________________
Total # NHCES employed
= NHCE ratio
# of benefited HCEs__________________
Total # of HCEs
= HCE ratio
NHCE ratio from above__________________
HCE ratio from above
= Ratio percentage
Must be equal to or greater than 70%
Actual Deferral Percentage (ADP) And Actual Contribution Percentage (ACP) Tests
Let’s look at ADP and ACP together since the IRS gives a threshold—or range—of allowable results that can be applied to both tests.
Purpose: To determine if discrimination exists between the actual pre-tax or Roth contributions made to the respective 401k plan types by HCE employees compared to that of NHCE employees. The ADP and ACP are similar but calculate different numbers.
The ADP test compares average contributions (salary deferrals) made by employees to their plan. Whereas the ACP test compares average contributions made by the employer (such as a company match) on behalf of the employee.
When calculating ADP/ACP make sure to include all eligible employees, even if they are not making any contributions, as is the case with Sarah in our hypothetical example below. Also of note is that catch-up contributions are not included in the calculations.
For the ADP/ACP use data from the most recent full year of the plan.
Let’s look at an example to make sense of all of the above definitions:
|Employee||Income||% Income Deferred||$ Amount Deferred||Company Match (50% of first 4%)||ACP Calculation:Match/Income|
|Juan (NHCE)||$35,000||5||1,750||$700||700/35,000= 2%|
|Debbie (HCE)||$170,000||10||17,000||$3,400||3,400/170,000= 2%|
|ADP Calculation:Average of % deferred||ADP|
|NHCEs||(0+5+7)/3 = 4%|
|ACP Calculation:Average of % contributed by employer||ACP|
|NHCEs||(0+2+2)/3 = 1.3%|
Do the 401k ADP/ACP tests above pass? Now we have to look at the allowable limits.
|ADP or ACP Calculated NHCE Average %||Maximum AllowableHCE Average %|
|<2%||2 x NHCE Rate|
|2% – 8%||2% + NHCE Rate|
|Over 8%||1.25 x NHCE Rate|
Using the table above let’s look at the ADP results. For the NHCE group, the ADP was 4%. 4% is between 2% and 8% so the maximum allowable ADP for the lone HCE in the group would be 2% + 4% = 6%. Our example 401k fails the ADP test since the HCE ADP was 10%, well above 6%.
Using the same table, let’s evaluate the ACP. The ACP for the NHCE group was 1.3%, therefore, the max HCE must be within 2x the NHCE rate. 2x 1.3% = 2.6%. The 401k passes the ACP since the HCE ACP is below 2.6%.
Correcting A Failed ADP Or ACP
The IRS gives plan sponsors 2.5 months (by March 15th) after the plan year to correct excess contributions. Refer to the IRS Fix-it guide for detailed help, but if the employer “doesn’t distribute/recharacterize excess contributions by 2 ½ months…after the plan year of excess, the employer is liable for a 10 percent excise tax on excess contributions.” The tax can be avoided by making certain contributions to employees’ plans.
Essentially, you have a few options in order to correct the failed ADP/ACP. The most common is to refund the excess contributions made by HCE to the point of achieving passing ADP/ACP results. This will result in the HCE receiving the excess contributions and will count as taxable income and will most likely result in disgruntled HCEs.
HCEs that do receive a refund will have to report it on a 1099-R and must be notified that the refund is not “eligible for a favorable tax-free rollover.”
Another option for correcting a failed ADP/ACP is to make a Qualified Nonelective Contribution (QNEC) on behalf of the NHCEs in order to elevate their averages in the calculations and pass the tests. By making QNECs based on the most recent year of the plan, the employer can avoid paying the 10% excise tax but the employer must make sure that the QNECs will correct the failed test, otherwise, the tax will be applied. QNECs are always 100% vested. An employer could also do a combination of refunds to HCEs and QNECs to NHCEs.
If the employer doesn’t correct failed ADP/ACP tests in the 12 months following the failed tests, they still have to correct the tests and can do so by making QNECs.
How Large Will The HCE Refund Be?
That is going to depend on the numbers and the actual dollar amounts of contributions made to the plan. Those that contributed the most to their plan will receive a refund first and may be larger than other refunds. At the same time, the employer may have to make non-elective contributions to NHCEs as well with the overall goal being to shift refunds and contributions toward more even averages so that the ADP/ACP tests pass.
What If The Plan Allows For Catch-Up Contributions?
If an HCE is going to receive a refund due to an employer failing ADP/ACP tests and the same HCE was also eligible to make catch-up contributions (because the HCE is over 50 years of age), then the refund can be re-characterized as a catch-up contribution as long as the HCE has not already surpassed the catch-up limit for the year.
Avoid Failed ADP/ACP tests
There are a few things you can do in order to avoid failing nondiscrimination tests:
- Increase NHCE participation in the plan
- Run mid-year projection tests
- Consider a Safe Harbor 401k
- Set a cap on HCE deferrals (however, this would limit the HCE’s ability to take full advantage of the plan)
Top Heavy Test
The top-heavy test compares the balance of assets of the accounts of all key employees against the balance of all employees under the plan. A plan is deemed as top heavy if the total value of the balances of key employees exceeds the total plan value of all employees by more than 60%.
The total values of the accounts on the determination date are used in the calculation. The determination date is the last day of the plan year immediately prior to the plan year being tested. If you were testing 2018’s plan, the determination date would be December 31, 2017. If 2019 is the first year of the plan, then you would use the total values present on December 31, 2019.
Recall that when determining who is a key employee, family aggregation rules apply, as explained above. Before calculating, make sure to make the following adjustments:
Subtract from the total plan value
- Any non-related rollovers into your plan
- Amounts of employees that did not work during the plan year
- Amounts of any employee that is no longer a key employee, but was once one
Add back into the total value for calculation purposes:
- Termination distributions made in the 12 months prior to the determination date
- All in-service distributions made in the 5 years prior to the determination date
If the ratio between the sum of the key employees’ balances divided by the entire plan balance is more than 60%, then the plan is considered to be top heavy.
A Failed Top Heavy Test
Many small family-run businesses may have the problem of having top heavy plans since many of the family members will be considered key employees and may outnumber a small group of additional employees. A plan with very low non-key employee participation may also easily become top heavy.
If your plan is considered to be top heavy you generally have to make contributions to the plans of non-key employees. Typically, contributions are 3% of compensation and must be placed on a vested schedule so that the contributions are 100% vested in 3-6 years (3-year cliff or a 6-year graded schedule).
As long as the top-heavy error is considered minor, or insignificant, the employer can self-correct the top-heavy nature of the plan by making employer contributions to non-key employees. If the top-heavy failure is deemed to be significant, then usually the plan must work directly with the IRS in order to correct the top-heavy status which can occur under a Voluntary Correction Program (VCP) or via an audit.
Participant limit testing
This is a much simpler test that takes into consideration the annual plan addition limits and the elective deferrals limits. The 2019 elective deferrals limit is $19,000 with an additional $6,000 catch-up if over age 50. The annual plan addition limits take into account the sum of all employee plus employer contributions such as employer matches or recharacterizations.
The 2019 limit for annual additions is the lesser of:
- 100% of employee compensation
- $56,000 ($62,000 including catch-up contributions)
Plan sponsors should be monitoring plan participants so that they don’t surpass these values, and that if they do exceed the limits, ensure that refunds are promptly executed in order to avoid a double taxation (once in plan year for having exceeded the limit, and again the next year when removed from the account in the case of delayed refund). It would be best to not allow over-contributions in the first place.
401k testing is without a doubt a confusing and daunting administrative task. You should educate yourself well on the topic, even if you decide to hire a third-party administrator to perform the testing.
Many tests can be passed by finding ways to increase the contributions made by NHCEs. If NHCEs participate more in the plan, HCEs are less likely to be limited, discrimination tests are more easily passed, and the plan will remain qualified. All parties would benefit from that scenario.
If you have any questions regarding 401k compliance testing please reach out to my team. We are happy to help you create and manage the best 401k possible!