401(k) Nondiscrimination Testing

 

Compliance tests, which are also known as nondiscrimination tests, are required to confirm that 401(k) plans do not favor highly compensated employees in comparison to nonhighly compensated (or rank-and-file) employees. These tests will confirm that employees who are not highly compensated employees are not disadvantaged when compared to those employees who are highly compensated employees.

Various areas of plan operation are tested, such as coverage (does the plan cover enough employees by not excluding certain groups or classes?); contribution amounts (do non-highly compensated employees get to contribute as much as highly compensated employees?); and finally, benefits, rights and features (does the plan offer the same options to all participants fairly?).

Each year, a 401(k) plan must complete specific nondiscrimination tests which are focused on deferral contributions and employer matching contributions. The test used to confirm that 401(k) deferral contributions are nondiscriminatory is called the actual deferral percentage test (commonly referred to as the ADP test). The test used to confirm that matching contributions are nondiscriminatory is called the actual contribution percentage test (commonly referred to as the ACP test).

The Code also provides for certain plan designs that, if adopted, provide for automatic compliance with the ADP and/or ACP standards (i.e., safe harbor 401(k) plans).

ADP/ACP Testing

Highly Compensated Employees

To perform the ADP test and the ACP test (if applicable), the employer first has to properly identify which participating employees are “highly compensated employees” (“HCEs”).

An employee is an HCE if he or she:

• Was a 5% owner of the company or business organization at any time during the current plan year or the preceding plan year; or
• Earned compensation from the employer in the preceding plan year in excess of a specified amount (which is adjusted each year).
  • For example, if an employee was paid more than $125,000 in 2019, the employee is a HCE for 2020. The plan may elect to limit the number of employees in this category to the top 20% of all employees when ranked by compensation paid for the year.

Employees who are not HCEs are categorized as “non-highly compensated employees” (“NHCEs”).

Calculate ADP

Generally stated, ADP is determined by dividing:

• The participating employee’s 401(k) deferrals under the plan (including Roth 401(k) contributions, but not including catch-up contributions) for the plan year being tested; by
• The employee’s plan compensation for the plan year. If an eligible employee did not choose to make deferrals to the plan, that employee’s deferral percentage is 0%.

The deferral percentages of the eligible employees in the HCE group are added together, and an average is calculated. This figure is the “HCE ADP” that is used in the ADP test.

Next, the deferral percentages of the eligible employees in the NHCE group are added together, and an average is calculated. This figure is the “NHCE ADP” that is used in the test.

A common misunderstanding is that only those participants who are actually contributing are considered participants for testing purposes, but the rules actually treat anyone who is eligible as a participant, even if he or she chooses not to contribute.

When performing the ADP test, the NHCE average used to establish the HCE maximum can be taken from either the current year (the year being tested) or the prior year. The plan document must state whether current year or prior year testing data will be used, and the IRS limits how often the testing year can be changed.

Calculate ACP

A calculation similar to that used to determine ADP is performed to determine ACP This is done by dividing:

• the employee’s matching contributions and after-tax contributions (if any) made to the plan for the plan year; by
• the employee’s plan compensation for the plan year. If an eligible employee did not choose to make contributions to the plan and received no matching contributions, that employee’s non-deferral contribution percentage is 0%.

The contribution percentages of the eligible employees in the HCE group are added together, and an average is calculated. This figure is the “HCE ACP” that is used in the ACP test.

Next, the contribution percentages of the eligible employees in the NHCE group are added together, and an average is calculated. This figure is the “NHCE ACP” that is used in the ACP test.

A common misunderstanding is that only those who are actually contributing are considered participants, but the rules actually treat anyone who is eligible as a participant, even if he or she chooses not to contribute.

When performing the ADP test, the NHCE average used to establish the HCE maximum can be taken from either the current year (the year being tested) or the prior year. The plan document must state whether current year or prior year testing data will be used, and the IRS limits how often the testing year can be changed.

ADP Test

The purpose of the ADP test is to set a limit on the ADP for the HCE group. Under the ADP test, the ADP for the HCE group may not exceed the ADP of the NHCE group by more than a specified amount, as follows:

• If the NHCE ADP is 0 to 2%, the HCE ADP cannot exceed 2 times the NHCE ADP.
• If the NHCE ADP is greater than 2%, but no more than 8%, the HCE ADP cannot exceed the NHCE ADP plus 2%.
• If the NHCE ADP is more than 8%, the HCE ADP cannot exceed 1.25 times the NHCE ADP.

If the ADP for the HCE group tests above these stated limits, then the plan fails the ADP test.

ACP Test

The purpose of the ACP test is to set a limit on the ACP for the HCE group. Under the ACP test, the ACP for the HCE group may not exceed the ACP of the NHCE group by more than a specified amount, as follows:

• If the NHCE ACP is 0 to 2%, the HCE ACP cannot exceed 2 times the NHCE ACP.
• If the NHCE ACP is greater than 2%, but no more than 8%, the HCE ACP cannot exceed the NHCE ACP plus 2%.
• If the NHCE ACP is more than 8%, the HCE ACP cannot exceed 1.25 times the NHCE ACP.

If the ACP for the HCE group tests above these stated limits, then the plan fails the ACP test.

Correcting Failed ADP or ACP Test

If a plan fails the ADP or ACP test, corrective action must be taken to avoid losing the plan’s tax-favored status. It is important that you check the plan document before any corrective action is taken to determine whether the plan requires a specific correction method to be used.

There are various methods for correcting testing failures that may be included in the plan document. Generally, the failed ADP and/or ACP test can be corrected by:

• Returning the excess HCE contributions that are causing the plan to fail the test back to the HCEs (in order to decrease the HCE percentage); or
• Contributing additional amounts to the NHCEs (in order to increase the NHCE percentage).

If the correction method involves refunding deferral contributions, the HCE may also have to forfeit matching contributions that are attributable to the excess deferrals. The plan must also return any income (or offset any net lost) allocable to excess deferrals and/or contributions which are refunded to the HCE.

Permitted Correction Period

If the ADP and/or ACP test results for a year require the refund of excess amounts to certain HCEs, these excess amounts generally must be refunded to such HCEs before 2 1/2 months after the end of the plan year. If the refunds are not made within 2 1/2 months (by March 15 for calendar year plan years), the employer must pay a 10% excise tax on the amount of the excess. 401(k) plans having certain eligible auto enrollment provisions have six months instead of 2 ½ months in which to avoid the 10% excise tax.

Top-Heavy Testing

Key Employee

A key employee is an employee, who at any time during the plan year containing the “determination date” is:

• A more than 5% owner of the employer in the current year;
• A more than 1% owner of the employer, having annual compensation greater than $150,000 in the current or previous year; or
• An officer of the employer, having annual compensation greater than $180,000 for 2019 (amount was $175,000 for 2018).

For the initial plan year, the “determination date” is the last day of the first plan year. For all subsequent plan years, the determination date is the last day of the prior plan year.

Example: An employer maintains Plan A, a 401(k) plan, in which key employees participate. For Plan A’s 2019 plan year, (a calendar year), the determination date is December 31, 2018. As of the determination date, the aggregate of the accounts of the key employees under the plan exceeds 60 percent of the aggregate of the accounts of all employees under the plan. Plan A is top-heavy for the 2019 plan year.

Certain Contributions

If a plan fails the top-heavy test for a particular year, it is considered to be a top-heavy plan, and it is required to make minimum contributions to non-key employees and to adhere to specific vesting requirements. Top-heavy plans must:

• Make a top-heavy contribution of up to 3% of compensation for all non-key employees participating in the plan that are actively employed on the last day of the plan year; and
• Adhere to one of two minimum vesting schedules:
  • Three-year cliff vesting – 100% vesting after three years of service, with no minimum vesting prior to that; or
  • Six-year graded vesting – 20% vesting after the second year of service, and an additional 20% vesting for each subsequent year, until 100% vesting is reached after six years of service.

The 3% required contribution is based on employee compensation, and must be made no later than the regular contribution deadline specified under the plan’s terms.

415 Testing

Code Section 415 limits the total amount of employer contributions, employee contributions (including 401(k) contributions), and forfeitures that can be allocated to a participant in a single year, and these amounts are referred to as “annual additions.”

The general limit for 401(k) plans is the lesser of 100% of the participant’s compensation or the dollar limit under the Code which is adjusted each year ($56,000 for 2019 and $55,000 for 2018). If the maximum dollar limit in effect for the year is less than the participant’s compensation, then the participant’s annual additions for the year are limited to that dollar amount. Because the limit is adjusted each year, it is important to develop internal control procedures for confirming the Code Section 415 limit each year.

For a 401(k) plan, if a determination is made that a participant’s annual additions exceed the 415 limit, corrective action must be taken as provided in the plan document. Typically, this requires a refund of part of the participant’s elective deferrals.

415 Testing: EPCRS

EPCRS makes it clear that a plan generally may use self-correction to correct excess annual additions so long as the excess annual additions for a year are “regularly corrected” by returning elective amounts to affected participants within 9½ months (previously 2½ months) after the end of the year to which the contributions relate. The IRS website provides additional information.

Minimum Coverage Testing

A. The Ratio Percentage Test: A plan passes the ratio percentage test if the percentage of NHCEs benefiting under the plan is equal to at least 70% of the number of HCEs benefiting under the plan. For purposes of the test, you may legally exclude certain classes of employees.
An employee is an HCE if he or she:

• Was a 5% owner of the company or business organization at any time during the current plan year or the preceding plan year; or
• Earned compensation from the employer in the preceding plan year in excess of a specified amount (which is adjusted each year).
  • For example, if an employee was paid more than $125,000 in 2019, the employee is a HCE for 2020. The plan may elect to limit the number of employees in this category to the top 20% of all employees when ranked by compensation paid for the year.

Employees who are not HCEs are categorized as “non-highly compensated employees” (“NHCEs”).

If a plan passes the ratio percentage test, then it passes Section 410(b) and there is no need to proceed to the average benefits test.

B. The Average Benefits Test: If a plan does not pass the ratio percentage test, then there is an alternative test – the average benefits test. To pass this test, the plan has to pass both of the following:

• Nondiscriminatory Classification Test; and
• Average Benefit Percentage Test.

B. 1. Nondiscriminatory Classification Test: To pass this portion of the average benefits test, the classification of employees benefiting under the plan must be shown to be both” reasonable” and “nondiscriminatory.”

• Reasonable classifications generally include:
  • Specific job categories (for example, secretaries, office staff, salespersons);
  • nature of compensation paid (e.g., salaried or hourly);
  • geographic location (e.g., specific office or factory);
  • specific company or division; and
  • similar bona fide business criteria.

• Excluding certain individuals by name — or creating artificial, excluded job descriptions for the specific purpose of preventing a particular person, or group of employees, from benefiting under the plan — are examples of classifications that would most likely be considered “unreasonable.”

Classifications are considered “nondiscriminatory” if they meet either:

• A coverage ratio equaling or exceeding the “safe harbor percentage” contained in IRS regulations; or
• A coverage ratio exceeding the IRS “unsafe harbor percentage,” provided the facts and circumstances for this classification:
  • Demonstrate “acceptable underlying business reasons”; and
  • Cover a representative number of employees in each salary range.

Because the facts and circumstances test is largely open to interpretation, most sponsors prefer to fit within the IRS “safe harbor percentage” contained in regulations.
To meet the nondiscriminatory safe harbor, the plan sponsor should calculate the NHCE concentration percentage, and then compare the actual coverage results to the IRS-provided table under Treasury Regulation 1.410(b)-4. Generally stated:

1. STEP ONE: Calculate the NHCE percentage by taking the total number of NHCEs in the controlled group and dividing that number by the total number of all employees in the controlled group.
2. STEP TWO: Compare the result in STEP TWO to the table contained in Reg. Section 1.410(b)-4.
3. STEP THREE: Multiply the safe harbor percentage rate from STEP TWO to the HCE coverage rate obtained from the ratio percentage test (see 3A, above). If the product of these two numbers exceeds your NHCE coverage rate from the ratio percentage test, then the plan passes part one of average benefit test.

B. 2. Average Benefit Percentage Test:Very broadly stated, this test requires that the rate of the benefits received by each of the NHCEs be averaged together and compared to the average rate of benefits received by the HCEs.

When the benefits are compared together, the aggregate benefit levels received by the NHCEs must be equal to at least 70% of the rate of benefits provided to the HCEs.

When performing the testing calculations for the average benefit percentage test, all contribution sources, such as 401(k) elective deferrals, matching contributions and profit sharing contributions (if any), are generally aggregated to produce a single benefit level for each employee.

If the plan has already passed the nondiscriminatory classification test (see above), and now also passes the average benefit percentage test, then it is deemed to have passed the minimum coverage rules under Code Section 410(b).]

Testing Failure

Treasury Regulations Section 1.401(a)(4)-11(g)(vii) provides that a plan generally may remedy Code Section 410(b) testing failures by means of timely adoption of a retroactive, corrective amendment.

Basically, such an amendment must provide that retroactive benefits (commonly known as (qualified non-elective contributions” or “QNECS”) will be provided to the group of NHCEs in an amount sufficient enable the plan to pass the test.

The corrective amendment must be adopted and implemented on or before the 15th day of the tenth month after the close of the plan year, in order to be effective for the preceding plan year (the year of the testing failure).]

Testing Data

Controlled Group

A “controlled group” of companies may exist when there is overlapping ownership between two or more companies or business organizations. There are two kinds of controlled groups:

• A parent-subsidiary controlled group; and
• A brother-sister controlled group.

A parent-subsidiary controlled group exists when one company owns 80% or more of a subsidiary.

A brother-sister controlled group exists when five or fewer individuals own 80% or more of two or more companies.

In some cases, ownership by a spouse, parent, child or grandchild may be combined to determine whether a controlled group exists.

The third-party administrator, accountant, or other person performing the testing will ask the employer to provide information regarding other companies in its “controlled group.” It is important that the employer accurately reports whether it is part of a controlled group, and its relationship between or among any such members, in order to provide complete census data needed for accurate testing.

Excludable Employees

A plan may statutorily exclude employees who have not attained age 21 and/or completed a “year of service.”

A plan also may exclude employees who are covered by a collective bargaining agreement that does not provide for participation in the plan, if retirement benefits were the subject of good faith bargaining.

Other examples of excludable employees include illegal aliens, employees of “qualified separate lines of business,” and certain terminating employees.
Employees excluded under any of the above categories may be treated as “excludable” for nondiscrimination testing purposes.

Although certain categories of employees may be excluded from participating in the plan (within legal limits) (for example, temporary employees), those excluded employees must sometimes be counted for nondiscrimination testing purposes. Since they will not “benefit” under the plan, they could cause the plan to fail the coverage testing for the plan.