If you administer Defined Contribution (DC) Plans, like a 401(k), you’re likely familiar with the rigorous compliance tests associated. One of the key jobs of compliance testing is to ensure your plan is not unfairly favoring highly compensated employees (HCEs). If 401(k) compliance testing determines your plan is unfairly favoring HCEs, you could face serious consequences ranging from IRS penalties to lost tax deductions or plan disqualification.
At Watkins Ross, we educate our clients on 401(k) compliance testing so they can be prepared and avoid common pitfalls in plan administration. It’s important to note that not all testing will apply to your plan. The testing your plan requires will depend on its design features (like whether or not it’s safe harbor) and the types of contributions made to the plan.
Below is a summary of the most common tests that keep a plan compliant.
Actual Deferral Percentage Test 401(k) (ADP)
The Actual Deferral Percentage Test 401(k) (ADP) is an annual test comparing the average salary deferral percentages of highly compensated employees (HCEs) to those of the non-highly compensated employees (NCHEs). To pass the test, the ADP of the HCE may not exceed the ADP of the NHCE by more than 1.25%. Another way to calculate this is that it may not exceed 2 percentage points or two times the NHCE ADP, whichever is less.
Read our blog here to learn more about what happens if you fail this test.
Actual Contribution Test 401(m) (ACP)
Similar to the ADP test, the Actual Contribution Test (ACP) is an annual test comparing the average employer matching percentages of the HCEs to that of the NCHEs. Again, the ACP of the HCE may not exceed the ACP of the NHCE by more than 1.25%, or the lesser of 2 percentage points or two times the NHCE ACP.
Top Heavy Test 416
The top-heavy test ensures that non-key employees receive a minimum benefit in a top-heavy plan. A plan is top-heavy if the total value of key employee accounts is more than 60% of the plan’s total assets on the last day of the prior plan year.
If the plan is deemed top-heavy, an accelerating vesting schedule and a top-heavy minimum employer contribution may be required.
415(c) Annual Additions
The 415 annual additions test determines whether the total amount of all the plan contributions that both the employee and employer made to the plan (including forfeitures), does not exceed a specified amount. This amount is either 100% of the participants’ compensation or the allowable limit for the plan year – whichever is less.
402(g) on Elective Deferrals
The 402(g) on elective deferrals test determines whether a participant’s elective deferrals (pre-tax and Roth) exceed the limit for the calendar year. This limit is determined annually by the IRS and applies at an individual not a plan level.
401(a)(4) General Nondiscrimination Testing
The purpose of the general nondiscrimination test is to ensure that HCEs are not receiving more benefits than NHCEs.
410(b) Minimum Coverage Requirements
To be qualified, the plan must pass one of two tests: the Ratio Percentage Test or the Average Benefits Test.
Ratio Percentage Test
To pass the Ratio Percentage Test, the ratio of NHCEs who are benefitting from the plan compared to HCEs benefitting from the plan must be at least 70%.
Average Benefits Test
The Average Benefits Test permits a plan that would not otherwise pass the Ratio Percentage Test to satisfy coverage if the average benefit to NHCEs is at least 70% of the HCEs’ average benefit.
Catch-Up Contributions 414(v)
Eligible participants are allowed catch-up contributions, or additional deferrals that exceed standard IRS, plan, or testing limits. Participants who are at least 50 years old by the end of the calendar year are eligible for catch-up contributions. Participants who are 60-63 years old are eligible for higher catch up limits.
Easily Prepare for Compliance Testing
While 401(k) compliance testing may feel overwhelming, it serves a valuable purpose: To safeguard your employees from unfair discrimination. Even if unintentional, discrimination within DC plans can have serious consequences leading to penalties and more. Plus, it keeps your business honest and professional.
At Watkins Ross, we help our clients prepare for compliance testing, making sure they understand what’s being identified and how to avoid issues.
Do you have questions about 401(k) compliance testing, or other compliance-related procedures? Contact us today to book an appointment with one of our licensed and experienced team members.
