If your company offers a retirement plan, you know the IRS offers tax breaks in return. However, those tax breaks come with a caveat: your plan can’t be solely for owners and top executives. It needs to include a “fair share” of your regular employees too.
That’s where Coverage Testing, from IRS Code Section 410(b), comes into play.
What is Coverage Testing?
Each year, the IRS requires companies offering retirement plans to pass a series of compliance tests. Think of it as a yearly checkup for your plan.
The coverage test is one of the tests you’ll need to prepare for in order to pass the annual compliance testing. This test ensures your plan is fair and accessible to a majority of employees, not just the higher-ups.
The Magic Number: 70%
In general, a plan passes coverage testing if at least 70% of eligible employees are covered or eligible to benefit, or if a specific percentage of non-highly compensated employees (NHCEs) are covered.
At its core, the coverage test compares two employee groups:
- Highly Compensated Employees (HCEs): The owners and employees with the highest salaries.
- Non-Highly Compensated Employees (NHCEs): Everyone else.
In simple terms, if 100% of your HCEs are benefiting from the plan, at least 70% of your NHCEs must also benefit. If the percentage of covered NHCEs is at least 70% of the percentage of covered HCEs, you’re good to go!
What Does “Benefiting” Mean?
In a defined contribution plan, an employee is “benefiting” from the plan if they’re allowed to make contributions (even if they choose not to) or if they are eligible for employer contributions. In a defined benefit plan, an employee is benefiting if they accrue a meaningful benefit during the plan year.
Two Ways to Test Coverage Compliance
There are two main ways to confirm your plan meets the required ratio percentage for coverage:
- The Ratio Percentage Test: This compares the percentage of non-HCEs who can participate in the plan to the percent of HCEs who can participate.
- Average Benefits Test: This test looks at the average benefit HCEs receive compared to NHCEs.
The Ratio Percentage Test
The Ratio Percentage Test is the most common way to prove coverage compliance. To confirm your plan’s compliance, your Third-Party Administrator (TPA) will:
- Figure out what percent of your non-HCEs are eligible.
- Determine what percent of your HCEs are eligible.
- Divide the non-HCE percentage by the HCE percentage.
If that ratio is 70% or higher, your plan passes. For example, if 100% of HCEs and 70% of NHCEs are eligible, you meet the coverage testing requirements.
The Average Benefits Percentage Test
If your plan doesn’t pass the Ratio Percentage Test, the Average Benefits Test (ABT) offers another way to demonstrate compliance. It is often considered a “last chance” to show that the plan does not favor highly compensated employees (HCEs).
Unlike coverage testing, where “benefiting” simply means being eligible to participate, the Average Benefits Test looks at the actual value of benefits employees receive from all retirement plans offered by the employer. This typically includes employer contributions, such as matching or profit-sharing contributions, expressed as a percentage of each employee’s compensation.
The test checks whether the average benefit received by non-highly compensated employees (NHCEs), relative to their pay, is reasonably close to what highly paid employees receive.
For example, the table below shows employer contributions as a percentage of pay:
| Employee Group | Salary | Retirement Benefit | Benefit % |
| Highly Compensated | $200,000 | $10,000 | 5% |
| Non-Highly Compensated | $60,000 | $2,700 | 4.5% |
Even though the dollar amount for the executive is much higher, the percentages are close. As long as the average benefit for NHCEs is at least 70% of the HCE average benefit percentage, you pass the test.
Who Automatically Passes Coverage Testing?
A plan will automatically pass coverage testing if:
- There aren’t any NHCEs to include
- No HCEs benefited from the plan during the year
- The plan is just for union employees
- Your business went through a merger or acquisition and qualifies for the IRS transition relief rule (also outlined in IRS Code Section 410(b))
When Does Coverage Testing Get Complicated?
While the 70% rule may sound straightforward, certain business situations can make coverage testing a little tricky.
Related Employers
If your company is part of a larger group of businesses, for example, a parent-subsidiary company or companies with common ownership, you can’t just look at one company in isolation. Coverage testing looks at all employees from every business in the group, not just the employees of the company that sponsors the plan.
Mergers and Acquisitions
If your company goes through a merger, acquisition, or any major change in structure, the mix of employees can shift quickly. This means your plan may suddenly develop gaps in coverage. After these types of changes, employers will need to review and possibly redo their coverage testing to make sure the plan still meets the 70% coverage ratio.
Different Contribution Types
Many plans offer multiple types of contributions, like salary deferrals, employer matching contributions, and profit-sharing. Because each contribution type may have different eligibility requirements, the IRS might require separate coverage tests for each one. This means a plan could pass coverage testing for employee deferrals but still need additional testing for employer match or profit-sharing contributions.
What If Your Retirement Plan Fails Coverage Testing?
If your plan fails coverage testing, there is no need to panic. However, it’s important to act quickly to bring the plan back into compliance. Your Third-Party Administrator can help identify the cause of the failure and recommend the best correction.
Common remedies include:
- Expanding eligibility: Allow more NHCEs to participate in the plan by adjusting waiting periods or service requirements.
- Increasing employer contributions for NHCEs: Make additional employer contributions through profit-sharing or corrective contributions.
- Adjusting plan design: Revise eligibility rules or contribution formulas.
- Using the Average Benefits Test: If the plan fails the Ratio Percentage Test, it may still satisfy the Average Benefits Percentage Test requirements.
Remember, although your TPA usually runs the calculations, you are responsible for providing accurate data. Regular, annual reviews of your workforce and plan design before year-end are the best way to avoid surprises and reduce the chance of future testing problems.
The Key to Keeping Your Plan Fair and Compliant
Keeping your plan compliant does more than just satisfy IRS rules. It ensures you provide a fair and valuable benefit to your entire team. By reviewing your workforce changes and plan design throughout the year, you can spot potential gaps long before testing deadlines approach.
At Watkins Ross, we work with employers to help them better understand the requirements that affect their retirement plans. Our team can help you identify potential coverage issues early and then guide you through the steps needed to keep your plan running smoothly.If you have questions about 401(k) coverage testing or other retirement plan compliance requirements, contact Watkins Ross today.
