One of the primary requirements of a qualified plan is that it passes a myriad of compliance tests and limits. These tests focus on nondiscrimination and contribution limitations.
Let’s start off with a few brief definitions:
Highly Compensated Employees (HCE) – Participants whose salary was above the highly compensated Employee limit set by the IRS in the previous plan year or who was a greater than 5% owner in current or previous plan year.
Non-Highly Compensated Employees (NHCE) – Does not meet HCE criteria
Key Employee – 1) An officer with wages in excess of $130,000 (Indexed by IRS), 2) owns more than 5% of plan sponsor, 3) owns more than 1% of plan sponsor and has wages in excess of $150,000
Below are a list of tests and their primary purpose:
Actual Deferral Percentage (ADP) test (401(k) nondiscrimination) and Actual Contribution Percentage (ACP) test (match nondiscrimination)– these tests focus on the differences in the average deferral and match rates of the HCE’s and NHCE’s in a 401(k) and 403(b) (ACP only) Plan. The ADP and ACP tests are separate tests, but are performed under similar parameters. The margin of difference between the HCE and NCHE groups vary:
|NHCE Average Deferral/Match Rate||HCE Average
Deferral/Match Rate Limit
|Less than 2%||NHCE Average Deferral Rate/Match x 2|
|Between 2% and 8%||NHCE Average Deferral Rate/Match + 2%|
|Above 8%||NHCE Average Deferral Rate/Match x 1.25|
If the plan fails the test, corrective measures must be taken: Either 1) the HCE’s would be required to receive a refund or 2) Plan Sponsor must make a fully vested Qualified Non-Elective Contribution to the NHCE’s.
The ADP test is waived if a Plan Sponsor commits to a fully vested Safe Harbor contribution 30 days before the later of the beginning of the plan year or the implementation of 401(k) provisions.
A Safe Harbor plan must either contribute 1) a fully vested 3% nonelective contribution (independent of whether participant is contributing) or 2) a minimum match if 100% of deferrals up to 3% of wages plus 50% of deferrals from 3% to 5% of wages. An annual notice must be sent to all participants 30 days prior to plan year stating commitment to Safe Harbor contribution. Additional fixed or discretionary matching contributions are permitted without the ACP testing requirement. If fixed or discretionary match contributions match at a level % and do not match on wages above 6% and the discretionary match amount does not exceed 4% for any one participant’s wages, then the ACP testing requirements are waived. Fixed contributions are contributions that are designated in the plan document and Summary Plan Descrption. Discretionary contributions are decided by a resolution during plan year or after plan year end but before the company’s tax deadline.
A plan sponsor can also avoid Top Heavy (see below) contribution requirements if no additional employer contributions are made beyond the ADP and ACP contributions.
Compensation Test – If the plan uses a Safe Harbor definition of compensation, no compensation test is required. Some permitted exclusions are 1) compensation earned prior to becoming eligible for plan, 2) deferred compensation, including 401(k) contributions, and 3) severance pay. However, if your definition of compensation excludes bonuses, commissions or overtime, you may have to perform a compensation test. This test focuses on the average percentage of compensation used for the plan compared to the gross compensation. The comparison of the average percentage compensation of the HCE’s versus the NHCE’s should not vary more than a “de minimis” amount. This is not clearly defined by the IRS, but it appears that the NHCE/HCE compensation ratio should be at or above 97%.
Coverage Testing – Coverage testing is meant to focus on whether a plan is discriminating with regard to who is “benefitting” under the plan. For example, you can’t have a stand alone plan where you allow only HCE’s to benefit. Most plans will not have an issue with this test. If the plan does not exclude certain groups of employees, then the plan will typically pass this test. However, especially in a small plan with last day requirements for employer contributions, this test could fail. To correct a test, you need to amend the plan to allow more participants to receive benefits/contributions.
There are two ways to pass this test: 1) ratio test or 2) average benefits test. The average benefits test is complicated and is beyond the scope of the intentions of this website. For further details contact our office. The ratio test basically says that the NHCE/HCE ratio of the % of benefitting participants versus all eligible participants be at or above 70%.
Cross Testing/New Comparability – Most plans use a Safe Harbor profit sharing allocation. Typical Safe Harbor allocation methods are pro rata based on wages (i.e. same % of compensation for all participants) or integrated with Social Security Taxable Wage Base. However, you can design a plan that allocates a profit sharing skewed more to the HCE’s provided it passes an age and wage based test known as cross testing.
Top Heavy – If more than 60% of the plan’s assets are attributed to the Key Employees at the end of prior plan year, the plan is top heavy in the current year and may owe a profit sharing contribution up to 3% of compensation for each non Key Employee.