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Commentary

401K Compliance Testing Rules

Introduction

Minimum Standards of Coverage

Nondiscrimination Requirements
-- Actual Deferral Percentage (ADP) Testing
-- Actual Contribution Percentage (ACP) Testing
-- Top Heavy Testing

Using Your Plan Administration Software to Run Compliance Tests
-- End of Year Top Heavy Testing

Correcting ADP or ACP Test Failures
-- Correction BEFORE the End of the Plan Year
-- Correction AFTER the End of the Plan Year

Option to Plan Testing: The Safe Harbor Method of Plan Administration
-- Decision Deadlines
-- 1,000 Hours/Last Day Rules
-- Quitting the Safe Harbor Method

Excluding Recent Hires in Nondiscrimination Testing

A Note About Plan Testing and Auto Enrollment




Introduction

401k plans were created by the U.S. Government to allow persons, especially middle- and lower-income persons, to save for retirement. Therefore, the Government was particularly concerned that 401k plans not favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs), and established nondiscrimination rules to promote fairness. There are four basic nondiscrimination requirements:

1. The 401k plan must meet certain minimum standards concerning coverage of employees.
2. The plan must not discriminate in favor of highly compensated employees with respect to contributions, benefits, or other rights and features of the plan.
3. A plan that is top heavy must meet additional rules concerning the vesting of benefits and minimum contributions or benefits.
4. The amount of compensation considered by a plan in calculating contributions or benefits for a participant is limited. These limits are set annually -- for 2001, for instance, the limit was $170,000 and for 2002 it was $200,000 -- and are part of your year-specific plan administration software.

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Minimum Standards of Coverage

The minimum coverage rules require the employer to make the plan available to a cross-section of employees. Your 401k plan must satisfy either of two tests: the ratio percentage test or the average benefits test

A plan meets the ratio percentage test for a plan year if the percentage of NHCEs benefiting under the plan is at least 70% of the percentage of HCEs benefiting under the plan.

A plan meets the average benefits test if it satisfies two sub-tests: the nondiscriminatory classification test and the average benefit percentage test. The nondiscriminatory classification test is satisfied if the 401k plan benefits a class of employees established by the employer that is both reasonable and nondiscriminatory. The average benefit percentage test is satisfied if the average benefit percentage of the 401k plan for the plan year is at least 70%.

As a practical matter, all employees who are eligible to participate in a 401k plan, whether or not they join the plan, are considered to be “benefiting” under the plan. It is a rare situation where less than 70% of the non-highly compensated employees are not eligible to participate in a plan.

401k Tip

Mutual fund 401(k) plans have been aggressively promoted to the small business communities both by no-load fund companies (e.g., Fidelity Funds, Vanguard Funds) and load fund companies (e.g., MFS, John Hancock, Putnam). recent new articles, however, have reported a trend among many of these plan vendors to abandon the very small plans because the costs of providing 401(k) services for such plans versus the revenue generated from them has proved to be a losing proposition. For economic reasons, the sales target for mutual fund bundled plans has been raised, and now companies with fewer than 100 employees are not being actively solicited by most of these vendors. One company that has enjoyed the benefits of a 401k using no-load mutual fund investments is Target Labs (www.targetlab.com) a small employer.

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Nondiscrimination Requirements

The IRS requires that testing be conducted annually to ensure that highly compensated employees are not benefiting substantially more than non-highly compensated employees. A plan must pass the tests as of the last day of each plan year.

The definition of a highly compensated employee changed in 1997. A highly compensated employee is now defined as an employee who is a member of either of two groups:

  • A 5% owner at any time during the determination or lookback year (see the Glossary for definitions of determination and lookback years)
  • An employee who earned more than $85,000 (in 2001) during the lookback year and is in the top 20% of all employees ranked by W-2 compensation in the lookback year

A non-highly compensated employee is any eligible employee who does not meet the definition of a highly compensated employee.

To ensure that a 401k plan conforms to the nondiscrimination requirements, two tests must be performed: the actual deferral percentage (ADP) test, which is performed on the employee salary deferrals, and the actual contribution percentage (ACP) test, which is performed on the employer matching contributions. There are also "safe harbor" options that eliminate the need for ADP and ACP testing (see Safe Harbor Options at the end of this chapter).

The amount of salary deferrals HCEs may make and the amount of matching contributions HCEs may receive is based on the amount of deferrals and matching contributions made and received by NHCEs. The averages for the HCE group may not exceed the averages of the NHCE group by more than a specified amount, as follows:

If the NHCE average is… The HCE maximum average may equal the NHCE average…
0 - 2% times 2
2 - 8% plus 2%
8% or greater times 1.25

The averages are determined by adding the deferral or matching percentages for all eligible employees in the group and dividing by the number of eligible employees in the group. As a result, eligible employees who do not choose to defer will reduce the average. In the NHCE group, a reduction in the average deferral amount reduces the amount that HCEs may defer.

Fortunately, your plan administration software runs the ADP and ACP tests for you (along with top heavy tests) as often as you wish, and allows you to see the results any time during the plan year, so that if a problem trend appears, your company can do something about it before the end of the year. Failure to correct a failed year-end test by the close of the following plan year can result in penalties and possible disqualification of your company's plan.

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Actual Deferral Percentage (ADP) Testing

Any eligible employee can contribute up to the maximum amount allowable by law per year, but how much each actually contributes is the thing that interests the IRS. Specifically, the agency does not want to see highly compensated employees contributing substantially higher portions of their income than do lower compensated employees. The contributions used for ADP testing include 100% vested contributions.

The ADP test passes if the ADP for the highly compensated employees does not exceed the greater of:

1.25 times the ADP of the non-highly compensated group, or

Two percentage points above the ADP of the non-highly compensated employee group, not to exceed two times the ADP of the non-highly compensated employee group.

The ADP for each group of employees (highly compensated and non-highly compensated) is the average of the actual deferral ratios (ADRs) for the employees in that group. The ADR is calculated by dividing each participant's salary deferral contributions made during the plan year by his or her gross compensation for the plan year. An employee who is eligible but chooses not to defer a portion of salary is included in the calculation with an ADR of zero.

The maximum ADP for the highly compensated employee group for the current year may be determined by reference to the ADP for the non-highly compensated employee group calculated for the "preceding plan year." The individuals taken into account in determining the preceding year's ADP for non-highly compensated employees are those individuals who were non-highly compensated in the preceding year, even if their status has changed in the current year.

Based on information input into your plan administration software, the system calculates whether or not the plan passes the ADP test. During the first nine months of the plan year, your plan administration software uses estimated data, and during the last quarter of the year, actual data. See below, Using Your Plan Administration Software to Run Compliance Tests.

Actual Contribution Percentage (ACP) Testing

The ACP is performed in the same way as the ADP test, and the parameters for passing are the same. The ACP for each group of employees (highly compensated/non-highly compensated) is the average of the actual contribution ratios (ACRs) for the employees in that group. The ACR for each employee is the ratio of his or her employer match to their compensation for the year, expressed as a percentage. As with the ADP test, an employee who is eligible but receives no match is included in the calculation with an ACR of zero.

NOTE…If your company is making employer matching contributions and having them immediately fully vested to participants' accounts, your plan administration software will categorize the contributions as "qualified matching contributions" and correctly include them in the ADP test rather than ACP test.

The maximum ACP for the highly compensated employee group for the current year may be determined by reference to the ACP for the non-highly compensated employee group calculated for the "preceding plan year." The individuals taken into account in determining the preceding year's ACP for non-highly compensated employees are those individuals who were non-highly compensated in the preceding year, even if their status has changed in the current year.

Based on information input into your plan administration software, the system calculates whether or not the plan passes the ACP test. During the first 9 months of the plan year, your plan administration software uses estimated data, and during the last quarter of the year, actual data. See below, Using your plan administration software to Run Compliance Tests.

Top Heavy Testing

Certain plans that do not have discriminatory benefit formulas may still provide the majority of plan benefits to highly paid employees or owners of the company because, for example, they are the only participants with long service. These plans run the risk of being categorized as "top heavy plans." The IRS considers a plan "top heavy" if the account values for key employees exceed 60% of the account values for all employees; it is "super top heavy" if the percentage exceeds 90%. (See the Glossary for a definition of key employee.)

If a plan becomes top heavy it is required to provide a minimum contribution to all non-key employees. The minimum contribution amount is based on how much key employees have contributed to the plan -- out of their own salary OR in the form of employer contributions -- during the year:

If key employees are contributing 3% or more, a 3% (of salary) contribution must be made to each eligible non key employee.

If key employees are contributing less than 3% but more than 0%, a contribution equal to the highest contribution percentage of any key employee must be made to each eligible non key employee.

If the key employees do not contribute anything for a full year, then there is no contribution requirement to non key employees for the year.

An appropriate top-heavy vesting schedule must be applied to any top-heavy contributions. Please consult your 401k Adoption Agreement item E4: Top Heavy Testing if you do not remember the vesting schedule chosen for your plan should it become top heavy.

If an employee is hired during a year that the plan becomes top heavy and the employee is not eligible to participate in the plan for the full year, their full salary IS still considered in the top heavy calculations.

Salary deferrals made by key employees are counted in determining their contribution percentage. But salary deferrals made by non-key employees are not counted in determining if a non-key employee has received a top heavy minimum contribution.

Generally, employer matching contributions may not be used to satisfy the minimum contribution requirement; however, qualified nonelective and employer discretionary profit sharing contributions may be.

Once you have identified the key employees, your plan administration software calculates whether or not your plan passes the top heavy test (see below).

Accelerated vesting is required for top heavy plans. If yours is a new plan, the available vesting schedule meets the top heavy requirements. If your plan is a restatement of an existing plan, a vesting schedule that complies with the top heavy requirement will have to have been elected in the adoption agreement in case the plan becomes top heavy. Please refer to your 401k Adoption Agreement for specifics.

Once a plan becomes top heavy, the top heavy vesting schedule will continue to apply until the plan is amended, even if the plan later stops being top heavy.

Top heavy testing must take into account all the plans your company maintains. If necessary, this complex issue should be discussed with your company's tax or legal advisor.

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Using Your Plan Administration Software to Run Compliance Tests

Your plan administration software performs the following critical IRS-mandated tests:

Top heavy testing

ADP compliance test of employee contributions

ACP compliance testing of employer matching contributions

Multiple use testing (which, as of January 1, 2002, is no longer required and will be phased out in post-2002 versions of the software)

Testing results are based on employees' actual wage data input by you each month combined with actual monthly contribution data. Testing can be performed as frequently as you wish. The capability for frequent ad hoc compliance tests helps you anticipate the year-end results and head off problems.

IMPORTANT!!!The first year you use your 401k administration software to run your plan, you'll need to supply the system with payroll data for the previous December to give the system the prior year's wage data it needs to determine which employees are highly-compensated, a critical determination for running of compliance tests. See the end of Chapter 3 for instructions on how to do this.

Compliance testing is accessed through the Reports button in the "Welcome. . ." window: At the "Welcome..." window, click on Reports, then, on the resulting scrren, on Compliance Testing in the left panel, and Compliance Testing Reports in the right panel, choose a year from the pull-down menu at the top of the window, and then click Print.

The Compliance Testing Preprocessing Grid will appear. If you designated the current year in the previous step, the report will give year-to-date data as of the last month processsed; if you designated a prior year, the data will be as of the end of that year.

For each eligible employee the grid displays prior year salary, current year estimated salary, actual year-to-date earnings, actual contributions to date, actual matching contributions to date, estimated total contribution for the year, estimated matching contribution for the year, estimated account value, actual current account value, and whether the employee is eligible, a highly compensated employee, and/or a key employee.

Estimated contributions, earnings, and account values can be used to run the top heavy tests DURING the year, whereas actual values are used for the year-end top heavy test. Please see below, End of Year Top Heavy Testing, for instructions about supplying your software with actual values.

Press Print and four reports are displayed or printed out:

ACP Test Results, which shows the employer matching contribution as a percentage of employee compensation for two groups: I. Highly Compensated Employees and II. Non-Highly Compensated Employees, plus the average contribution percentage for each group

ADP Test Results -- Data Out, which shows the employee contribution as a percentage of his or her contribution for the same two categories: I. Highly Compensated Employees and II. Non-Highly Compensated Employees, plus the average contribution percentage for each group.

Top Heavy Test Results, which lists separately for key employees and non-key employees the individual's name, social security number, and estimated (or, if actual account values have been entered, the actual) plan assets for that individual and the group as a whole.

Compliance Testing Summary, which tells you whether or not you pass the top heavy, ADP, and ACP tests

(When you press Print, you will first see the ACP results; to view the others, click on the Close button: the ADP results will appear; click on Close again, and the top heavy results will appear, and, in turn, the compliance testing summary.) button: the ADP results will appear; click on Close again, and the top heavy results will appear, and, in turn, the compliance testing summary.)

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End of Year Top Heavy Testing

For your year-end top heavy test, you need to supply the software with the actual current account value for each eligible employee. The value figure is contained in the year-end statement you'll receive from the investment company(ies) housing your plan's investments.

To enter the information into your software, click on Reports at the "Welcome..." window, then on Compliance Testing in the left panel of the resulting screen, and Compliance Testing Reports in the resulting right panel, choose a year from the pull-down menu at the top of the window, then click Print; the Compliance Testing Preprocessing Grid will appear.

Scroll to Actual Contributions & Earnings in the pull down menu at the top right hand section of the window. The Current Acct. Value column will change from greyed-out to normal white.

Enter each employee's current account value from the information provided by the investment company(ies). Make sure to EXCLUDE any rollovers from the value. (To check for rollovers, print the year's Auditor's Worksheet --

Reports, Yearly 401k Activity Reports, Year End Auditor's Worksheet, Print, (year), Print -- to see if any employees had any Net Rollovers for the year).

Click Print.

Correcting ADP or ACP Test Failures

Failing the ADP or ACP test does not necessarily mean disqualification of your 401k plan. Failed ADP/ACP tests can be corrected in any of a variety of ways. See below: Correction BEFORE the End of the Plan Year and Correction AFTER the End of the Plan Year.

Correction BEFORE the End of the Plan Year

Failed ADP/ACP tests can be corrected in either of two ways: one, the sponsor can either contribute a sufficient amount to the NHCEs to pass the test, or two, the sponsor can return excess contributions to the HCEs. The latter is the more common method.

However, because the latter alternative results in unhappy HCEs and the former alternative in extra expense to the employer, it is highly advisable to conduct preliminary tests during the year -- your plan administration software allows you to do it monthly if you wish, or quarterly. If the tests show that the ADP or ACP of the group of eligible highly compensated employees is likely to be too high compared to the ADP/ACP of the group of non-highly compensated employees, the employer can limit, before the end of the plan year, the prospective elective contributions of its highly compensated employees and possibly avoid the need for corrective measures later.

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Correction AFTER the End of the Plan Year

If, at the end of the plan year, the ADP or ACP test is not satisfied, the employer must correct the excesses within 12 months or the plan will be disqualified.

To correct an excess your company can make additional qualified nonelective or matching contributions to the accounts of non-highly compensated employees, or your company can, before March 15 of the new year, distribute the excess aggregate contributions made by highly compensated employees.

METHOD 1: Make Additional Contributions to Non-Highly Compensated Employees
Because the ADP and ACP are not weighted averages, an employer might make additional contributions only for the lowest-paid employees. This often can increase the non-highly compensated employees' ADP or ACP at the lowest cost. (Unfortunately this approach can also create discontent among those employees who receive no contribution.) An employer might prefer to make additional contributions to all eligible non-highly compensated employees sufficient to pass the test. Such contributions would be 100% vested and would be subject to the same distribution restrictions as salary deferrals.

METHOD 2: Distribution of the Excess
This is probably the most commonly used method. If the plan returns the excess contributions to the highly compensated employees, it must also return any income (or offset any net loss) allocable to the excess. An employer may calculate the income allocable to the excess under any reasonable method as long as the method is consistent with that used to allocate income under the plan.

NOTE…The multiple use test is repealed as of January 1, 2002 and thus irrelevant from that date forward.

EXCISE TAXES:
If the ADP or ACP excess is not corrected by March 15, the employer is subject to a 10% excise tax on the amount of the excess, unless the employer corrects it by making additional QNECs within 12 months after the end of the plan year. The penalty must be reported to the IRS on Form 5330 and filed with the company's tax return. If the excess contribution is not returned by the end of the year following the year of the excess, the plan is disqualified.

INCOME TAX CONSEQUENCES:
Taxation of distributions depends on the timing of such distributions. Distributions of excess contributions made within the 2 1/2 month period following the close of the plan year (March 15 for calendar year plans) are taxable:

In the case of an excess contribution, in the employee's taxable year in which the amount would have been received in cash if he or she had not elected to contribute it to the plan

In the case of an excess aggregate contribution, in the employee's taxable year ending with or within the plan year for which the excess aggregate contribution was made.

If the corrective distributions are made following the 2 1/2 month period after the close of the plan year, they are taxable in the year distributed. All distributions totaling, without related income, less than $100 are treated as distributed after the 2 1/2 month period.

The employer must provide the affected employee(s) with correct W-2s with compensation totals increased to reflect the addition of the excess.

Option to Plan Testing: The Safe Harbor Method of Plan Administration

There is a safe harbor option that allows an employer to omit ADP testing. The reasoning behind this safe harbor is that if a plan provides certain minimum benefits that ensure broad participation, the company ought not to have to prove yearly that the plan is nondiscriminatory

To qualify for the safe harbor option, a 401k plan sponsor must satisfy three criteria:

1. The plan sponsor (employer) must make either a 3% non-elective contribution to all eligible employees each year, or a dollar-for-dollar matching contribution to non-highly-compensated employees on salary deferrals up to 3% of compensation and a 50-cents-to-the-dollar matching contribution to non-highly-compensated employees on salary deferrals of 3% to 5% of compensation, making sure not to exceed these rates in any matching contributions made to highly compensated employees. (Non-elective contributions are made to all eligible employees, regardless of whether they participate in the plan or not. Matching contributions, on the other hand, being based on salary deferral amounts, are made only to active plan participants.)

2. The safe harbor contributions must be 100% vested, regardless of the length of service of the employee. However, only the amount of contribution necessary to satisfy the ADP safe harbor need be 100% vested. Any amount above this minimum contribution (for example, if the employer offers both a matching and a non-elective contribution) can be subject to a vesting schedule. The safe harbor contributions may not be distributed before termination of employment, age 59 1/2, or disability, nor are they eligible for financial hardship withdrawal.

3. The employer must provide annual information to employees to make sure they understand the safe harbor 401k plan and its benefits.

Decision Deadlines

Employers can wait up to December 1 of the testing year to adopt a safe harbor non-elective contribution of 3% of compensation.

For example, a calendar-year plan could wait as late as December 1 2001 to amend its 401k plan to provide the safe harbor contribution and to avoid ADP/ACP testing for 2001. However, the employer must provide participants with a notice prior to January 1, 2001 that the plan might be amended to provide the 3% safe harbor non-elective contribution for the plan year. (The notice in Appendix A is a sample of such a communication.) Also a supplemental notice must be provided to eligible employees no later than 30 days before the last day of the plan year notifying them of the safe harbor amendment.

This rule is of particular importance to your plan administration software plan employers who periodically test during the year and discover that significant refunds will be required to pass the ADP or ACP test. Such employers can take advantage of the nonelective contribution safe harbor and avoid year-end refunds.

1,000 Hours/Last Day Rules

Some employers require participants to have 1,000 hours in the plan year or to be employed on the last day of the plan year in order to be eligible for a contribution. These rules cannot be imposed for safe harbor contributions.

Quitting the Safe Harbor Method

An employer is not required to continue using the nonelective contribution safe harbor for future plan years and is not limited in the time that it can take advantage of the December 1 amendment process.

Additional non-profit websites that include relevant unbiased information about 401k plans include: www.401k-rules.com

Excluding Recent Hires in Nondiscrimination Testing

Another option for ADP/ACP testing as of 1999 is relevant to plans that allow employees to participate at an earlier age or with less service hours than the law requires. Many companies now allow employees to become participants the day they're hired, regardless of age.

A problem with immediate eligibility is that younger, short-service employees tend to have lower deferral rates, particularly in the lower-paid group, adversely affecting ADP/ACP testing. The new option allows all non-highly compensated employees with less than a year of service or under age 21 to be excluded from testing. The rationale is that the plan sponsor should not be penalized for allowing employees to join the plan earlier than required.

A Note About Plan Testing and Auto Enrollment

Some companies have found that immediately and/or automatically enrolling employees in the 401k plan have had positive benefits connected with passing the ADP test. One company found its participation rates increased from 70% to 85% when it eliminated the waiting period and went to immediate enrollment upon hire. With negative election (a.k.a., automatic enrollment), each employee is automatically enrolled in the plan as soon as he or she meets the plan's age and length of service requirements, whether or not he or she has made any active effort at joining the plan. Passively enrolled employees participate at whatever salary deduction rate and into whatever 401k investments the company's published passive enrollment policy stipulates. If your company uses passive enrollment, its policies are explained in both your plan's Summary Plan Description (as supplied in hard copy format at your plan's outset) and in your plan's 401k Enrollment Pac (from the "Welcome..." screen, go to Reports, All Reports, Enrollment Pac, Print).

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