Understanding Non-Discrimination Testing
Every 401(k) plan is required, by the Employee Retirement Income Security Act of 1974 (ERISA), to have non-discrimination testing completed annually. There are several tests to be completed, and all or some of these tests are required depending on the type of plan. The most common tests completed include ADP/ACP test, 402(g) limit test, 415 annual additions test, coverage test and top-heavy test.
The plan sponsor often has a third party administrator that will perform these tests. Many plan sponsors provide the necessary data to the third party administrator for them to complete the tests, but do not have an understanding of what the tests are accomplishing and, more importantly, what the repercussions are of a failed test.
ACP/ADP Test
The Average Deferral Percentage (ADP) test determines whether the plan is discriminating in favor of Highly Compensated Employees (HCEs) with respect to employee deferrals, which include pre-tax contributions and Roth contributions, and do not include catch-up contributions. HCEs include 5% owners of the employer or affiliate as well as any direct relatives of the owner in the current year and prior plan year, or an employee that earned more than the limit set by the Internal Revenue Service (IRS) which is $120,000 for the 2015 and 2016 plan years. In order for the plan to pass, the ADP of the HCEs can’t exceed the greater of 125% of the ADP of the non-highly compensated employees (NHCEs), or the lesser of 200% of the ADP of the NHCEs or the ADP of the NHCEs plus 2%. The plan can utilize the current year testing method or the prior year testing method, which means the ADP % of the NHCEs would be calculated using the 2014 plan year data if the prior year method is being used for the 2015 plan year testing.
The Average Contribution Percentage (ACP) test determines whether the plan is discriminating in favor of HCEs with respect to employer matching contributions. This test compares the ACP of the HCEs to the ACP of the NCHEs to make the determination if the plan is favoring HCEs.
If the plan fails the ADP and/or ACP testing, the most common way of correcting the failure is distributing the excess contributions to the HCEs in the amount necessary for the Plan to pass the testing. Some of the excess deferral contributions may be reclassified as catch up contributions, if allowable, in order to reduce the amount of excess deferrals being distributed. Excess contributions should be distributed within 2 ½ months after the close of a plan year, or prior to March 15th for a calendar year plan, without incurring any penalty. If this distribution is made after the 2 ½ month deadline, a 10% excise tax may apply. Another correction option allows for an additional contribution to be made to the plan known as a Qualified Non-Elective Contribution (QNEC). In this case, a contribution would be made to all NHCEs in amount necessary for the testing to pass. Either correction option must be implemented by the end of the following plan year in order to maintain qualified plan status. If the corrective actions are not done timely the plan may use the IRS’s self-correction program to correct the error. If all participants in the plan are HCEs or all are NHCEs then the ADP and ACP tests are not required. The ADP/ACP testing is not required if the plan has certain design features which qualify it as a safe harbor plan. These design features include certain levels of matching contributions for all eligible participants whether actively deferring or not. Contributions are immediately 100% vested.
402(g) Limit Test
The 402(g) limit test determines if the individual deferrals made through pre-tax and Roth deferrals are within the annual limit set by the IRS. When determining the amount of the contribution made by the individual it should include both pre-tax and Roth contributions. For those participants age 50 and over, there is a separate pre-tax catch-up contribution limitation. The 2015/2016 limits are as follows:
- Combined pre-tax and Roth contributions $18,000
- Catch-up contributions $6,000
Contributions in excess of these limits must be returned to participants by April 15th following the plan year. If the excess deferral is not refunded by this date then the participant will be taxed on the amount of the deferral in the year it was withheld and in the year it was refunded (double taxation). In addition, early withdrawal penalties may apply.
415 Annual Additions Test
The 415 annual additions limitation limits the overall annual defined contributions a participant can receive. The contributions include all contributions made to the plan including pre-tax and Roth contributions, employer contributions, safe harbor contributions, and any allocation of forfeitures. Rollover contributions and catch-up contributions are not included. The 415 limit set by the IRS for 2015 is the lesser of 100% of the participant’s gross compensation or $53,000.
If the contributions made are in excess of the limits they will be corrected based on the provisions in the plan document, which most commonly are refunding of excess employee deferrals, and forfeiting of excess employer contributions.
Coverage test
The coverage test is required to ensure that the plan meets minimum coverage standards set by the IRS. This test is completed for each type of contribution in the plan, for example, employee deferral, employer matching contributions, and profit sharing contributions. Each type tested must pass either the ratio percentage test, or the average benefit test. In order to pass the ratio percentage test the plan must cover 70% of employees who have met the minimum age and services requirements set by the IRS, which is the age of 21 and the completion of one year of service. Employees who have not met the age and service requirement, union employees, nonresident aliens with no U.S. income, and terminated employees with less than 500 hours worked during the year can be excluded from the calculation. The calculation is as follows:
number of eligible NHCEs in the plan / number of eligible NHCEs employed by the company
divided by
number of eligible HCEs in the plan / number of eligible HCEs employed by the company
If the plan fails this test then the average benefit test is performed. If the plan fails the average benefits test, the employer may make an amendment to the plan, up to 9 ½ months after the plan year end in order to retroactively expand the plan coverage in order to pass the test.
Top Heavy Test
If, as of the determination date, the account balances for the key employees exceed 60% of the total account values for all employees, then the plan is considered to be top-heavy. A key employee is defined as an employee with gross compensation over the limit set by the IRS, which for 2015 and 2016 is $170,000, a 5 % owner of the business, or an employee owning more than 1% of the business with gross compensation greater than $150,000. If the plan fails this test, the employer must make a contribution of 3 % of compensation to all non-key employees that are employed on the last day of the current plan year. This contribution is subject to a three year vesting cliff or a six-year graduated vesting schedule. An employer matching contribution or profit sharing contributions can be used when determining the corrective contribution. A top-heavy plan does not include a plan for any year in which contributions consist solely of cash or deferred arrangements meeting the safe harbor requirements.
Employer’s Fiduciary Responsibility
The above is the most common test performed, and based on the design of the plan additional tests may be required. It is important to provide complete and accurate employee census data to the third party administrator to ensure the testing is properly completed. The plan sponsor should review the census data to ensure hire dates and termination dates are correct, annual hours worked are accurate, and all compensation and deferral amounts for each participant are correct. It is the employer’s fiduciary responsibility to understand and monitor the required annual discrimination testing and results. It is important to ensure all corrections are properly made, by the specified deadlines, and to keep the qualification of the plan from being jeopardized.
If you should have any questions related to the IRS determination letter program or would like more information, please contact us at [email protected].
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