Clearing Annual 401(k) Compliance Test Hurdles

Of all the regulatory hurdles defined contribution retirement plan sponsors must clear, "nondiscrimination" compliance testing is one of the most important. Not only are these tests vital to maintaining the viability of a tax-qualified plan, but passing these tests is also critical from an employee relations perspective.

Indeed, companies can find themselves in regulatory hot water if their 401(k) plan fails required nondiscrimination tests, which are designed to make sure a plan does not benefit highly paid employees more than their non-highly paid colleagues.

Annual Tests

These standard nondiscrimination tests must be performed and passed annually (unless the plan falls into the safe-harbor exception described below), taking into account all employees eligible to participate in the plan—whether or not they actually participate. The tests follow the tax code requirements set out by the IRS (and these requirements gets complicated, which is why ensuring compliance often falls to finance and accounting professionals).

[Note: the Pension Protection Act of 2006 created a new, optional safe harbor exemption from annual compliance testing for automatic enrollment 401(k)-type plans, described in a box at the end of this article. But the older safe harbor rules, as presented below, remain available as an option for all 401(k) plans, whether or not they provide for automatic enrollment.]

The actual deferral percentage (ADP) test. This test compares elective deferrals made by highly compensated employees (on a before-tax basis and excluding the extra "catch-up contributions" allowed to those age 50 or older) to those made by non-highly compensated employees. The percentages for employees within each group are totaled and averaged to get the average deferral percentage for both groups. Next, the ADP for the highly compensated group is compared with the ADP of the non-highly compensated group to determine if the plan passes the test according to these formulas:

• If the ADP for the non-highly compensated group is 2 percent or less, the plan passes if the ADP for the highly compensated group is not more than twice the ADP for the non-highly compensated group.
  
  
• If the ADP for the non-highly compensated group is more than 2 percent but not greater than 8 percent, the plan passes if the ADP for the highly compensated group is not more than 2 percent greater than the ADP for the non-highly compensated group.
  
  
• If the ADP for the non-highly compensated group is more than 8 percent, the plan passes if the ADP for the highly compensated group is not more than 125 percent of the ADP for the non-highly compensated group.

In other words, taking a case involving the 2 percent spread limitation that is relevant where the average rate of elective contributions by non-highly compensated employees is relatively low: If the average rate of elective contributions by non-highly compensated employees is 4 percent of pay, then the average rate of elective contributions on behalf of highly compensated employees may not exceed 6 percent of pay.

The actual contribution percentage (ACP) test. This has similar testing limits but measures employer matching contributions and employee after-tax contributions. It's also known as the section 401(m) matching test.

If a plan is found to be discriminatory, the plan sponsor must:

• Refund by March 15 of the year following the failed test a portion of the deferrals made by highly compensated employees (or, if practicable, reclassify regular contributions as catch-up contributions subject to the annual catch-up limit for those highly compensated employees over 50), or
  
  
• Make a qualified non-elective contribution (QNEC) to the accounts of non-highly compensated employees—such as an end-of-year bonus made directly to non-highly compensated employees' 401(k) plans. In either case, the amounts involved must be large enough to allow the plan to satisfy the nondiscrimination tests.

The "top heavy" test. In general, a plan is "top heavy" when the qualified plans of the plan sponsor provide more than 60 percent of the present value of benefits to "key employees" (a term that differs from "highly compensated employees" under the above tests). In addition, there are special rules as to the timing and method used to determine the 60 percent threshold. Two or more employer-provided retirement plans may be aggregated to determine top heaviness.

For each year that a 401(k) plan is top heavy, the employer must provide certain minimum contributions to all eligible nonkey employees. If not satisfied by a related plan, the minimum plan contribution amounts for all nonkey participants employed on the last day of the plan year is the lesser of 3 percent of their compensation or, if less, the highest percentage accrued for any key employee. In no case does an employer have to contribute more than the percentage contributed for key employees.

Here's a twist: Participants' elective contributions cannot be used to satisfy this minimum contribution requirement for nonkey employees. However, when determining the highest percentage accrued for a key employee, the plan must count all employer contributions plus elective contributions by key employees.

The IRS provides this example: Assume two nonkey employees made elective deferrals of 2 percent and 8 percent of their compensation respectively, and the key employee made an elective deferral of 4 percent of compensation. If the plan is top heavy, the plan must make an additional employer contribution for the two nonkey employees equal to 3 percent of compensation.

Once Is Enough

For most companies, failing nondiscrimination testing once is enough. Making a QNEC can be expensive. And few benefits professionals are keen to explain to highly paid employees why the plan must refund a portion of their pre-tax contributions.

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Few benefits professionals are keen to tell
highly paid employees that the plan must
refund a portion of their pre-tax contributions
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Because those contributions were tax deferred, highly compensated employees will now have higher taxable income as a result and may have to amend their income tax returns to reflect that. This involves the company's top executives and you dont want to have to come back and give them the same message next year, says John Graham, director of regional compliance research for The Segal Company in New York.

There are a few ways to avoid future problems with nondiscrimination testing. For one thing, federal regulations allow companies to conduct nondiscrimination testing using either the current years plan activity or the prior years plan activity.

But if the company uses current year data, it cannot conduct full nondiscrimination testing until the plan year is over and all the data has been accumulated. This can leave companies flatfooted because problems will not be confirmed until all the nondiscrimination testing is completed, probably sometime during the first quarter following the close of the plan year. This timing can be troublesome for employees who receive a refund of pre-tax contributions because this refund is likely to occur well after the plan year is over and, possibly, well after they have filed their tax returns for the year.

However, if a company switches its nondiscrimination testing methodology to one that relies on the prior years data, it will have full access to the relevant data during the plan year and can periodically check to make sure the plan will pass nondiscrimination tests, according to Karen Sanchez, partner and director of employee benefits services at Sikich LLP in Aurora, Ill.

Moreover, the plan sponsor can identify the appropriate level of contributions by highly compensated employees and can halt those employees contributions in real time if necessary to get the plan back in compliance with nondiscrimination requirements. While this situation is still troublesome for highly compensated employees, it will not require cumbersome tax issues for these individuals if the company stays on top of the plans nondiscrimination status.

Increase Participation

The best way to avoid problems with nondiscrimination testing is to make sure the plan does not benefit highly paid employees more than other employees. Not surprisingly, most 401(k) plans fail nondiscrimination testing because of low participation and low contribution levels among lower-paid employees.

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Most 401(k) plans fail nondiscrimination testing due to
low participation and low contribution levels
among lower-paid employees.
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Therefore, increasing enrollment and contribution levels among these individuals is a key issue if a company wants to avoid future nondiscrimination testing failures.

For example, companies can automatically enroll new hires in the 401(k) plan unless these employees specifically opt out. They automatically begin deducting from employees' pay some level of employee contribution such as 2 percent and invest it in a designated vehicle such as a balanced fund (mixing stocks and bonds), or a target-maturity asset allocation "lifecycle" fund that shifts to more conservative investments as retirement approaches. Some then automatically increase the percentage with each raise the employee receives (again, unless the employee affirmatively provides contrary instructions).

Other companies simply make plan contributions themselves on their employees' behalf.

But if a company does not want to use automatic enrollment or make plan contributions itself, it can still review the plans design and the level of vendor service to identify changes that might encourage more employees to sign up, for example by:

• Introducing or increasing a matching contribution.
  
  
• Providing employee education sessions on the importance of retirement savings.
  
  
• Offering access to financial advice from an independent financial adviser, or online tools that demonstrate how much the employee should be saving to secure his or her retirement.

Find a Safe Harbor

Another way to avoid nondiscrimination testing problems is to adopt one of the two available safe-harbor plan designs that allow plan sponsors to forego nondiscrimination testing altogether. As described in the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001:

• The first safe-harbor design option requires the plan sponsor to provide a 100 percent match of pre-tax contributions by non-highly compensated employees of up to 3 percent of pay, plus a 50 percent match on the next 2 percent of pay.
  
  
• The second safe-harbor design option requires plan sponsors to automatically contribute at least 3 percent of pay to the accounts of all non-highly compensated employees, whether or not those employees contribute to the plan on their own.

No matter which safe-harbor design a company chooses, all company contributions must vest immediately. That can have a financial downside for companies with high turnover that use unvested company contributions forfeited by terminating employees to offset overall plan costs. But that expense may be offset somewhat by the time, resources and hassle saved by skipping nondiscrimination testing.

The approach chosen for complying with nondiscrimination standards needs to be weighed carefully, since it must be made before the year begins and cannot readily be changed.

Joanne Sammer is a New Jersey-based business and financial writer. Her articles have appeared in a number of publications, including Business Finance, Consulting, Compliance Week and Treasury & Risk Management.

Related SHRM Article:

10 Steps If Your 401(k) Plan Fails Nondiscrimination Testing, SHRM Online Benefits, January 2009