<img height="1" width="1" style="display:none" src="https://www.facebook.com/tr?id=796832240471337&amp;ev=PageView&amp;noscript=1">
It’s 401(k) Testing Season! What Small Businesses Need to Know About 401(k) Testing Blog Feature
Eric Droblyen

By: Eric Droblyen on February 24th, 2016

Print/Save as PDF

It’s 401(k) Testing Season! What Small Businesses Need to Know About 401(k) Testing

Fiduciary Responsibiilty | Testing

Each plan year, ERISA requires every 401(k) plan to complete certain tests to confirm they do not discriminate in favor of Highly Compensated Employees (HCEs) or exceed IRS contribution limits. Generally, this annual testing is completed as soon as possible following the close of a plan year. For 401k plans with a plan year that ended December 31, 2015, that means now.

While most employers hire a professional third-party administrator (TPA) to complete this work, all employers should understand testing basics to confirm all necessary tests are completed and any failed tests are corrected each year.   Otherwise, costly penalties, plan disqualification or fiduciary liability are more likely.

Who is a HCE?

For 2015, a HCE is defined as an individual who meets one of the following two criteria:

  • They own more than 5% of the employer (directly or by family attribution) at any time during 2014 or 2015
  • They received compensation in excess of $115,000 during 2014. A plan can limit this group to the top 20% of employees, ranked by compensation

We know, it’s hard to believe 401(k) pricing can be this low!

Check out our Pricing page to see how we can reduce your 401(k) fees by 70% or more!

View Our Fees


Nondiscrimination Testing

401k plans must pass certain “nondiscrimination” tests each year to show they do not impermissibly discriminate in favor of HCEs with respect to plan benefits. These tests include:

IRC §410(b) Coverage Testing

Purpose of Test

Ensure a sufficient number of non-HCEs are covered by a 401k plan.

Calculation

To pass coverage testing, each contribution source (employee deferral, match, profit sharing) must satisfy either the ratio percentage or the average benefit test.

The ratio percentage test is most commonly used. To pass this test, the following calculation must equal or exceed 70%:

(# of eligible non-HCEs covered by the plan / # of eligible non-HCEs employed by the company) / (# of eligible HCEs covered by plan / # of eligible HCEs employed by the company )

Correction method

To correct a failed coverage test, the employer may adopt a corrective amendment, up to 9½ months following the plan year-end, to retroactively expand plan coverage.

Comments

The following employee groups can be disregarded when completing a coverage test:

  • Employees who have not met a source’s age and service eligibility requirements
  • Union employees
  • Non-resident aliens with no U.S income
  • Terminated employees that worked <500 hours during the year

A controlled group or affiliated service group is considered a single employer by ERISA.

Actual Deferral Percentage (ADP) Testing

Purpose

Test employee deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) for nondiscrimination.

Calculation

An ADP is calculated by averaging the deferral percentages of HCEs or non-HCEs.

To pass the ADP test, the ADP of the HCE group cannot exceed the greater of:

  • 125% of the non-HCE group ADP, or
  • the lesser of:
    • 200% of the non-HCE group ADP, or
    • the non-HCE group ADP plus 2%.
The non-HCE group ADP can be based on the group’s current or prior year contributions.

Correction method

The most common correction method is distributing excess contributions to HCEs in the amount necessary to make the ADP test pass. A 10% excise tax may apply to excess contributions distributed after March 15, 2016.

Comments

Safe harbor 401k plans are not subject to ADP testing

Actual Contribution Percentage (ACP) Testing

Purpose

Test employer matching and after-tax contributions for nondiscrimination.

Calculation

Same methodology as the ADP test.

Correction method

Same methodology as the ADP test.

Comments

Safe harbor 401k plans are generally not subject to ACP testing

When a new comparability profit sharing contribution is made to a 401k plan, an IRC §401(a)(4) “General Test” is required to test the contribution’s allocation for nondiscrimination.

Top Heavy Testing

In addition to nondiscrimination testing, 401k plans are subject to a Top Heavy Test (IRC §416). A 401k plan is considered top heavy for a plan year when the account balances of Key Employees exceeded 60% of total plan assets on the last day of the prior plan year.

When a 401k plan is top heavy, non-Key Employees must generally receive an employer contribution equal to 3% of their annual compensation. Any employer matching or profit sharing contributions can be used to offset this top heavy minimum contribution requirement. Safe harbor 401(k) plans automatically satisfy the minimum contribution requirement if safe harbor contributions are the only contributions made to the plan during the year.

A Key Employee is defined as any employee (including former or deceased employees), who at any time during the plan year was:

  • An officer making over $170,000 (2015 and 2016)
  • A 5% owner of the business (a 5% owner is someone who owns more than 5% of the business)
  • An employee owning more than 1% of the business and making over $150,000 for the plan year

Participant limits testing

In addition to plan-level testing, participants must be tested each year to confirm the contributions made to their account do not exceed IRS limits. These limits include:

  • Annual Additions Limitation (IRC §415) – “Annual Additions” represent the sum of employee and employer contributions (including any reallocated forfeitures) made to a participant’s account during the limitation year (generally, the plan year). For 2015, the 415 limit was the lesser of:
    • 100% of the participant’s compensation
    • $53,000 ($59,000 including catch-up contributions)
  • Elective Deferrals Limitation (IRC §402(g)) – This limit applies to total pre-tax and Roth 401k contributions. For 2015, the 402(g) limit was $18,000 ($24,000 for catch-up eligible participants).  Any 402(g) excess contributions must be distributed by April 15 of the following year to avoid double-taxation to the participant.

Annual testing is important – attention is required

401k plans offer valuable tax benefits to employers and employees alike. These benefits are not free, however – to be eligible, employers must keep their 401k plan in compliance with IRS qualification requirements.

One of the most technical qualification requirements is annual nondiscrimination and limits testing. Fortunately, a professional TPA most often completes this work today. However, employers should still understand testing basics even when a TPA is hired. Why? Employers have a fiduciary duty to monitor their 401k TPA for performance and knowing the tests to expect each year can make that job easier.


Are you paying too much for your company’s 401(k) Plan?

Check out our 401(k) Fee Comparison page to compare our fees to 40+ competitors or request a fee comparison for your plan!

Compare Our Fees

 

About Eric Droblyen

Eric Droblyen began his career as an ERISA compliance specialist with Charles Schwab in the mid-1990s. His keen grasp on 401k plan administration and compliance matters has made Eric a sought after speaker. He has delivered presentations at a number of events, including the American Society of Pension Professionals and Actuaries (ASPPA) Annual Conference. As President and CEO of Employee Fiduciary, Eric is responsible for all aspects of the company’s operations and service delivery.

  • Connect with Eric Droblyen