To retain their tax-qualified status, 401(k) plans must undergo extensive IRS testing each year to prove they don’t discriminate in favor of Highly-Compensated Employees (HCEs). One of these tests is the IRC section 410(b) “coverage” test. The purpose of this test is to ensure a 401(k) plan covers a sufficient number of Non-Highly Compensated Employees (NHCEs).
If you’re a 401(k) plan sponsor, understanding the basics of coverage testing is crucial. While your 401(k) provider will likely complete this test for you, it will be your responsibility to supply the information they’ll use for the test. By understanding the basics of the test, you’ll be less likely to omit key information that can trigger an inaccurate test result, which can take years to discover and be very expensive to fix.
Generally, coverage testing is straightforward, though there are a few nuances to be aware of. We’ll explore these and more below.
The Coverage Test Equation
For a 401(k) plan to pass the coverage test, each employee and employer contribution funded during the year (e.g., salary deferrals, match, profit sharing) must satisfy either the ratio percentage or the average benefit test. The ratio percentage test is far and away the most commonly used. To pass this test, the following equation must equal or exceed 70%:
(# of “benefitting” NHCEs / # of “eligible” NHCEs) / (# of “benefitting” HCEs / # of “eligible” HCEs)
Eligible vs. Benefitting Employees
Generally, “eligible” employees are employees that met the applicable contribution’s age and service eligibility requirements for the year. However, the following employee groups can be disregarded:
- Union employees
- Non-resident aliens with no U.S income
- Terminated employees that worked <500 hours during the year
As the name implies, “benefitting” employees benefit from the contribution. An employee is considered to benefit from 401(k) or matching contributions when they have the right to make salary deferrals. They are considered to benefit from a profit sharing contribution when they receive an allocation.
Common examples of eligible employees that don’t benefit include:
- Employees excluded by the plan document (e.g., hourly, leased)
- Employees of a controlled group member (see next section) that does not co-sponsor the plan
- Employees that failed to meet the contribution’s allocation conditions (e.g. terminated prior to year-end, worked <1,000 hours during the year).
Confused? Just report every employee that received a $1 or more in compensation during the year to your 401(k) provider – they should follow-up if they have questions regarding an employee’s status. This is best practice anyway.
Is Your Company Part of a Controlled Group?
If your company is part of a controlled group, your 401(k) plan must coverage test the entire controlled group as a single employer. That means your 401(k) provider will need employee information for all members of your controlled group to properly complete your coverage test. The controlled group rules exist so employers can’t subdivide their company into separate companies - one employing HCEs and the other employing NHCEs – to discriminate in favor of HCEs.
Your company is considered part of a controlled group with another company when either a “parent-subsidiary” or “brother-sister” relationship exists:
- A parent-subsidiary relationship exists when one company owns 80% or more of another company
- A brother-sister relationship exists when two companies meet two thresholds.
- Common Ownership - 5 or fewer individuals own 80% or more of each company; and
- Identical Ownership - the common owners have identical ownership of more than 50%.
To complicate matters further, business owners are attributed the ownership of certain family members. When these “family attribution” rules apply, any attributed ownership must be added to an owner’s direct ownership to determine if a controlled group exists.
Below is a summary of the controlled group family attribution rules:
|Family Member||Attribution Rule|
Is generally attributed their spouse’s ownership unless all of the conditions listed in IRC §1563(e)(5) are satisfied.
Is always attributed the ownership of a minor child (under age 21).
Is attributed the ownership of an adult child (21 or older) only if the parent owns (directly or by other attribution) more than 50% of the company.
|Siblings||Are never attributed the ownership of other siblings.|
A minor child is always attributed the ownership of a parent.
An adult child is attributed a parent’s ownership only if the adult child owns (directly or by other attribution) more than 50% of the company.
Is attributed a grandchild’s ownership (regardless of age) only if the grandparent owns (directly or by other attribution) more than 50% of the company.
A grandchild (regardless of age) is attributed a grandparent’s
ownership only if the grandchild owns (directly or by other attribution) more than 50% of the company.
If you have questions about your company’s controlled group status, ask your 401(k) provider. They can help you make this essential determination.
Failing the Coverage Test Can Be a Costly Mistake!
To correct a failed coverage test, you must adopt a corrective amendment, up to 9½ months following the close of the plan year in which the failure occurred, to retroactively expand plan coverage. However, since the new participants can’t retroactively make 401(k) deferrals, a Qualified Nonelective Contribution (QNEC) must be made to the new NHCEs to remedy their “missed deferral opportunity.” Any missed employer contributions must also be made.
When a coverage failure is not corrected within 9½ months, it’s considered a demographic failure by the IRS. Demographic failures can only be voluntarily corrected using the IRS’ Voluntary Compliance Program (VCP). When a VCP correction is necessary, employer fines apply. Not correcting a coverage failure at all can result in plan disqualification if the issue is found during an IRS audit.
In short, the consequences for failing the coverage test can be brutal. To avoid them, you want to be sure you give your 401(k) provider the information they need to accurately complete the test. A basic understanding of the coverage testing rules can help.