INVESTMENT

Did your 401 (k) plan fail its compliance test?


Consent Failure Q&A

Q: First things first: What exactly is a 401 (k) compliance test and when is it done?

Sometimes called “non-discrimination” testing, compliance testing is conducted immediately after the end of a plan year, so the average year for a calendar year plan is from mid-January to mid-April. In short, the 401 (k) plan must pass these tests each year to verify that it does not benefit highly compensated employees (HCEs) and non-highly compensated employees (NHCEs) unjustly. Although there are many compliance tests, one of the most important is the “actual delay percentage,” or ADP test.

Q: What exactly does the ADP test show?

With the ADP test, we compare the average 401 (k) suspended percentage of HCEs with the average 401 (k) suspended percentage of NHCEs. If the difference is greater than a certain margin (shown in the table below), the plan is considered “failed” in the ADP test.

Average NHCE rate Highest HCE average rate
Below 2% 2 x NHCE rate
2% to 8% 2% + NHCE rate
More than 8% 1.25 x NHCE rate

It is important to note that the average deferred rate plan for testing purposes takes into account all eligible employees, including active and finished employees for the year. As a side note, this may differ from how the average suspension rate is defined for determining the plan, which typically looks at the average suspension rate of actively contributing participants.

Q: What exactly is the consequence of failing the ADP test?

This is probably scarier than it sounds because it is fairly easily corrected. There are two ways to correct failure. One is to return the additional 401 (k) contribution to the affected HCE. The amount of the return depends on the size of the failure, but it is taxable to the affected employees (often employers and senior managers) who will probably be unpleasantly surprised by these events. This is never an easy conversation for a plan administrator.

The second method is a corrective contribution (equivalent to a failed margin) known as the Eligible Non-Electoral Contribution (QNEC) for all non-highly compensated employees. This can be costly for the employer, but if the failed margin is small and the company is on the small side, it can be a good option to correct the failure. Generally, this amendment needs to be completed within two and a half months of the end of the plan year (March 15 for calendar year plans).

Q: Well, before we do anything else, let’s make sure everyone is on the same page when it comes to the definitions of HCE and NHCE.

Ah, and that’s where 401 (k) comes in because there are actually different ways to define these types of employees. And there is some flexibility in choosing the definition of plan sponsor which can make it easier to pass the compliance test for the plan. But one thing that is important to know is, you only need to define who falls into the HCE category because NHCE is the only residual (i.e. everyone else).

Compensation is understandably a factor that determines whether or not someone has HCE. But it is based on the previous year’s compensation information. So if we are in February 2021, testing 2020 compliance with a plan, we will need 2019 compensation data from plan sponsors. This can cause a lot of confusion at first, especially for plans that have just begun. For example, a plan launched in June 2020 would obviously question why they should provide our company’s compensation information – even before the 101 (k) plan existed. This is because we need to determine who was HCE, and this is based on the previous year, also known as the “Lookback Year”. Obviously, if the company didn’t even exist in the previous year, we would have to rely on more recent information. And indeed, in such cases, we will not rely on compensation to define HCEs, but only the definition of ownership, which we will enter.

Q: So that sounds like the next logical question: What are the different HCE definitions?

Sure. Some types of employees are automatically defined as HCE regardless of their compensation. This can be tricky for businesses, especially those who run small and / or families. An HCE is an employee who meets one of the following criteria:

  • Ownership in the current or previous year – irrespective of the compensation, (1) the outstanding corporate stock, (2) the voting power across the corporate stock, or (3) the owner of the capital or profits of an entity not considered a corporation. This includes family members.
  • The previous year’s compensation exceeded HCE’s IRS definition. This is regardless of the current year’s compensation. In 2019, this amount was ,000 125,000.

Q: I guess it leads to other ways to define HCEs and NHCEs.

That’s right. Alternatively, larger plans can specifically define HCE using the top-paid group selection (TPG) method that allows them to limit the number of HCEs for their top 20% of employees based on their previous year’s compensation. This must be defined in the planning document and can be beneficial if those high earners who are not in the top 20% are contributing significantly, which can help increase the average contribution rate to another 80%.

One thing to note is that the compensation of employees who are considered highly compensated under the definition of ownership will be treated as HCE regardless. Thus the exact percentage of HCE using the TPG method can actually exceed 20%.

Q: So what are the factors that contribute to ADP test failure?

One of the most common challenges we face is when plans begin at the end of the year. Often, HCEs who have more prudent incomes are excited about their plans and their maximum ability to save and defer their taxes. So with only a handful of salaries and allowances remaining in the year, they make the most of their contribution, contributing at a much higher rate than the NHCE, and the plan fails.

Plans starting at the end of the year should be aware of this potential problem. If they do not want to delay the start of the plan, they should contact HCEs as they are not likely to contribute the maximum annual amount (and there may be a risk of taxable refund of contributions after the end of the year).

Although our message to administrators to plan is: If the sole purpose of starting a 401k plan is to allow the owner or other HCE to maximize their contribution, be aware that your plan may fail the ADP test. Remember that as a trustee, you must manage the plan in the best interests of all your employees.

Q: Any other issues to keep in mind?

Other plans that may require more caution include smaller plans, especially where the owner may be the sole HCE. If other employees don’t contribute or contribute enough, it can be difficult.

Another wrinkle can occur when there are HCEs who are earning less than the statutory maximum compensation amount. Among other things, this is the maximum amount that can be used when calculating the test. Consider HCEs under the age of 50 who make the maximum annual 401 (k) contribution of 19,500. If they had earned the statutory maximum compensation amount of $ 55,000 for 2020, that would be equivalent to 8. %% of salary. However, if they only earn $ 150,000 (which also qualifies as their HCE), that translates to the same $ 19,500 13% contribution rate. So the range of HCE compensation can have a huge impact on that HCE ADP.

Q: How can plans ensure that they do not fail the ADP test?

A very simple solution for those who are not aware. The ADP compliance test can be completely bypassed if the plan adopts the Safe Harbor Plan design, which requires a mandatory contribution. Of course, the company needs to consider the additional costs against compliance headaches and the potentially better-funded retirement benefits for their employees. But for plans starting later this year, taking Safe Harbor is a great way to avoid potential test failures and return contributions to HCE.

Q: And what if the design of a safe harbor plan is too expensive?

A safe harbor plan can make plans short of adopting the design, reducing the chances of failing the test. For example, implementing automated enrollment at a substantial rate for all employees can go a long way. Most people do not opt ​​out of the plan or change the amount of their default contribution. So if the plan contributes 6% to everyone, then perhaps the plan has a much better chance of passing the ADP exam.

In addition, sometimes (but not always) a matching contribution can really motivate employees to save more. For example, if employees had to contribute 6% to the maximum employer contribution, they would be more likely to contribute that amount. Often this requires clear and consistent communication to ensure that even newly qualified employees for the plan are aware of the combined features and how they can earn the maximum amount. That said, if an employer is willing to bear the cost of matching contributions, designing a safe harbor plan may be more meaningful because it completely eliminates the uncertainty associated with compliance testing.

Plans may decide to use the Prior Year Testing method, which allows them to limit HCE plan contributions based on their previous year’s test results. This is not a guarantee that the plan will pass the ADP test, but it does reduce the chances.

Q: What is your advice on plans that failed the ADP test?

First, don’t panic. Plans to fail the ADP test are not uncommon. That said, it is valuable to analyze what else is going on with the plan design that could negatively affect the rate of participation or contribution. In this case:

  • Are qualification requirements limiting contributions to plans that might otherwise help increase NHCE participation?
  • Is the plan being made available to all eligible employees as per the plan document? Unless the plan document states that part-time and / or intern-based employees such as interns cannot contribute to the plan unless they meet certain qualification requirements (specific to this employee class), they must be given the opportunity to contribute to the plan.
  • Does the definition of plan compensation (excluding pre-participation compensation, for example) slash the average contribution percentage and affect the test in an unexpected way?

Of course, we warn everyone that testing can change year after year, especially for new plans or companies that are just starting out, so it’s not something that’s been done. New plans should protect those who pass their first year from becoming too complacent, especially in the future.

In addition, plans should monitor plan participation, focusing not only on the participation rate but also the average contribution of different employee groups, and continue to communicate the benefits of the plan, especially to the groups that need to hear it the most. Improvements can work with a strategy development plan to reach out to their employees.

The Q&A was conducted in 2021 and it is of an educational nature.



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