To ensure employee benefit plans meet certain Internal Revenue Service (IRS) and Department of Labor (DOL) standards, plans must be subjected to a number of compliance tests each year. These tests are often referred to as the annual non-discrimination tests, and are required of plans in order to maintain their tax exempt status. Fiduciaries of plans should be aware of the various tests and ensure the plan passes them on an annual basis. Auditors of plans will review testing results, to confirm the plan has passed and corrective measures have been taken to rectify any failures.
Below is a summary of the various types of compliance tests to help you with the annual non-discrimination testing process.
Pre-work in advance of compliance testing
The most important piece of compliance testing is the census data. This information is generally gathered by plan sponsors from the payroll system and provided to the third party service providers who conduct the tests. Plan sponsors generally begin gathering data for the census as soon as payroll close has been performed for the year. Some service providers ease the burden of collecting this data by interfacing directly with payroll systems during the periodic payrolls cycles. Relevant information in a census file may include employee names, social security numbers, birth dates, hire dates, entry dates into the plan, termination dates, gross compensation, plan compensation, deferral amounts for employee and employer, and other data fields that help determine eligibility requirements. Most service providers require census information be provided to them annually by January 31.
Compliance testing basic definitions using 2013 plan year limits
Highly compensated employee (HCE)
- More than 5 percent owners (and direct relatives)
- An employee with compensation greater than $115,000
- More than 5 percent owners (and direct relatives)
- Officers with compensation greater than $165,000
- 1 percent owners earning greater than $150,000
Common compliance tests
The plan must pass certain annual testing to prove it does not discriminate in favor of HCEs or exceed certain limitations. Some common tests include the following:
The Average Deferral Percentage (ADP) test is performed to determine if the plan is discriminating in favor of HCEs with respect to employee deferrals. This test compares the ADP of HCEs against the ADP of non-highly compensated employees (NHCEs) to determine any favoring.
The Average Contribution Percentage (ACP) test is performed to determine if the plan is discriminating in favor of HCEs with respect to employer matching contributions. This test is calculated in the same manner as ADP.
If the plan fails the ADP or ACP test, the plan would reclassify corrective distributions as catch-up contributions, issue corrective distributions to HCEs (refunds), or make any additional contribution needed to the plan, known as a qualified non-elective contribution (QNEC). The ADP and ACP tests are not required for Safe Harbor 401(k) Plans. Corrective distributions must be made within 12 months following the plan year-end. However, to avoid a federally imposed 10 percent excise tax on the excess amounts, corrective distributions must be issued within 2.5 months after the end of a plan year. For plan years ending December 31, that deadline is usually March 15.
Top heavy test
A defined contribution plan is generally considered top heavy if, as of the last day of the prior plan year, the account values of key employees represent more than 60 percent of the account values of all employees. If the plan is top heavy, the employer is required to make a 3 percent top heavy contribution to all non-key employees that are actively employed on the last day of the plan year. All match and profit sharing contributions count toward the minimum contribution.
The plan is required to prove it meets certain minimum coverage standards set forth under the Internal Revenue Code (IRC). This test is run separately for each component of the plan (i.e., employee contribution, employer match, and profit sharing components). The plan must cover 70 percent of employees who have met the minimum age and service requirements set forth under the IRC. If the plan fails, an additional employer contribution is required to satisfy the test.
415 limit test
This test considers the overall annual contributions of individual participants. These contributions include pre-tax and Roth deferrals, employer match and other employer contributions, safe harbor contributions, and forfeiture allocations. Rollover contributions and catch-up contributions are not included in this test. If the test limit is exceeded, the excess deferrals are normally refunded and excess employer contributions are forfeited to reduce future employer contributions.
The schedule of annual limits is available on the IRS website. While plans may fail certain compliance tests, the IRS does provide methods to rectify these failures so a plan may continue maintaining its favorable tax status. The 401(k) Plan Fix-It Guide published by the IRS is available to help plan sponsors correct noncompliance or errors.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.