Compliance testing: What plan sponsors need to know

Traditionally, compliance testing can be a daunting process for employers. Testing conjures up images of the IRS, plan corrections, and paperwork upon paperwork. Things are different with Guideline. With the ease of a Guideline plan, all testing is automatically performed for you, freeing you up to focus on your business and your employees. Learn more about the compliance testing series below.  

Why is compliance testing necessary?  

Because contributing to a 401(k) comes with significant tax advantages, a plan could fall into the trap of being almost exclusively enjoyed by company owners and executives. Staying compliant with 401(k) regulations ensures that all employees are fully encouraged and enabled to save for retirement.

The Nondiscrimination and Limit Tests

Nondiscrimination Tests

Limit Tests

ADP/ACP Tests

Purpose

The Actual Deferral Percentage and Actual Contribution Percentage (ADP/ACP) tests are both used to ensure that a plan is not discriminating in favor of Highly Compensated Employees (HCEs). The ADP test is performed to determine if the plan is discriminating in favor of HCEs with respect to Pre-tax and Roth employee contributions, while the ACP test looks at employer contributions. Note that, if you have a Safe Harbor plan, you do NOT need to perform these tests every year!  

Defining HCE/NHCE

The ADP/ACP compliance tests use Highly Compensated Employees in their calculations. A Highly Compensated Employee (HCE) is:

  • An employee making over $120,000 AND was in the top 20% of employees when ranked by compensation; OR
  • Someone who owns more than 5% of the business; OR
  • A family member of someone who owns more than 5% of the business

A Non-Highly Compensated Employee (NHCE) is everyone else.

Testing Method

Actual Deferral Percentage (ADP) Test. This test compares the average “deferral” (salary contribution) percentages of HCEs against the average of NHCEs. Each participant’s ADP is calculated by taking their total salary contributions for the calendar year (not including catch-up contributions) and dividing this number by their compensation for the same year.  

Actual Contribution Percentage (ACP) Test. This test compares the average employer contribution percentages of HCEs against the average of NHCEs. Each participant’s ACP is calculated by taking the amount of employer contributions they received during the year and dividing this number by their compensation for the year.  

HCE deferrals and contributions are both limited by the following:

  • If the ADP/ACP for NHCEs is 0%-2%, the ADP/ACP for HCEs must not be more than 2 times the NHCE rate
  • If the ADP/ACP for NHCEs is 2%-8%, the ADP/ACP for HCEs must not be more than the NHCE rate + 2%
  • If the ADP/ACP for NHCEs is greater than 8%, the ADP/ACP for HCEs must not be more than 1.25 times the NHCE rate

Fix It

If testing determines that a plan is unfairly discriminating in favor of HCEs, the plan will need to make corrections by:

  • Refunding excess contributions to HCEs; OR
  • Offering additional employer contributions to NHCEs; OR
  • Using a combination of both methods

Top-Heavy Test

Purpose

Top-heavy testing has similar goals to the ADP/ACP tests, but it is concerned with plan balances as opposed to plan contributions. The goal of top-heavy testing is to make sure that key employees are not being unfairly favored in the 401(k) plan design. If you have a Safe Harbor plan, you do NOT need to perform this test every year!

Defining Key Employee

The top-heavy test uses Key Employees in calculations. A Key Employee is:

  • An officer making over $180,000 for 2019; ($175,000 for 2018 and $170,000 for 2015, 2016 and 2017); OR
  • Someone who owns more than 5% of the business; OR
  • An employee owning more than 1% of the business AND making over $150,000 for the plan year

A non-key employee is everyone else.

Testing Method

A plan is top heavy if account values of key employees represent more than 60% of the account values of all employees (after deducting certain amounts such as rollovers, terminated employee balances, etc.).  

Fix It

If a plan is found to be top heavy, the correction method is generally for the employer to make a 3% nonelective contribution to all non-key employees.  

Limit Tests

402(g) Limit Test

Purpose

This test determines whether any participant exceeded their 402(g) Annual Contribution Limit on Pre-tax and Roth 401(k) salary contributions ($19,500 in 2020). Catch-up contributions are not included in this limit.

Testing Method

Make sure each participant does not contribute more than $19,500 in 2020 to their 401(k) account (includes both Pre-tax and Roth contributions, but not catch-up contributions).  

Fix It

If a participant contributes over the annual limit, they must withdraw their excess contributions by April 15 of the next year. If the participant misses the deadline, the excess contributions will be doubly taxed, meaning they will be taxed both in the year contributed AND in the year distributed. They could also be subject to a 20% withholding and a 10% tax penalty.

If excess contributions are not withdrawn by the April 15th deadline, the entire plan will be at risk of disqualification. This applies only to a plan in which the participant surpassed their limit entirely in that plan. If a participant surpassed their limit between two plans but neither account went over $19,500 by itself, only the participant will be penalized.

415 Annual Additions Test

Purpose

This test determines whether any participant exceeded their 415 Annual Additions Limit on total overall annual contributions. This limit does not include rollover and catch-up contributions, but does include:

  • Pre-tax and Roth employee contributions
  • Employer matching and nonelective contributions
  • Safe harbor contributions
  • Forfeiture contributions
  • Voluntary after-tax contributions*

*Guideline does not currently offer after-tax contributions.  

Testing Method

Add up all annual contributions listed above for each participant and make sure each individual does not go over the limit. The limit for 2020 is the lesser of 100% of gross compensation or $57,000.

Fix It

If a participant exceeds their Annual Additions Limit, they must withdraw excess contributions in the following order:

  1. Unmatched after-tax* employee contributions
  2. Unmatched employee contributions
  3. After-tax* employee contributions with associated matching contributions
  4. Employee contributions with associated matching contributions

*Guideline does not currently offer after-tax contributions.  

Any excess contributions distributed will not incur a 10% tax penalty, however, a 20% tax withholding does apply, and the withdrawals will be taxable in the year they are distributed. Distributions of excess contributions may also impact ADP/ACP testing.

Coverage Test

Purpose

This test is used to ensure that a plan’s eligibility requirements are not overly restrictive.  Testing determines whether the plan meets certain minimum coverage standards set by the IRS.  

Testing Method

Generally, every 401(k) plan must cover at least 70% of employees who have met the minimum age and service requirements set forth by the IRS. Union employees and nonresident aliens may be excluded from this test.

If you have a Guideline 401(k), your plan should automatically pass this test in normal situations. An outlier situation may be one where your company is part of a controlled group (e.g. a wholly owned subsidiary), and the group does not share a 401(k) plan. In this case, all companies in the group must be tested together.  If this happens, the ratio percentage test is applied.  

Ratio Percentage Test (RPT). A plan will pass the RPT if the percentage of NHCEs benefiting under the plan is equal to at least 70% of HCEs benefiting under the plan.

If a plan does not pass the RPT, additional tests may be applied, but the need for this is rare.

Fix It

Plans have until October 15th of the year after the plan year to correct a coverage failure. The Plan Sponsor must generally extend plan coverage to a broader group of NHCEs.

If uncorrected, the plan could become disqualified, and HCEs, possibly NHCEs as well, must report contributions as income in the year the plan fails.

Want to avoid compliance testing next year?

Nondiscrimination compliance testing is an important part of building up retirement in America, because it gives employers incentive to encourage even lower-paid employees to start contributing toward their retirement nest egg. However, it can be troublesome and time-consuming for plan sponsors to conduct annual testing, not to mention cover the costs involved with plan corrections, if needed. The best way to support your employee’s retirement while avoiding the hassle of nondiscrimination testing is to create a Safe Harbor plan. Safe Harbor plans are intended to satisfy nondiscrimination requirements and, as such, are automatically exempt from much of the above testing. Learn more about creating a Safe Harbor plan here.

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