If your company sponsors a 401(k) plan without safe harbor employer contributions, you’ll want to ensure plan contributions and balances stay within IRS-prescribed limits to ensure you pass annual compliance testing. “Compliance testing” refers to a series of IRS-required tests performed after year-end to ensure that a company’s 401(k) plan does not unfairly favor owners and highly compensated employees.
Guideline actively monitors your plan throughout the year to help maintain your plan’s compliance. If your plan is at risk for failing these tests, we will recommend actions you can take to increase the likelihood of passing and mitigate the impact of any required corrections.
This article builds upon our Compliance Testing Basics article by focusing on the three compliance tests which most frequently affect small businesses: the Actual Deferral Percentage (ADP), the Actual Contribution Percentage (ACP), and the Top-Heavy tests. Each is described below, along with recommendations to improve your chances of passing.
- I see a compliance alert on my dashboard -- what does this mean?
- Actual Deferral Percentage (ADP) TEST
- Actual Contributions Percentage (ACP) TEST
- Top Heavy Test
- Use a Safe Harbor Plan and Never worry
Don’t be alarmed. It simply means if the year ended today, your company’s 401(k) plan would fall outside IRS-prescribed ratios for one or more compliance tests. While your preliminary compliance status is updated daily, the only test results that matter are those based on your year-end data.
If your plan is currently outside the limits of one or more tests, Guideline will contact you with details and instructions. By acting early, you have more options at your disposal to help pass compliance at year’s end.
My plan is outside the Actual Deferral Percentage (ADP) limit
The Actual Deferral Percentage (ADP) test compares contributions made by your highly compensated employees and owners (HCEs) against contributions made by non-highly compensated workers (NHCEs).
What’s an HCE and NHCE?
Workers designated as HCEs are individuals who are either:
(1) compensated at least $120,000 in the previous year and were among the top 20% of the company’s earners; or
To measure a plan's ADP ratio, the average deferral percentage for all workers in the NHCE group are compared against the average deferral percentage of all workers in the HCE group. The permissible limit for HCE deferrals is determined by the average NHCE deferral rate, as shown in the table below:
|If the Average NHCE Deferral Rate is...||Then the maximum HCE rate is:|
|Between 0%-2%||NHCE rate multiplied by 2|
|Between 2%-8%||NHCE rate plus 2%|
|Greater than 8%||NHCE rate multiplied by 1.25|
For example, if your NHCEs have only deferred an average of 1% for the first part of 2018, your HCEs are currently projected to be limited to a 2% average deferral for the year. If your HCEs have deferred more than an average of 2%, your plan is at risk for failure.
Improve Your Chances of Passing ADP Test
If your plan is currently outside the permitted ratio, you can close the gap by a combination of:
- Encouraging NHCEs to increase contributions, and/or
- Requesting that HCEs reduce their contribution,
Effective ways to boost NHCE participation in your plan include:
- Educating NHCEs on the importance of retirement saving and the valuable benefits of a tax-advantaged 401(k) plan,
- Increasing your plan’s default automatic enrollment contribution rate,
- Implementing employer matching contributions up to a certain percentage of employee deferrals to encourage participation,
- Using a combination of employer matching and vesting schedules to encourage participation and employee retention.
If measures to boost NHCE participation fall short, then placing a cap on HCE contributions can help. In most cases, simply letting participants know that they may receive year-end taxable refunds if they continue contributing at their current rates can help to encourage a contribution adjustment.
These compliance-mitigating strategies are illustrated below. Guideline can assist with implementing any of these, or crafting another solution that’s right for your company. Just email Guideline Support.
Example 1: Increase NHCE deferrals & Reduce HCE deferrals
This example illustrates how a plan outside the IRS limits for ADP testing at mid-year can pass testing at year-end by encouraging modest changes by participants.
On July 1st, the plan is outside ADP limits due to high HCE deferrals
|Name||Status||YTD Wages||Total Deferrals||Deferral %||HCE ADP|
After learning that excess contributions may need to be refunded, HCEs reduce their deferral percentages modestly. Also, after learning more about the benefits of retirement saving, NHCEs make a modest increase in their deferrals.
In the second half of the year, HCEs contribute a little less and NHCEs a little more
|Name||Full Year Wage||New Deferral %||Annual Avg %||Total Deferrals||NHCE ADP ADP|
Over a period of six months, these modest changes in contribution rates are enough to bring a plan that was outside the ADP limit back within the limit.
Example 2(a): Boost NHCE Participation with Matching
The below example demonstrates how a plan is well outside the IRS limits for ADP testing at mid-year can encourage broader participation by offering a modest 25% match up to 4% of deferrals (totalling a mere 1% of compensation).
On July 1st, the plan is outside the ADP ratio by 2%
|Name||Status||Salary to date||YTD Contributions||Deferral %|
HCE ADP: 6% NHCE ADP: 2% HCE ADP LIMIT: 4%
The plan starts offering a 25% match up to 4% of compensation, a cost of only 1% of compensation to the employer. All employees adjust their contributions to 4% to make sure they are getting the full match at year-end. Understanding that excess contributions would need to be refunded, an HCE reduces her contribution rate but continues to contribute enough to qualify for the full matching amount.
In the second half of the year, HCEs contribute a little less and NHCEs a little more:
|Name||Full Year Wage||New Deferral %||Annual Avg %||Total Deferrals||NHCE ADP|
After the match is implemented, average NHCE contributions increase from 2% to 3% for the year, while the reduction in contributions by one HCE brings the HCE average down from 6% to 5%. The plan passes ADP testing and no refunds or contributions are required. The total employer cost of this match is only $1,600.00 (excluding $400 to Anna, the owner).
Implement Vesting to Control Costs Matching contributions can be made subject to a vesting schedule to reward longer tenured employees. Implementing a vesting schedule in conjunction with employer matching means that if an employee terminates employment before their employer contributions fully vest, they will forfeit some or all of the employer match back to the plan, which can then be used to pay plan expenses.
Consequences of Failing ADP Test
If your plan shows a preliminary ADP failure and remedial methods are unsuccessful, or if no action is taken to mitigate and employees continue to contribute at the same rates, the plan will almost certainly fail compliance testing. In this event, your company will either have to:
- Make employer nonelective contributions to raise the ADP ratio for NHCEs; or
- Refund deferrals to HCEs to reduce the ADP after year-end.
Example 2(b): ADP Corrections
Revisiting the above Example 2, if no change was made during the year, the employer could choose to make qualified nonelective contributions (QNECs) to the three NHCEs to raise their average deferral rates by 2% each, which would cost a total of $4,600:
|NHCE: 4.00%||HCE: 6.00%||Allowed HCE: 6.00%|
In contrast to the matching amounts, these QNECs cannot be subject to vesting.
If the company chooses not to make a QNEC to NHCEs, then HCE deferrals would have to be refunded to reduce the average HCE ADP by 2%.
|Name||Status||Earnings||Deferral %||Refund||NHCE %|
|The reason Anna receives a larger refund in the above example is that her total deferral was higher. A process known as leveling is used to calculate refund amounts taking into account first deferral rates and then dollar amounts with the goals of ensuring that HCEs are equally able to participate.|
My plan is outside the Actual Contributions Percentage (ACP) limit
ACP testing will follow the same limits as ADP testing, but instead of using employee deferrals, ACP calculations measure employer matching, as a percentage of total compensation.
If the Average Contribution Rate to NHCEs is...
Then the maximum Contribution to HCEs should be:
|Between 0%-2%||NHCE rate multiplied by 2|
|Between 2%-8%||NHCE rate plus 2%|
|Greater than 8%||NHCE rate multiplied by 1.25|
To measure a plan’s ACP ratio, the average employer contributions to NHCEs (as a percentage of compensation) is compared against the average employer contributions to HCEs (as a percentage of compensation). The IRS limits the discrepancy between the two averages in the same way as the ADP testing.
Improve Your Chances of Passing the ACP Test
If your plan is currently outside the permitted ratio, you can close the gap by:
- Encouraging NHCEs to increase contributions to earn the maximum match they’re eligible for; and/or
- Requesting that HCEs reduce their contribution; and/or
- Adjusting your employer contribution formula.
If you are are matching a low percentage of employee deferrals or a high percentage of employee compensation, you may need to adjust your matching.
Again, Guideline can assist with providing information about the benefits of saving to NHCEs or helping adjust to your discretionary match to encourage broad participation.
At midyear with 25% matching to 8% of compensation:
|Name||Status||Deferral %||Matching||Matching||HCE ACP|
The plan responds by reducing matching to 50% up to 4% of compensation. The total potential maximum match, and maximum potential employer cost remains the same at 2% of compensation but the higher percentage and lower cap make the matching seem more obtainable. Employees increase their contribution percentage to capture the available matching and the plan easily passes ACP testing at the end of the year.
After change to 50% matching to 4% of compensation:
|Name||New Match||Salary||Total Match||ACP||NHCE ACP|
If you have a non safe harbor match, it can be adjusted at anytime without the need for a plan amendment. Just contact Guideline Support and we will assist in adjusting your company's discretionary employer match.
Keep in mind that you can also provide employer contributions via one of two profit sharing formula which will not be subject to ACP testing.
Consequences of Failing ACP Test
If matching continues to be offered at the same levels and employees do not make a significant change in their deferrals, the plan will almost certainly be outside of ACP limits at year-end. In this event, the company will either have to:
- Make employer nonelective contributions to raise the ACP ratio for NHCEs; or
- Refund deferrals to HCEs to reduce the ACP after year-end.
Example 3(b) ACP Corrections
Revisiting the above Example 3, if no change was made during the year, the employer could choose to make qualified nonelective contributions (QNECs) to the three NHCEs to raise their average contributions rates by .25% each, which would cost a total of $575:
|NHCE: 0.75%||HCE %: 1.50%||Allowed HCE: 1.50%|
If the company chooses not to make a QNEC to NHCEs, then HCE contributions would have to be refunded to reduce the average HCE ACP from 1.5% to 1%. Unvested contributions would be forfeited.
|Name||Status||Earnings||Contribution %||Refund||NHCE %|
My plan is outside the Top Heavy limit
Top-Heavy testing assesses account balances of key employees as a percentage total plan assets. Top Heavy testing is performed on the last day of the year for new plans and at the last day of the prior year for all plans after their first year. Plan assets are adjusted to exclude rollover but include loans and early distributions. Plan assets held by key employees may not exceed 60% of total plan assets.
|Key employees include individuals who:
a) Are officers that earn annual compensation of $180,000 or more for 2019 ($175,000 for 2018 and $170,000 for 2015, 2016 and 2017); or
b) Own more than 5% of the company, whether directly or by family relationship; or
c) Own more than 1% of the business and earn over $150,000 for the plan year.
Non-key employees are all other employees who do not fit the above criteria.
If you have received a warning that your plan may be at risk for being Top Heavy, you should first ensure that Guideline has the correct information on file about your key employees. Review your Company Information regularly to confirm that all key employees, including officers, owners, and children and spouses of owners have been correctly identified. Generally, for employees who hold vested options or restricted stock, these holdings should be included in determining ownership percentage.
Improve Your Chances of Passing the Top Heavy Test
Some of the steps that you will use to address Top Heavy issues are the same as those used to address ADP/ACP testing. If your plan is currently outside the permitted ratio, you can close the gap by:
- Encouraging non-key employees to increase contributions;
- Requesting that key employees reduce their contributions.
Top Heavy testing can be particularly difficult for small businesses with a high proportion of owners. Guideline can help, including answering any questions about ownership and officer status. Reach us Guideline Support.
Example 4(a) Increase Participation with Matching
Let’s reconsider Example 2(a) above, (assuming it is a new plan that began on January 1st), with the variation that Debra has become a 5% owner. The changes in contribution rates made after matching was introduced midway through the year bring a plan that was significantly top heavy into compliance.
At July 1, before matching added:
|Name||Status||Salary to date||Total Assets||Deferral %||Key EE Assets|
|Debra||key||$65,000||$2,600||4%||Top Heavy %|
As in earlier examples, employees adjust their contribution rate to 4% to maximize the matching amounts that they receive, while Anna reduces her rate to 4%.
After 25% to 4% matching is instituted for the second half of the year:
|Name||Status||New Deferrals||Deferrals||Employer||Combined||Key EE Assets|
|Debra||key||4%||$5,200||$650||$5,850||Top Heavy %|
Over the course of six months, the adjustments to the contribution rate bring the plan within the Top Heavy limit of 60%. The total employer cost of this match paid would be $2,200 with nearly half $1,050 accruing to the owners Anna and Debra.
Consequences of Failing Top Heavy Test
If no action is taken and the employees continued to contribute at the same rates for the rest of the year, your plan would be considered Top Heavy. Top Heavy minimum contributions would have to be made to non key employees.
Example 4(b) Top Heavy Corrections
A Top Heavy plan requires contributions to be made to all non-key employees of up to 3% of compensation or the highest deferral contribution of any key employee. Any “Top Heavy minimum contributions” owed are reduced by any matching or profit sharing contributions that have been or will be paid for the plan year.
In contrast to the modest cost of matching, a Top Heavy plan triggers employer nonelective contributions to all nonkey employees totaling $6,900.
Changes in employees can also make a big difference in top heavy testing, so keeping ownership information up to date is important. For example, the hiring of one or two non-key employees, or an employee making partner, can cause significant shifts in the top heavy testing for small plans, and Guideline will be in a better position to assist you with mitigation strategies when the risk is identified early.
401(k) plans with Safe Harbor provisions are exempt from the three tests discussed above. Safe Harbor provisions must be added 30 days before the start of the year and remain effective for the entire year. You can add a Safe Harbor provision to your plan for the coming year by contacting Guideline Support. To allow adequate time for amending plan documents and providing required notices to participants at least 30 days prior to the new year, please start the process before November 1st.