Coverage Test

Purpose

This test is used to ensure that a 401(k) plan is available to enough of the rank and file employees of a business known as the Non-Highly Compensated Employees (NHCEs).  It is one way the IRS prevents plans from discriminating in favor of high-paid employees and officers known as Highly Compensated Employees (HCEs).  

Testing Method

Generally, where a 401(k) plan covers 100% of eligible employees, a plan will pass coverage testing automatically. Note that union employees and nonresident aliens may be excluded from this test.

If you have a Guideline 401(k) plan, your plan should automatically pass this test in most situations. However, if your company is part of a controlled group (e.g., the owners have common ownership in other entities, or there are subsidiary and parent organizations and the group of entities does not share a 401(k) plan between them, it is possible the plan could fail the coverage test. In this case, all companies in the group must be tested together applying the ratio percentage test.  

Ratio Percentage Test. Where a plan has a last day requirement for allocations, it will always be subject to the 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 used to help you pass, though 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 employer sponsoring the plan must generally extend plan coverage to a broader group of NHCEs as a correction.

If uncorrected, the plan could experience adverse tax consequences for both the employer and plan participants, including but not limited to disqualification, taxation, and penalization. 

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