Compliance

401(k) Nondiscrimination Tests Explained

By PLANSPONSOR staff editors@plansponsor.com | December 01, 2014
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The first method provides that the ratio of the contribution average of HCEs to that of the NHCEs may be no more than 125%. For example, if the average NHCE contribution is 3%, then the average HCE contribution may be no more than 3.75%.

Under the second method, the average contribution for the HCEs may not exceed the lesser of the average contribution of the NHCEs plus 2% or the average contribution of the NHCEs times two. For example, if the average contribution for the NHCEs is 3%, then the average contribution for the HCEs may not exceed 5% (the average contribution of the NHCEs plus 2%). If the average contribution for the NHCEs is 1%, then the average contribution for the HCEs may not exceed 2% (because 1% times two is less than 1% plus 2%).

Repercussions of Failing

If the 410(b) coverage test is failed, plan sponsors must bring the plan into retroactive compliance by the end of the plan year, either by extending coverage to a broader group of NHCEs or by modifying contribution allocations or benefit accruals. According to information on the Employee Benefit Research Institute website, if the sponsor fails to bring the plan into compliance—i.e., leaving the failed coverage test uncorrected—HCEs will have to report as income their vested accrued benefit that was not previously reported as income on their income tax returns.

For the ADP and ACP tests, Kaplan says, “If the plan fails either test the employer must take corrective action in the 12-month period following the close of the plan year in which the oversight occurred.”

The IRS explains two methods for correcting a failed ADP or ACP test:

  • Determine the amount necessary to raise the ADP or ACP of the NHCEs to the percentage needed to pass the tests, and make a qualified nonelective contribution (QNEC) to all eligible NHCEs in that amount, and
  • Distribute excess contributions, adjusted for earnings, to the HCEs. If any excess matching contributions are not 100% vested for the participant, the applicable percentage must be forfeited. Kaplan notes that, for calendar year plans, distributions must be done by March 15 (2.5 months following the plan year) to avoid excise taxes.

 

If a plan is found to be top-heavy in a plan year, the plan sponsor must make a minimum contribution to the non-key employees. The contribution is generally 3% of compensation.

Kaplan notes that SIMPLE 401(k) and safe harbor 401(k) plans are not subject to either the ADP or ACP tests because, in lieu of testing, they deposit mandatory fully vested contributions.

“Congress prefers increased benefits for NHCEs or non-key employees. That is why there are provisions in the law to give employers an exemption from the ADP and ACP tests and the top heavy rules,” Richter adds. “Specifically, safe harbor 401(k) plans can be designed to avoid these tests. That is the carrot. The cost is that safe harbor plans require certain minimum contributions for NHCEs.”

 

Noel Couch

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