You Failed Nondiscrimination Testing, Now What?

According to a survey from Judy Diamond Associates, nearly 60,000 401(k) plans failed Internal Revenue Service (IRS) nondiscrimination testing, with more than one in 10 issuing corrective distributions to highly compensated employees (HCEs) in 2012.

“The plan design is by far the best way to get to a point where more employers are passing their nondiscrimination testing,” says Geno Cufone, senior vice president, retirement administration, at Ascensus in Dresher, Pennsylvania. “But you have to consider whether or not they have the wherewithal to afford doing some type of employer match.”

He says there are three factors that determine whether or not the plan will be prepared for the next round of testing: plan design, employee behavior and continuous monitoring.

“From a plan design perspective, automatic enrollment will definitely provide the best opportunity for getting your non-highly compensated employees [NHCEs] into the plan, to offset the contributions of the highly compensated employees,” Cufone notes. If rank-and-file workers are not making sufficient deferrals, the plan sponsor should try to change employee behavior. One—admittedly unpopular—possibility is to have HCEs cut down their deferrals. “Ask them to contribute a little bit less if they know that [otherwise] they’re going to be getting a refund.”

The best thing for the plan and for participants, Cufone says, is to “influence the non-highly compensated employees to contribute more if you see that you’re falling within the range where, potentially, you’re going to fail.” He recommends sending out targeted communications to urge participants to increase their deferrals. “We know it’s in their best interest to contribute more to the plan, and you get the added benefit of having a greater opportunity to pass your nondiscrimination testing.”

What is most advisable for plan sponsors, Cufone says, is to regularly monitor the plan and look at participants’ deferrals in order to avoid reaching that point. Otherwise, the plan may want to adopt a safe harbor employer contribution, to avoid testing altogether.

“If you can afford to do that, choosing a safe harbor basic employer match will eliminate the need for testing at all. Offering a safe harbor match contribution—100% of the first 3% of compensation employees defer and 50% of the next 2% they defer—eliminates the need for both ADP [testing of employee deferrals] and ACP testing [of employee after-tax and employer contributions], and then you get the added bonus of not having to do top-heavy testing as well,” he says. “Another option is to offer a 3% nonelective contribution to all employees in the plan, regardless of whether or not they’re contributing. By doing that, you no longer have to do any of the required testing.”

With regard to actual deferral percentage (ADP) and actual contribution percentage (ACP) testing, Cufone says, “In our experience, [a plan’s failure] really depends on how long the plan has been in existence and whether or not the plan administrator at the employer has had any experience running a 401(k) plan in the past. Especially with start-up plans, plans that have just begun, there does seem to be a surprise element, more often than not.”

To avoid being caught off-guard, he recommends that plan sponsors provide complete census information to their recordkeepers on an ongoing basis and have their recordkeepers test their plans mid-year to see where participants fall. “The more information that they provide … to the recordkeeper, the better prepared we can make them, to ensure that they don’t fail,” Cufone says.