Qualified Plan Compliance
Much of what is written the press about retirement plans focuses on the responsibilities of plan fiduciaries when it comes to fees and investments. Although very important, complying with all the IRS rules, regulations, tests and limits is just as important. In fact, if a plan sponsor experiences any missteps in operating its plan, it is much more likely to involve these IRS requirements rather than the Department of Labor’s fiduciary rules.
The reason is that most of the fiduciary requirements focus on subjective standards such as reasonableness and best interest. On the other hand, things like nondiscrimination testing and contribution limits use objective criteria to determine whether or not a plan is in compliance.
Nondiscrimination Testing
Those nondiscrimination tests, in turn, are based on several detailed definitions. For example, some tests require that key employees be identified, while others require identification of highly compensated employees. The two groups sound similar, and it is pretty common for people to use the two terms interchangeably. However, they both have very different definitions and ramifications.
Here is a quick rundown of the nondiscrimination tests that typically apply to 401(k) plans and, with the exception of the ADP test, to other types of retirement plans as well.
Minimum Coverage Test This test is meant to demonstrate that a plan covers enough non-highly compensated employees (NHCEs) relative to the number of highly compensated employees (HCEs) that are covered. To the extent a plan provides that different groups of employees are eligible for different components of the plan, e.g. ability to make 401(k) deferrals vs. eligibility to receive a company profit sharing contribution, each different component of the plan must pass the minimum coverage test separately.- ADP & ACP Tests The ADP - actual deferral percentage test - compares the average deferral rate (including both pre-tax and Roth deferrals) of the HCEs to that of the NHCEs. If the variance is greater than a certain amount (usually two percentage points), the ADP test fails, requiring refunds to HCEs and/or additional contributions on behalf of NHCEs. The ACP - actual contribution percentage test - works just like the ADP test except that it reviews employer matching and employee after-tax contributions instead of 401(k) deferrals.
- Compensation Ratio Test This test compares the average “benefit eligible” compensation of the NHCEs to that of the HCEs. If a plan is written to carve out certain types of compensation when determining benefits, this test must be run to ensure the types of compensation being excluded do not disproportionately impact the NHCEs.
- Top Heavy Determination A plan is considered top-heavy if the sum of all key employee balances exceeds 60% of the total balances in the plan as of the determination date. If a plan is a top-heavy, the plan sponsor may have to make additional company contributions on behalf of non-key employees. Note that this test reviews key and non-key employees rather than HCEs and NHCEs.
The minimum coverage test is the foundation and must be run to determine which employees must be counted for most other nondiscrimination testing. Skipping that to jump straight into the ADP test could lead to the ADP test being prepared incorrectly. A plan could cover 100% of its employees and provide for a very generous matching contribution; however, if that plan is top heavy, non-key employees who didn’t defer and, therefore, did not receive a match would be entitled to additional contributions. Since failure to provide those contributions must be reported on the Form 5500 filed by the plan year, the consequences for even an innocent oversight can be significant.
It is true that safe harbor 401(k) plans get a free pass on the ADP test and sometimes the ACP test and top-heavy determination as well. But those free passes come with additional compliance strings attached. Not to mention, there are certain plan provisions that can void some of those free passes. For example, if the sponsor of a safe harbor plan makes a profit sharing contribution for a given year, it loses the free pass on the top heavy determination.
There are industry service providers who look at compliance testing as something ancillary that they can just throw in as an after-thought. Some will even say that it is free or deeply discounted if bundled with other services. It can be tempting to go along with that, because after all, everyone cares about that groovy participant website a whole lot more than a bunch of boring reports with a bunch of seemingly random numbers and calculations.
There are industry service providers who look at compliance testing as something ancillary that they can just throw in as an after-thought. Some will even say that it is free or deeply discounted if bundled with other services. It can be tempting to go along with that, because after all, everyone cares about that groovy participant website a whole lot more than a bunch of boring reports with a bunch of seemingly random numbers and calculations. But no matter how impressive other bells and whistles might be, compliance with all these tests is still critical to preserving the tax and retirement benefits offered by the plan.
An error related to compliance testing, company contribution calculation, and/or other limits can be costly, and there is no substitute for working with experienced professionals who really understand the rules rather than just thinking of them as a necessary evil.
