What is Non-Discrimination Testing?
Nondiscrimination testing is required for qualified retirement plans to ensure that benefits under the plan do not discriminate in favor of officers, owners, shareholders, employees in authority of other employees or any other employee classified as a highly compensated employees (HCEs).
WHY WHERE THE NON-DISCRIMINATION TESTING REGULATIONS CREATED?
These regulations were created to prevent retirement plans from discriminating in favor of Highly Compensated Employees.
WHAT ARE THE CATEGORIES OF THE NON-DISCRIMINATION TESTING?
- Compliance Testing (ACP/ADP)
- Top-Heavy Testing
- Minimum Coverage & Participation Testing
WHAT ARE THE ANNUAL LIMITS THAT MUST BE MAINTAINED EACH YEAR?
- Sections 402(g) – Annual Pre-tax Limit
- 415 Limitation Testing – Annual Contribution Limit
- 401(a)(17) – Annual Compensation Limit
WHAT IS COMPLIANCE TESTING?
Compliance Testing measures whether a plan discriminates in favor of an HCE. Compliance testing became necessary as a result of the Tax Reform Act of 1986 and the re-defining of permissible contribution and deferral opportunities available to HCEs covered under IRS-qualified 401(k) plans and after-tax savings plans.
WHO IS CONSIDERED A HIGHLY COMPENSATED EMPLOYEE?
An HCE is defined as a 5% owner of the business in either the current or prior year and/or an employee who earned in excess of $115,000 in the previous (2012) plan year. All other employees are considered Non-Highly Compensation Employees (NHCE).
HOW DO YOU DETERMINE IF A PLAN DISCRIMINATES IN FAVOR OF AN HCE OR KEY EMPLOYEE?
In order to determine if a plan does not discriminate in favor of HCEs, There are 3 tests that must be performed. They are as follows:
- The Actual Deferral Percentage (ADP) and the Actual Contribution Percentage (ACP). The ADP tests 401(k) and Roth contributions and ACP tests after-tax and employer matching contributions.
- The Top Heavy Test tests the account balances of key employees vs. non-key employees.
- Minimum Coverage Test – Tests the population of HCEs vs. NHCEs
HOW DOES TESTING THE 401(K) CONTRIBUTIONS WORK?
The Actual Deferral Percentage (ADP) applies to the employee pre-tax and/or Roth contributions. The ADP for HCEs and NHCEs is determined by calculating the contribution percentage for each individual in the group, then adding these percentages together and dividing by the total number of participants in the group to determine the average for the group. A separate application of the test is made to determine if the ADP of the HCEs fall within the limit that is determined by the ADP of the NHCEs.
HOW DOES TESTING NON-401(K) CONTRIBUTIONS WORK?
The Actual Contribution Percentage (ACP) applies to the employer matching contributions and employee after-tax contributions. The ACP for HCEs and NHCEs is determined by calculating the contribution percentage for each individual in the group, then adding these percentages together and dividing by the total number of participants in the group to determine the average for the group. The ACP of the HCE must be in an acceptable limit. This limit is determined by the ACP of the NHCEs.
WHAT ARE THE ADP/ACP TESTING REQUIREMENTS?
On the last day of the play year, the plan will satisfy the ACP and ADP rules if either the 1.25% Test or the 2 Times/2% Test is satisfied.
- 1.25% Test- The ACP/ADP of the highly compensated group cannot be more than 1.25% times the ACP/ADP of the non-highly compensated group.
- 2 Times/2%/ Test- The ACP/ADP of the highly compensated group cannot be more than 2 times the ACP/ADP of the non-highly compensated group. The ACP/ADP of the highly compensated group cannot be more than 2 percentage points higher than the ACP/ADP. Which ever is less of these two tests is applied.
WHAT HAPPENS IF A TEST FAILS?
If a test fails the ADP test, employee pre-tax contributions may need to be refunded to certain HCEs. Corrections are determined by starting with the HCE deferring at the highest percent; the HCE who deferred the highest percent is reduced down to the HCE who deferred the next highest and so on until a deferral percent is reached that ensures the plan will pass the test.
Then take the adjusted deferral percent and multiply it by each of the reduced HCEs current year compensation and subtract the calculated amount form the original amount deferred to get the total amount that needs to be refunded from the plan.
Then determine the distribution amount for each HCE, starting with the HCE who contributed the most and bring the participant down to the next highest HCE to see if the satisfies the amount needs to be refunded and so forth until the amount to be refunded out of the plan is allocated among the HCEs.
HOW DO YOU MINIMIZE THE PROBABILITY OF REFUNDS?
To minimize the likelihood of HCEs receiving refunds you may want to take advanced planning steps to minimize any uncertainty and the consequences of the testing process. Some approaches to adopt are:
- Make plan participation more attractive to lower-paid employees through plan redesign, adding more investment options, improving vesting schedules, adding a plan loan feature, or making withdrawal provisions more liberal.
- Adopt the “prior-year” testing method. The prior-year testing method compares the ADP/ACP of the NHCEs from the prior plan year to the ADP/ACP of the HCEs for the current year. This method allows the employer to know ahead of time how much the HCEs can contribute, on average, for the current plan year.
- Increase the plan’s matching formula, by changing the matching formula. Consider that employees aim for a level at which their salary will be matched and may not contribute if no match is available. The match should be enough to encourage NHCEs to select higher payroll deduction rates.
- Allow immediate participation on the date hired, since participation may be easier to encourage when employees have just been hired. The new employees then will not “miss” the amounts they elect to defer if they have not previously received full pay. Note, this feature may not be advantageous for companies that have very high turnover.
- Improve the level and frequency of employee communications to increase the participation of NHCEs.
- Adopt a nonqualified plan for some or all HCEs. The nonqualified plan might be structured to allow employees to defer salary and receive a matching contribution in the same manner as they would under the 401(k) plan.
- An employer may provide a safe harbor match in order to avoid ADP testing. The safe harbor match is an employer match on the employee’s 401(k) contributions equal to 100% of the first 3% of compensation plus a 50% match for the next 2% of compensation (i.e., the contributions in excess of 3% of compensation, but not in excess of 5% of compensation). Other matching formulas that provide as beneficial a match may constitute a safe harbor match.
- Employer contributions that are utilized to satisfy the safe harbor must be immediately vested, and will only be able to be distributed under the same circumstances that apply to 401(k) contributions (generally termination of service, attainment of age 59½, death or disability).
- Add an Eligible Automatic Contribution Arrangement (EACA)
- Add a Qualified Automatic Contribution Arrangement (QACA)
WHAT WOULD DISTRIBUTING FUNDS LOOK LIKE FOR AN ADP TEST?
|Employee||Age||Compensation||Elective Contribution||Contribution Percentage||ADP Reclassified as Catch-up||Refund|
Actual Deferral Percentage for HCE (HCE): (6.80% + 8.00%)/ 2 = 7.40%
Actual Deferral Percentage for NHCEs (NHCE): (5% + 0% + 3.5% + 3.5%) / 4 = 3%. In this example, the ADP of the HCEs cannot be greater than 2% plus the ADP of the NHCEs to pass the test. (3% + 2% = 5%) Because the test failed, the HCEs will receive a refund of their excess deferrals.
Refunds are calculated using a two-step process. First we must determine the amount of the contributions which must be refunded from the plan. The HCE with the highest percent is reduced down to HCE with the next highest deferral percent and so forth until we reach the adjusted deferral percent of 5%, as determined above.
Once we have determine the percentage that each HCE must be reduced we take the adjusted deferral percent and multiply it by each of the reduced HCEs current year compensation and subtract the calculated amount from the original amount deferred to get the total amount that needs to be refunded from the plan.
|Employee||Compensation||Elective Contribution Percent||Adjusted Contribution Percent||Amount to be Refunded from the Plan|
|In this example, a total of $9,900 of deferrals must be refunded out of the plan. We start with the HCE who contributed the most and bring him down to the next highest HCE to see if that satisfies the amount that needs to be refunded and so forth until the $9,900 has been distributed. The employer first returns $2,600 to HCE1, since this is the employee with the highest dollar deferral, to bring the elective contribution of HCE1 down to $14,400, the amount of elective contribution deferred by HCE2. HCE1 and HCE2 would then each receive refunds in the amount of $3,775 (a total of $6,375 for HCE1). Top-paid employees are likely to be more affected whenever a distribution of excess deferrals or contributions is necessary. Since HCE1 is over age 50 and he has not contributed any catch-up for the plan year a portion of his refund can be reclassified as catch-up contributions.|
WHAT IS 415 LIMITATION TESTING?
In the Internal Revenue Code Section 415 sets limits on “annual additions” made to a participant account ($51,000 for 2012). The amount allocated to an employee under a qualified defined contribution plan(s) cannot exceed this amount. If an employer sponsors more than one qualified retirement plan the contributions for each plan must be aggregated to determine the total contributions for the year.
WHAT ARE THE 415 LIMITATIONS FOR DEFINED CONTRIBUTION PLANS?
The plan is usually defined as the sum of:
- Employer Contributions
- Employee Contributions
HOW DO YOU CORRECT 415 LIMITATION VIOLATIONS?
A 415 limitation violation is corrected by refunding employee pre-tax deferrals, employee after-tax contributions (if any), and/or forfeit employer contributions.
WHAT IS TOP HEAVY TESTING?
The Top Heavy test is a calculation whereby the present value as of the determination date (the determination date is the last day of the prior plan year) of the accrued benefit of all key employees is determined and if the value of the Key Employee account balances exceeds 60% of the present value of the accrued benefits for all employees then the test is deemed to have failed and corrective measures need to be taken.
HOW IS A TOP-HEAVY PLAN CORRECTED?
The plan must provide for a more liberal vesting schedule as well as a minimum level of employer contributions.
WHAT IS A KEY EMPLOYEE?
A key employee is an employee who is a 5% owner in the current or prior plan year, an officer whose annual compensation is in excess of $165,000 and/or is a 1% owner earning more than $150,000.
HOW DO YOU ASSESS THE RESULTS?
The minimum required contributions for non-key employees are generally the lesser of 3% of compensation or the highest contribution percentage rate for any key employee. The annual retirement benefit of non-key employees must not be less than the employees average compensation over a 5-year period multiplied by the lesser of 2% times the number of years of service, and 20%.
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