Non-Qualified Plans: The Remedy to 401(k) Plan Testing Issues

Jul 06, 2020

The COVID-19 pandemic has caused major disruptions to businesses across the country. As a result of difficult employment decisions and reduced contributions, many of your clients’ 401(k) plans could potentially fail their 2020 nondiscrimination tests. One option to address the potential storm of testing failures is to remove highly compensated employees (HCEs) from 401(k) plans and place them in non- qualified deferred compensation (NQDC) plans, which will alleviate testing failures and allow HCEs to continue to save for retirement. Another option is to establish an NQDC plan to help HCEs offset income they may have to report as the result of receiving corrective distributions from 401(k) plans.

Background

401(k) plans have become the standard for companies to help their employees save for retirement; however, their governing rules present potential issues for employers and HCEs:

• Contribution Limits: As with all participants, HCEs can contribute up to $19,500 to their qualified plan in 2020, with an additional “catch-up” contribution of $6,500 for employees age 50 or older.1
• Non-discrimination Testing: Each year, 401(k) plans undergo compliance tests to ensure that they are not discriminating in favor of HCEs2. The following tests must be performed – and passed – to ensure plan benefits and contributions fall within the permitted ranges:
  • 1. 410(b) Minimum Coverage – tests the population of HCEs vs. non-HCEs benefiting from the plan
  • 2. Actual Deferral Percentage (ADP) – tests 401(k) and Roth contribution
  • 3. Actual Contribution Percentage (ACP) – tests after-tax and employer matching contributions
  • 4. Top Heavy – tests the account balances of key employees vs. non-key employees.

These tests provide many opportunities for a plan to fail. For example, plans must benefit a minimum number of employees pursuant to the 410(b) test, which is typically about 70% of an employee base. In addition, if lower-paid employees aren’t saving enough as a group, it can reduce the amount HCEs are allowed to save or require employers to make “corrective distributions” and return some HCEs’ savings.

Plan Discrimination in Extraordinary Economic Environments

While we don’t know the full impact of this crisis, if history is a guide, we know that the lowest paid employees are typically the first ones to lower or discontinue deferrals during times of economic hardships. That will have a direct impact on plan testing, particularly if HCEs continue to defer or have front loaded their deferrals early in the year.

Recordkeepers and third party administrators will generally conduct testing for this year between January 1 and March 15, 2021, so a testing failure might not be known until this plan year has ended. If a company fails testing, pre-tax contributions may need to be refunded to certain HCEs, particularly if they maxed out their contributions, which will count as taxable income in 2021 in addition to reducing tax-deferred savings and growth in their 401(k).

Plan Testing Defensive Strategies – The NQDC Plan

Employers and HCEs should plan now to mitigate the potential impact of plan year 2020 testing failures. While effective, the traditional strategies available to companies to avoid testing failures can be expensive. For example, a Safe Harbor 401(k) plan will eliminate the testing requirements, but an employer must make either matching or nonelective contributions to the plan. These payments can be significant (e.g., a $10mm payroll for eligible employees will cost the employer $300,000 in nonelective contributions).

A NQDC plan may be a better, less expensive option than traditional strategies. Requiring HCEs to defer only to the NQDC plan would allow the 401(k) plan to meet its testing requirements while preserving the ability of HCEs to defer salary and receive a matching contribution. If HCEs are allowed to defer to both the 401(k) plan and the NQDC plan, deferrals into the NQDC plan can help offset income attributable to any required refunds from the 401(k) plan. And employers can implement NQDC plans without the additional financial burden of other alternatives. Since they are funded from money that would have gone into the 401(k) plan, a typical NQDC plan has just a start-up fee and a yearly administration fee.
 

401(k) Plans vs. NQDC Plans

The primary difference between 401(k) and NQDC plans is that NQDC plans are not subject to many of the rules of the Employee Retirement Income Security Act of 1974 (ERISA), nor to compliance testing. These reduced regulations allow plan sponsors to have greater flexibility with plan design and participant eligibility. Another important consideration is that money that is set aside for the financing of an NQDC plan remains an asset of the company until paid out. As with a 401(k) plan, when benefit payments are paid out of an NQDC plan, the HCE will pay income taxes on that money. The following chart details the many other key differences between the two types of plans.

Considerations to Discuss With Employers for Setting Up an NQDC Plan

• Potential for Testing Issues: Advisors can help employers analyze whether their plans are facing potential nondiscrimination testing issues resulting from layoffs, reduced contributions, or HCEs front-loading their contributions.
• Business Structure: While NQDC plans are a good fit for most businesses, employers who have structured their businesses as pass-through entities, such as S-corps, LLCs and partnerships, should be aware that the addition of an NQDC plan will provide a benefit to HCEs but not to the business owner.
• Timing: For employers with potential testing issues, this strategy should be discussed today. The NQDC plan should be established in 2020 whether the goal is reducing HCE deferrals to the 401(k) plan in 2020 or offsetting 2021 income from refunds that will be issued next year. Fortunately, Newport can guide you and the employer through all the details and establish an NQDC in as little as 90 days.

Conclusion

Integrating an NQDC plan with a current 401(k) plan can help an employer resolve potential nondiscrimination testing issues and prevent testing failures, while allowing HCEs to maximize their retirement savings. Adding an NQDC plan to a 401(k) also helps companies maintain a competitive benefit package when they are recruiting key employees, particularly in challenging economic times. Contact your Newport Representative for more information.