Each year, 401(k) plans must pass a series of nondiscrimination tests to ensure that the company owners and key personnel are not benefitting disproportionately compared to lower paid employees. To pass these tests, plan metrics must fall within certain mathematical limits. Advisors can use this annual process to help plan sponsor clients understand the factors contributing to their testing results and introduce solutions that can not only help avoid testing failures in future plan years, but also improve participant outcomes.
If your plan sponsor clients receive failing results, they may also need to act quickly to take corrective action to maintain the tax qualified status of their plan. These actions may include making taxable distributions to highly compensated employees (HCEs) or making additional employer contributions for other employees.
Plans operating on a calendar year will soon be receiving 2017 year-end testing results, if they haven’t already. Following is a summary of the most common types of testing failures and the dates by which plan sponsors must correct them.
The Actual Deferral Percentage (ADP) test limits the percentage of compensation the HCEs can defer into the plan relative to the percentage deferred by non-highly compensated employees (non-HCEs). The Actual Contribution Percentage (ACP) test ensures that employer match and after-tax employee contributions for HCEs are not disproportionately higher than those for non-HCEs.
Correcting Failed Testing
If the non-HCEs are not actively participating and saving in the plan, HCEs will be limited as to how much they can put into the plan. HCEs may have to distribute some of their salary deferrals from the plan to get their savings rates to a level that will pass the tests. Excess contributions should be distributed within 2½ months following the close of the testing year (March 15, 2018 for a calendar-year plan). If distributions are not made by this date, plan sponsors may still make corrective distributions until the end of the following plan year, but they will have to pay a 10% employer excise tax. Another option for correcting a testing failure is for the plan sponsor to make qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs) to the eligible non-HCEs. Corrections made after the 12-month period must be made under the IRS’s Employee Plans Compliance Resolution System (EPCRS).
Top Heavy Testing
A plan is top heavy if more than 60% of its total assets are held by key employees as of the last day of the preceding plan year (December 31 for a calendar-year plan). If the plan fails the top-heavy test as of December 31, 2017, it will be considered top-heavy for the 2018 plan year.
For 2017, a key employee is one who
- Owns more than 5% of the employer,
- Owns more than 1% of the employer and earns more than $150,000, or
- Is an officer of the employer and earns more than $175,000
Advisor Action Steps
Help plan sponsors understand their testing results
Low participation and savings rates by rank-and-file employees can negatively affect year-end testing results. Help your plan sponsor clients identify factors that may be contributing to testing failures. Evaluate plan features such as plan eligibility requirements to determine whether they are reducing participation and savings. Review the enrollment process and enrollment materials to determine whether changes are needed. Identify any employee groups that have weak participation and savings metrics.
Educate plan sponsors about solutions
Enhanced enrollment education and targeted communications that address the needs of specific plan demographics may be beneficial in encouraging stronger participation among certain employee sectors such as young workers or low wage employees who are not actively saving in the plan. Discuss plan design changes such as age and service requirements, automatic enrollment, and automatic escalation that may increase participation and savings rates. Sponsors of plans that consistently fail the ADP/ACP and top-heavy tests may want to consider adopting a safe harbor 401(k) plan that bypasses these tests and allows HCEs to maximize their contributions in exchange for mandatory employer contributions.
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