Each year, 401(k) plans must pass certain tests to ensure that plan contributions stay within permissible limits and aren’t disproportionately benefitting the higher paid employees, officers and business owners. Some of the tests use mathematical calculations to determine whether plan contributions and account balances for the higher paid employees are within a permissible range as compared to those for lower paid employees. Others simply measure plan contributions for each participant to determine whether the statutory limits were exceeded.
When you receive your plan’s testing results for the 2019 plan year from Newport, your report will show a pass or fail score for each test or limit. If your plan failed one or more tests, you can change the score by taking corrective actions such as refunding contributions to higher paid employees or making additional contributions for lower paid employees. Newport will provide information on the correction options and the steps you’ll need to take to initiate a correction.
As you review your 2019 test scores, remember that a failing score is just a reflection of mathematical limits. If your plan consistently fails testing year after year, however, you may want to consider implementing one of the plan design changes that can bypass certain tests in exchange for employer contributions, or take other measures to help raise participation and contribution rates among your lower paid workers. Contact your Newport representative to learn more about plan design options to help your plan avoid testing failures in the future.
The following information is an overview of the tests and limits included in your year-end testing results.
Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Tests
Mechanics of the tests: The ADP test limits the percentage of compensation the Highly Compensated Employees (HCEs) can defer into the plan relative to the percentage deferred by non-HCEs. The ADP test includes both pre-tax and Roth elective deferrals. The ACP test ensures that employer matching contributions and after-tax (non-Roth) employee contributions for HCEs are not disproportionately higher than those for non-HCEs. To pass each of these tests, the average deferral percentage or the average contribution percentage of the HCE group cannot exceed the greater of
- 1.25% of the non-HCE group’s ADP or ACP or
- The lesser of
- 200% of the ADP or ACP for the non-HCE group or
- The ADP or ACP for the non-HCE group plus 2%.
Correction options: You have several options for correcting a failed ADP or ACP test, but the most common are to
- Distribute excess contributions (and forfeit matching contributions) to HCEs to lower their overall ADP or ACP, or
- Make qualified nonelective employer contributions (QNECs) or qualified matching contributions (QMACs) to non-HCEs to raise their overall ADP or ACP.
Testing excesses, plus any attributable investment earnings, distributed to HCEs are taxable in the year distributed (excluding designated Roth contributions).
Deadlines: The longer you wait to correct a testing failure, the more it could cost.
- If distributions are made within 2½ months after the plan year end (by March 15 for calendar-year plans), there will be no penalty cost for you as the plan sponsor. Plans with an eligible automatic contribution arrangement (EACA) feature may have up to 6 months to make the corrective distributions. If distributions are made after the applicable deadline and before December 31, you will owe a 10% employer excise tax on the taxable portion of the total corrective distribution for the plan year.
- If you make QNECs or QMACs to correct an ADP or ACP failure, the contributions must be made within 12 months following the end of the plan year. Depending on when these amounts are contributed, they may result in an annual addition for the plan year of deposit instead of the plan year being corrected. See below for information on the annual additions limit.
- If corrections are not made within 12 months following the plan year end, the failure may result in plan disqualification unless corrected using the IRS’s Employee Plans Compliance Resolution System (EPCRS). Please note that the cost for correction is usually significantly higher when correcting the failed test under EPCRS. Also, the plan must satisfy the other requirements of EPCRS to permit correction under this program. Not all plans or failures will meet the requirements.
Mechanics of the test: The year-end top-heavy test determines the plan’s top-heavy status for the coming year. A plan is top heavy if more than 60% of its total assets are held by Key Employees (defined differently from an HCE) as of the last day of the preceding plan year.
Consequences of a top-heavy determination: If your plan is determined to be top-heavy AND a Key Employee is credited with contributions for a plan year (including elective deferrals), you must make an employer contribution for each non-key employee. The required top-heavy contribution must equal at least 3% of the employee’s compensation for the plan year or, if less, the highest percentage of compensation credited to the account of any Key Employee. Your profit sharing contributions, matching contributions, nonelective contributions, and allocated forfeitures, count toward the top-heavy contribution requirement.
Correction: If you fail to make the top-heavy contribution for the top-heavy year, you may correct the failure under EPCRS if the requirements of EPCRS are met; however, self-correction under EPCRS will not avoid the employer contribution and will require an adjustment for earnings (but not losses) on the required contribution.
Salary Deferral Limit (IRC Sec. 402(g) limit)
Explanation of the limit: A participant in a 401(k) plan may contribute up to $19,000 of their compensation as pre-tax and Roth salary deferrals for 2019. If a participant is age 50 or older, they may save an additional $6,000 for 2019 if the plan permits catch-up contributions. This limit applies to salary deferrals across all 401(k), 403(b), and SIMPLE plans in which an employee participates. Plan sponsors are responsible for monitoring this limit within their own plan. A participant whose aggregate deferrals exceed this limit as a result of contributions to multiple employers’ plans must notify you by March 1, 2020 (for a 2019 excess) if the participant wishes to have any portion of the excess distributed from your plan.
Correction: Distribute the excess and any attributable investment earnings. The excess deferral is taxable in the year contributed, and the earnings are taxable in the year distributed.
Deadline: The corrective distribution must be made by April 15, 2020, for a 2019 calendar year excess. If the excess is not corrected by the deadline, the plan may be subject to disqualification unless the error is corrected using the IRS’s EPCRS guidance if the program requirements are met. Also, if an excess deferral is distributed after the deadline, it is taxable to the participant in the year contributed, and the entire distribution (excess deferral and earnings) is taxable in the year distributed – double taxation on the excess deferral portion of the distribution.
Annual Additions Limit (IRC Sec. 415 limit)
Explanation of the limit: The annual additions limit determines the maximum amount that can be allocated to a participant’s account in each employer’s plan each year. All employee and employer contributions allocated to a participant’s account in your plan for 2019, including any forfeitures allocated to that account, cannot exceed the lesser of:
• 100% of the participant’s compensation as defined in the plan document or
• $56,000, plus up to $6,000 for catch-up contributions if the participant is age 50 or older and deferred compensation into the plan.
Correction: Excess annual additions should be corrected as soon as possible. Under EPCRS, correction is accomplished by distributing excess after-tax contributions and elective deferrals adjusted for earnings to the participant. A distribution of pre-tax elective deferrals and investment earnings is taxable for the year in which it is distributed. Any associated matching contributions must be forfeited or held in a suspense account according to the terms of the plan document. The plan must meet all EPCRS requirements to be eligible to correct under EPCRS.
Newport Group and its affiliates do not provide tax, legal or accounting advice.
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