Mar 29, 2021
Even during good business years, some companies struggle to pass the annual nondiscrimination tests required for 401(k) plans – for example, because a percentage of the workforce had low participation or deferral rates. But throw in layoffs and reduced savings rates triggered by the economic uncertainty caused by a global pandemic, and many more plans may now be finding they did not pass year-end testing for 2020.
As a retirement plan advisor, you can make certain a failed test is simply a minor compliance issue easily remedied providing that your client attends to it right away. If this is not a one-time occurrence for a plan, but an ongoing issue, you can also introduce solutions that will help prevent testing failures in future years and still allow owners and highly compensated employees to save meaningfully for retirement.
401(k) plans operating on a calendar year will soon be receiving 2020 year-end testing results if they haven’t already. Following is a summary of the most common types of testing failures and excess contributions that should be corrected as soon as possible following the end of the plan year to avoid excise taxes and to maintain the tax qualified status of the plan.
ADP/ACP Tests
401(k) plans must pass two nondiscrimination tests to ensure the owners and executives are not benefitting disproportionately from the plan compared to lower paid employees. The Actual Deferral Percentage (ADP) test limits the percentage of compensation that highly compensated employees (HCEs) can defer into the plan relative to the percentage deferred by non-HCEs. The Actual Contribution Percentage (ACP) test ensures that employer matching contributions and after-tax employee contributions for HCEs are not disproportionately higher than those for non-HCEs. An HCE is generally defined as an employee who owns more than 5% of the company or who earned more than $130,000 during the 2020 testing year.
Correction Methods: If a plan fails the ADP or ACP test for 2020, the employer can correct the failure by either:
- Distributing excess contributions, plus attributable investment earnings, to HCEs or
- Making an additional contribution to the plan.
If distributing excess contributions, employers should ensure they are distributed within 2½ months following the close of the testing year (March 15, 2021 for a calendar-year 2020 plan). These distributions will be taxable to the HCEs in the year distributed. If distributions are not made by this date, employers may still make corrective distributions until December 31, 2021, but they will pay a 10% employer excise tax on the excess contributions. If the employer chooses to correct a testing failure by making qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs) to the eligible non-HCEs, contributions should be made by December 31, 2021. Corrections made after this 12-month period following the plan testing year must be made under the IRS’s Employee Plans Compliance Resolution System (EPCRS) to avoid plan disqualification.
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, 2020, it will be considered top-heavy for the 2021 plan year. A key employee is generally defined as one who owns more than 5% of the company, owns more than 1% of the company and earned more than $150,000, or is an officer of the company and earned more than $185,000.
Correction Method: If the plan is top-heavy, the employer must make a contribution for each non-key employee generally equal to at least 3% of the employee’s compensation. If profit sharing contributions, matching contributions, nonelective contributions, or forfeitures are allocated for the top-heavy year, those contributions can be used to satisfy all or a portion of the 3% requirement. If an employer fails to make the 3% contribution by the end of the year following the top-heavy year, they may correct the failure under EPCRS.
Salary Deferral Limit (402(g) limit)
A employee in a 401(k) plan may contribute up to $19,500 of their compensation as pre-tax and Roth salary deferrals for 2020. If an employee is age 50 or older, they may save an additional $6,500 for 2020 if the plan permits catch-up contributions.
Correction Method: Employers should distribute excess deferrals made in 2020 and the attributable investment earnings by April 15, 2021. The excess deferral is taxable in the year contributed (other than designated Roth contributions), and the earnings are taxable in the year distributed (2021). If a pre-tax excess deferral is corrected after April 15, it is taxable to the employee in the year contributed (2020) and the year distributed, and the attributable earnings are taxable in the year distributed. If the excess is not timely distributed, the plan may also be subject to disqualification unless the error is corrected using EPCRS.
Annual Additions Limit (415 limit)
The maximum amount that can be allocated to an employee’s account in an employer’s plan for 2020 cannot exceed the lesser of
- 100% of the employee’s compensation or
- $57,000, plus up to $6,500 for catch-up contributions if the employee is age 50 or older.
All employee and employer contributions allocated to an employee’s account must be counted in this limit each year.
Correction Method: Employers should distribute the excess amount and investment earnings attributable as soon as possible. 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.
Preventing Testing Issues in Future Years
If a plan consistently fails the ADP/ACP or top-heaving testing year after year or comes close every year, plan advisors may want to introduce the employee to solutions for resolving the types of issues that can lead to these failures. For example, low participation and savings rates by rank-and-file employees can negatively affect year-end testing results and limit how much HCEs can put into the plan.
Enhance Employee Education
Review the enrollment process and enrollment materials to determine whether changes could be made to increase plan enrollment rates for new employees or to help employees understand how to calculate their retirement savings needs. Identify specific employee groups that have weak savings metrics, such as young workers or low wage employees, and target communications to address the financial education needs of the specific demographic.
Adjust Plan Features
Evaluate plan features to determine whether they could be limiting participation or could be adjusted to increase savings rates. For example, allowing immediate eligibility or adding an automatic enrollment feature have proven effective in increasing participation and contribution rates, while adding an automatic escalation feature can increase deferral rates over time.
Adopt a Safe Harbor 401(k) Plan Design
This plan design approach to satisfying the nondiscrimination testing requires employers to provide a matching or nonelective contribution each year in exchange for an automatic pass on ADP/ACP testing. If the employer makes only safe harbor contributions to the plan, the plan is also deemed to satisfy the top-heavy requirement. Help employers engage a plan design expert who can project contribution costs based on workforce demographics to explain the benefits and considerations of this popular plan feature.
Adopt a Non-Qualified Plan
If business owners and other HCEs want to save more for retirement than is permitted under a 401(k) plan, an employer may want to consider adopting a non-qualified deferred compensation (NQDC) plan for its HCEs. A NQDC plan is not subject to the nondiscrimination testing requirements, which provides greater plan design flexibility to benefit just HCEs. By removing HCEs from the 401(k) plan and allowing them to defer salary and receive a matching contribution in the NQDC plan, employers may be able to alleviate 401(k) plan testing failures and allow HCEs to save more for retirement. See Newport’s article, Non-Qualified Plans: The Remedy to 401(k) Plan Testing Issues, for more information.
Next Steps
Advisors can use this annual testing process to clients understand the factors contributing to their testing results and introduce solutions that may help avoid testing failures in future plan years, improve participation rates, and maintain a competitive benefits package that is appealing to highly paid employees.
For more information on plan testing and design options, contact your Newport Representative.
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