401(k) plans are meant to give employees the ability to save money for their retirement years. However, if these plans are not properly monitored, they could potentially end up only benefitting employees who make the most money, also known as Highly Compensated Employees (HCEs). The Internal Revenue Service (IRS)’s definition or HCEs is either a) an employee who made $130,000 or more in compensation during the previous year, or b) an employee who has more than 5% ownership interest in the plan sponsor. The IRS was aware of the possibility of 401(k) plans favoring HCEs and designed various processes, referred to as nondiscrimination tests, to help ensure that 401(k) plans are not disproportionately benefitting HCEs.
Below, we’ll provide a breakdown of the following categories of nondiscrimination tests:
- Deferral Limit Test (also known as an IRC Section 402(g) Test)
- Annual Additions Test (also known as an IRC Section 415 Limit Test)
- Minimum Coverage Test (also known as an IRC Section 410(b) Test)
- Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Tests
- Top-Heavy Test (also known as an IRC Section 416 Test)
Deferral Limit Test: This test determines whether employees’ salary deferrals (pre-tax and Roth) are in excess of the pre-determined limits established by the IRS. For 2021, the contribution limits are $19,500, with an additional $6,500 available for eligible employees (those aged 50 and over by the end of the plan year) to make catch-up contributions. For 2022, the contribution limit will increase to $20,500, with the catch-up contribution limit remaining the same. A plan would fail this test if employees made contributions that exceeded the above thresholds during the current calendar year.
- How to correct: If your plan fails the Deferral Limit Test, your company will be required to refund the excess deferrals made back to the respective participants, along with any earnings that may have accumulated on the excess contributions.
Annual Additions Test: Every year, the IRS establishes limits on the maximum additions that an employee is eligible to make to the plan, which includes salary deferrals (pre-tax and Roth), matching contributions, profit-sharing contributions and allocations of forfeitures. For 2021, the annual additions limit established by the IRS was the lesser of 100% of the employee’s compensation, or $58,000 ($64,500 including catch-up contributions). For 2022, these limits will increase to $61,000 ($67,500 including catch-up contributions).
- How to correct: Similar to the Deferral Limit Test, if the Annual Additions Test is failed, you will be required to refund the excess deferrals back to the respective participants, along with any earnings that may have accumulated on the excess contributions.
Minimum Coverage Test: This test was specifically designed to determine if the plan favors HCEs by comparing the percentage of HCEs benefitting under the plan to the percentage of Non-Highly Compensated Employees (NHCEs) benefitting under the plan. The test is performed for each type of contribution in the plan – for example, salary deferrals, matching contributions and profit-sharing contributions. The term “benefitting under the plan” can be misleading, as it does not mean that the employee is participating in the plan. “Benefitting under the plan” includes all employees who are eligible to participate in the plan, even if a portion of them opt not to do so. The IRS has determined that the percentage of NHCEs benefiting under the plan must be at least 70% of the ratio of HCEs benefitting under the plan.
- How to correct: If your plan fails the Minimum Coverage Test for any contribution types, at minimum you will need to adopt a corrective amendment to retroactively expand the plan coverage to include more NHCEs. If the Minimum Coverage Test is failed specifically for salary deferrals, a Qualified Nonelective Contribution (QNEC) will be required to be made to all NHCEs, as the failed test is deemed a missed deferral opportunity. Amending the coverage criteria should eliminate the needs for QNECs in future periods.
Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Tests: The ADP test is used to verify that the average salary deferral percentage of HCEs does not exceed the average salary deferral percentage of NHCEs by more than IRS limits. The ACP test is very similar, but rather than salary deferrals, the test is performed on matching and after-tax contributions. The necessary percentages used for the ADP test are obtained by averaging the deferral percentages of the HCE and NHCE groups. The ACP test percentages are obtained by averaging matching/after-tax contribution percentages of the HCE and NHCE groups. The plan is deemed to pass the ADP/ACP tests, as long as the percentages of the HCE group do not exceed the greater of (a) 125% of the NHCE group or (b) the lesser of 200% of the NHCE group or the percentage from the NHCE group plus 2%.
- How to correct: If your plan fails the ADP/ACP test, the plan will be required to adjust the number of deferrals for HCEs or NHCEs in order to change the ADP/ACP percentages to be considered passing. There are several different methods for how this can be achieved. First, if a HCE is eligible to make catch-up contributions, some of the excess contributions can be recharacterized as catch-up contributions. There are two remaining options for any remaining excess deferrals not corrected by catch-up contributions: (a) make a QNEC or Qualified Matching Contribution to all NHCEs to increase the ADP/ACP percentage for NHCEs to be in the passing range or (b) refund the remaining excess contributions, plus earnings, to the HCEs.
Top-Heavy Test: This test is used to determine whether the plan primarily benefits key employees of the plan sponsor. You are considered a key employee if you (a) are an officer of the plan sponsor earning over $185,000, (b) own more than 5% of the plan sponsor or (c) own more than 1% of the plan sponsor and earn over $150,000. The plan is considered top-heavy if 60% of the total account balances are from key employees. Typically, the account balances from the last day of the preceding plan year are used to determine top-heavy status for the current plan year. So, for the 2021 top-heavy status, plan account balances from the 2020 year-ended would be used.
- How to correct: If your plan is considered top-heavy, the employer will be required to fund an employer contribution equal to 3% of eligible compensation for all non-key employees in most cases. If the plan already makes a matching or profit-sharing contribution, this amount can be used to reduce this required employer contribution resulting from the failed Top-Heavy Test.
Plans may adopt a safe harbor alternative that will allow them to forgo the ADP and ACP tests and, in some instances, the top-heavy test. We’ll provide an in-depth exploration of these options in a future blog post.
If you have questions relating to annual nondiscrimination testing and how it affects your plan, the experts at SST Accountants & Consultants are here to provide counsel! Learn more about our service areas, or contact us today for immediate assistance.
Special thanks to SST Audit Manager Chris Adams for providing the content for this post. For additional support, contact Chris today.