The Employee Retirement Income Security Act of 1974 (ERISA) requires plan sponsors of qualified retirement plans, such as a defined contribution plan or 401(k) plan, to act solely in the interests of participants and their beneficiaries. This means that the plan sponsor, as a fiduciary, must ensure that the plan itself does not discriminate in favor of business owners or highly-paid employees.
As part of their fiduciary duties, plan sponsors are tasked with making sure their retirement plans do not unfairly favor these individuals under the Internal Revenue Service (IRS) regulations. The IRS has developed methodologies to annually test qualified retirement plans for compliance with these regulations. Failing one of these tests may have costly consequences for plan sponsors, including potential disqualification of the plan if left uncorrected.
Having a broad understanding of these tests can be beneficial to a plan sponsor to keep their retirement plan from getting caught in a costly situation. The following are a few specific 401(k) plan compliance tests and suggestions for plan sponsors to potentially avoid testing issues and correct them when they arise.
Related Read: IRS Compliance Checklist: Keep Your Plan Running Smoothly and Legally
IRS Nondiscrimination Testing
The IRS has several nondiscrimination tests for plans to satisfy to remain compliant with IRS rules. Two of these tests, specific to 401(k) plans, are the (ADP) test and the Actual Contribution Percentage (ACP) test. The ACP test also applies to 403(b) plans. The ADP test examines what employees defer to their accounts and the ACP test examines what employers contribute on behalf of employees into their accounts in the form of matching. All 401(k) plans need to satisfy these tests unless they meet an exception, such as a safe harbor plan without a profit-sharing contribution.
The IRS designed the ADP and ACP tests to ensure that the average rates of employee contributions and related company matches are proportional between those employees that are highly paid versus those that are not highly paid. When testing, employees are separated into these two groups. In addition, these calculations include all eligible employees, even if they do not contribute to the plan. The deferrals and employer contributions for each group are compared to determine whether a plan meets the IRS limitations. To pass testing, the highly paid deferral and employer contribution rates must fall within certain acceptable ranges defined by the IRS.
Related Read: What You Need to Know About ADP/ACP Discrimination Testing
Failures and Remedies
The IRS realizes that failures happen and has several options that plan sponsors can use to remedy the testing failures. Sometimes correction may be made by shifting deferrals to employer contributions or vice versa. This works when one of the tests fails such as the ADP test, and the ACP test passes testing, for example.
The most commonly used correction is for a plan to refund just enough money to the highly paid employees to meet IRS requirements. Refunds are taxable at the employee’s personal income tax rate. Therefore, it is important to timely communicate with the employees who are receiving refunds.
Alternatively, employers may be able to make a corrective contribution to the non-highly paid employees to pass testing. Employers have the option of using a combination of these strategies to correct testing failures, as allowable in the plan document. Regardless of how an ADP or ACP failure is corrected, plan sponsors have 2½ months after the end of each plan year to correct it. If corrections are made after this date, an excise tax of 10% will apply to any excess contributions.
It is not uncommon for plans to fail nondiscrimination testing. Chronic annual failures should not simply be accepted as the status quo and consideration may be warranted related to changes in plan design. Some examples of changes to plan design that may be helpful include:
- Adding features like automatic enrollment and automatic escalation of annual deferral contributions may help to improve outcomes. Automatic enrollment particularly helps a plan where there is a lack of participation by non-highly paid employees. Whereas automatic escalation helps to raise deferral rates of the non-highly paid employees.
- Plan sponsors can adopt a safe harbor plan and be deemed to pass testing requirements altogether. However, additional matching cost is a consideration when adding this feature.
Be in the Know
Having an overall understanding and handle on ensuring plan compliance is an important part of a plan sponsor’s fiduciary duty. That will help you avoid being caught off guard by testing failures, additional tax bills and government filings. To avoid these unpleasant surprises, plan sponsors should work with a benefits consultant or plan administrator with expertise in plan design and compliance testing.
For more information, contact Larry Ruff at [email protected] or call him at 312.670.7444. Visit ORBA.com to learn more about our Employee Benefit Plans Services.