Every year plan sponsors must test 401(k) plans to ensure that the contributions made by and for rank-and-file employees, also known as non-highly compensated employees (NHCEs), are reasonably proportional to contributions made for highly-compensated employees (HCEs), generally a company’s owners and managers. As the NHCEs save more for retirement, the rules allow HCEs to defer more (up to limits). All employers should understand the tests — known as the actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test.
Generally, plans cannot disproportionately benefit HCEs. For 2014, plan participants are considered HCEs if:
- Their compensation in 2013 or 2014 was more than $115,000. For 2015 this limit is $120,000; or
- They owned more than 5% of the business at any time during the year or the preceding year, regardless of their compensation.
Once you know who your HCEs are, you can calculate deferral and contribution percentages for each test:
ADP Test — Under the ADP test, you calculate both HCE and NHCE pre-tax deferral rates. The deferral percentage is the average of the deferral percentages of those in the group, where the deferral percentage for each employee is the ratio of the amount of their annual deferrals to their eligible pay for that year. Please review your plan document for the definition of eligible pay as this definition is where we see the most errors. You must include eligible employees who do not participate in the plan with a deferral percentage of zero. Eligible nonparticipating employees tend to be NHCEs, pulling that group’s deferral percentage down. To pass the test, the HCEs’ average ADP cannot be higher than the greater of 1) 125% of the NHCEs’ average ADP, or 2) the lesser of two percentage points above or two times the NHCEs’ average ADP.
If your plan allows for catch-up contributions for participants age 50 and older, generally these are not included in the ADP test. Consult your benefits specialist for more information.
ACP Test — The ACP test is similar to the ADP test. It compares the average ratios of the employer-matching and other employer contributions to the compensation received by both HCEs and NHCEs for the year. For example, if the average match percentage for NHCEs is 3% of pay, the average match percentage for HCEs must be limited to 5% of pay.
Another important discrimination test is whether a plan is deemed “top heavy” or “super top heavy.” That determination is based on the proportion of plan assets held by “key employees” (defined differently from HCEs) relative to the total plan assets (at least 60% for top-heavy plans and 90% for super-top-heavy plans). If your plan is deemed top heavy, you may have to make a minimum contribution to NHCE accounts to meet top-heavy requirements.
Safe Harbor Design Alternative
If your plan failed discrimination tests or you want to avoid the testing altogether, you can instead adopt a safe harbor provision in your plan. However, the safe harbor plan contribution formula can be expensive.
You can create a safe harbor plan two ways:
- Matching deferrals dollar-for-dollar up to 3% of compensation, plus 50 cents on the dollar on the next 2% of compensation; or
- Making a non-elective annual contribution of 3% of compensation to all eligible participants’ accounts regardless of whether they make employee pretax contributions.
Under either formula, employer contributions are immediately fully vested. This contrasts with the six-year graded schedule (20% after one year, 40% after two years, and so on) or three-year cliff vesting options for non-safe harbor plans.
Before switching to a safe harbor plan design, however, analyze your plan to see why eligible NHCEs are not deferring. Educate them and encourage them to contribute. You may also consider an auto-enrollment plan in which they need to opt out rather than opt in. If your plan narrowly failed the discrimination testing, switching to a safe harbor plan may not be worth the added cost.
Do Not Be a Testing Failure
If your defined contribution plan failed the nondiscrimination test in the last testing cycle, you are not alone. According to a recent survey by Judy Diamond Associates, about 12% of plans did so, too. Your plan does not need to be one of these statistics. For more information, contact Mike Kovacs or your ORBA advisor at 312.670.7444. Visit orba.com to learn more about our Employee Benefits Group.