wHAT ARE THE 401(k) TESTING REQUIREMENTS?
If you are an employer and offer a traditional 401(k) Plan to your employees, then your plan is subject to annual testing requirements. It is very normal. Below are the two typical types of tests, real world examples, what they mean and how your plan can pass.
What is ADP/ACP testing?
Traditional 401(k)
Employee deferrals are subject to testing requirements
Highly Compensated Employees (HCEs) can usually defer 2% more than the average of Non-Highly Compensated Employees (NHCEs)
Key Employee account balances should be less than 60% of the total plans account value
HCEs can be limited in their participation if NHCEs do not participate at a substantial level
REAL WORLD EXAMPLE
Let's meet Caden and Carlie. They are 50/50 owners and have 10 employees.
Their employees save an average of 4%. With a Traditional 401(k) plan, Caden and Carlie are limited with how much they can contribute.
Their savings percentage is linked to their average employee deferral rate. They are allowed to save +2% more than the employee average (4% + 2%). With a Traditional 401(k) plan, Caden and Carlie can save 6%.
WHAT IT MEANS
Traditional 401(k) plans are required to meet certain non-discrimination requirements. To ensure the plan satisfies the non-discrimination requirements, the employer must perform an Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) test on an annual basis. The ADP/ACP testing compares the average ADP/ACP of the HCEs with the average ADP/ACP of the non-highly compensated employees (NHCEs). This is to ensure there is no discrimination in favor of HCEs.
HCEs include the following: any owner with more than 5% of the interest in the business for the current or prior year; the spouse, children or parents of a greater than 5% owner; any employee who received compensation of more than the annually specified limit.
The deferral percentage is determined by dividing the deferral by the compensation, then the HCEs and NHCEs groups are determined by dividing the sum of the deferral percentages by the total number of eligible employees in the groups. In most cases, to pass the ADP test, the ADP of the HCE group may not exceed the ADP for the NHCE by more than 2%.
What is tOP HEAVY Testing?
Highly Compensated Employees (HCEs)
5% or more ownership
Direct family members of 5% or more owners (e.g. spouse, children or parent)
Employees that earn more than annual specified limit
Non-Highly Compensated Employees (NHCEs)
All other employees that do not meet the HCE definition
REAL WORLD EXAMPLE
Caden and Carlie are 50/50 owners, therefore, based on DOL and IRS retirement plan rules, they are considered Highly Compensated Employees (HCEs).
For the plan to pass Top Heavy testing, the amount of Caden and Carlie's combined retirement account balances cannot be greater than 60% of total plan assets.
WHAT IT MEANS
In addition to the required ADP/ACP non-discrimination testing, Traditional and Roth 401(k) plans are also subject to Top Heavy Testing. A plan is Top Heavy for a plan year if the preceding year, the total value of account balances of Key Employees is more than 60% of total value of account balances in the Plan. If the plan is determined to be Top Heavy and is funded by a Key Employee, then the employer is required to make a minimum contribution (3% of the participant’s full year of compensation) to all non-key employees who are employed on the last day of the plan year.
A Key Employee is anyone who at any time during the plan year was: an employee who owns more than 5% of the business; an employee who owns more than 1% of the business and making over the annual IRS specified limit and/or an officer making over the annual IRS limit.
It is important to understand that Traditional 401(k) plans are
subject to non-discrimination testing on both annual contributions (ADP Testing) and cumulative assets (Top Heavy Testing).
For information on other types of plan design options, click here.
HAVE QUESTIONS OR NEED HELP?
Absolutely, give us a call today. We are intimately familiar with the types of plan options available today. We would be happy to discuss how we may design a company sponsored plan that meets your specific retirement plan goals.
WHY DO I NEED TESTING?
These tests are to ensure
that plans are set up for the benefit of all
employees, not just owners and Highly
Compensated Employees (HCEs).