Coloring Inside the Lines: Compliance Testing Basics for 401(k) Plans
Since the passage of SECURE 2.0 at the end of 2022, which included quite a few changes and enhancements for 401(k)s and other retirement plans, it is likely that many employers, along with their HR and payroll specialists, are reviewing their plans in anticipation of incorporating some or all of the revisions. This means that it’s probably also a good time to review some basics of non-discrimination testing. Though non-discrimination testing is typically performed by a third-party plan administrator, it’s important for employers and plan sponsors to understand the basic requirements for the plan to remain compliant.
Non-Discrimination and Highly Compensated Employees
The principal function of testing your 401(k) plan for non-discrimination compliance is to ensure that certain types of employees do not benefit disproportionately, to the detriment of other employees. Specifically, non-discrimination testing is designed to verify that the benefits provided to highly compensated employees (HCEs) do not unfairly impede or limit the benefits available to non-HCEs.
For 2023, HCEs are defined as follows:
- persons earning $150,000 or more in 2022; and/or
- persons holding 5% or more of ownership in the business, including family attribution.
Non-discrimination testing also involves key employees, who are defined as:
- officers of the company earning $215,000 or more per year;
- a person with ownership of the company amounting to 5% or more;
- a person with 1% ownership whose earnings exceed $150,000.
The Principal Non-Discrimination Tests
While a detailed explanation of the IRS requirements and calculations for non-discriminatory compliance are beyond the scope of this newsletter, employers and plan sponsors should understand the basic outlines of the principal tests involved. Summaries of these tests, their purpose, methods of calculation, and remedies for non-compliance follow.
1 – The IRC 401(b) Coverage Test. The purpose of this test is to determine that enough non-HCEs were covered during the plan year. In order to pass, each employee and employer contribution during the year—including salary deferrals, matching contributions, and profit sharing—must satisfy either a ratio percentage test (the most commonly used) or an average benefit test. To satisfy the ratio percentage test, the following formula must yield a result equal to or greater than 70%:
[# of benefitting non-HCEs / # of eligible non-HCEs] / [# of benefitting HCEs / # of eligible HCEs]
So, if Company A has 70 benefitting non-HCEs, 81 eligible non-HCEs, 20 benefitting HCEs, and 20 eligible HCEs, their ratio percentage would be:
[70 / 81] / [20 / 20]; or [0.86] / [1.0] = 0.86
Company A’s ratio percentage is 86%; it passes the test. If a plan fails this test, the plan will be required to file a corrective amendment, for up to 9 ½ months following the end of the plan year in which the failure occurred, which retroactively expands plan coverage. If the plan’s salary deferral feature fails, a qualified non-elective contribution (QNEC) must be contributed to the non-HCEs.
2 -The actual deferral percentage (ADP) test shows that the rate of salary deferrals for HCEs—including traditional and Roth contributions, but not including catch-up contributions—did not exceed the non-HCE deferral rate by more than the allowed amount. This calculation averages the deferral percentages of HCEs and non-HCEs. The ADP of HCEs must not exceed the greater of:
- 125% of the non-HCE ADPs; or
- the lesser of 200% of non-HCE ADPs or the total non-HCE ADP plus 2%.
If a plan fails the ADP test, the usual correction is to refund the contributions to HCEs in the amount necessary to bring the plan into compliance. A 10% excise tax may be applied to corrective refunds occurring 2 ½ months or more after the end of the plan year, and the final deadline is 12 months after the close of the plan year.
By the way, if all this is summoning unpleasant memories of word problems in high school math class, you are probably starting to grasp why the vast majority of plan sponsors leave this work to third-party administrators. Nevertheless, it’s important to understand that compliance testing for non-discrimination is both intricate and necessary to ensure that your plan meets the requirements (and that you don’t get slapped with penalties or, even worse, disqualification of your plan).
3 -The Top-Heavy Test. A plan is “top-heavy” when account balances of key employees (see above) exceed 60% of total plan assets on the last day of the prior plan year. If a plan is found to be top-heavy, non-key employees typically must receive an employer contribution equal to 3% of their annual compensation.
4 – Annual Contribution Limits. Contributions to any individual employee’s plan account, including employee and employer contributions, may not exceed $66,000 (for 2023, up from $61,000 in 2022). For persons age 50 and older, this limit is increased by $7,500.
Tax Credits and other Benefits for Employers
The news isn’t all about meeting requirements and calculating ratios. SECURE 2.0 actually added some provisions that ought to make it both easier and less expensive for employers to offer 401(k) plans to more of their employees. That’s important because, as you probably already realize, the more employees from all income levels who are covered by and participating in your plan, the less difficult it will be to maintain non-discriminatory compliance. One of the principal benefits for businesses with 50 employees or less is the expanded tax credit for plan startup costs. Formerly, businesses could receive a tax credit of up to 50% or $5,000 for eligible costs related to starting a qualified 401(k) plan, but SECURE 2.0 expanded this to 100% of qualified startup costs. In other words, a business with 50 or fewer employees can receive a 100% offset, in the form of a tax credit, for qualified expenses incurred in setting up a plan.
The other helpful tool created by SECURE 2.0 is mandatory auto-enrollment. In terms of achieving and maintaining maximum employee participation, the research is clear: plans with auto-enrollment achieve an average employee participation rate of 91%, compared to the 28% rate exhibited by plans with discretionary enrollment. Not only that, but higher percentages of survey respondents indicated that they were interested in saving for retirement when they were participating in a plan with automatic enrollment. Good for the plan, good for the people.
Savant is committed to providing professional, fiduciary guidance for companies seeking to maximize the benefits of their retirement plans, both for employees and for the enterprise. To learn more, click here to read our recent article, “SECUREly in the Bag: What the New Retirement Plan Rules Mean for Your Business.”
- Thomson Reuters: IRS Announces 2023 Retirement Plan Dollar Limits and Thresholds
- Employee Fiduciary: The Basics of 401(k) Nondiscrimination Testing
- IRS: 2023 Limitations Adjusted as Provided in Section 415(d), etc.
- Paychex: SECURE Act 2.0 Offers Incentives to Businesses and Employees for Retirement Plans
- Vanguard: How America Saves 2022
- Human Interest: The power of 401(k) automatic enrollment