As fiduciaries, defined contribution plan sponsors must act in the best interest of all participants and ensure that the plan itself does not cater to one person or group over another.
To make sure this rule is being followed, the Employee Retirement Income Security Act of 1974 (ERISA) requires that plans undergo annual compliance tests to verify that retirement benefits are distributed fairly among all employees. Failure to complete testing or correct errors can have serious consequences for plan sponsors, including potential disqualification of the plan.
To help prevent any potential issues, plan sponsors need to understand testing requirements and communicate with service providers regarding any changes to the plan. Following are a few specific compliance tests and present ways that plan sponsors can potentially avoid testing issues and correct them when they arise.
Non-Discrimination Tests: ADP, ACP, and Top-Heavy Tests
The Internal Revenue Service (IRS) has several nondiscrimination tests that plans must satisfy to remain compliant with IRS rules. Two of these tests are the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. As the names imply, 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.
The IRS designed the ADP and ACP tests to ensure that the average rates of employee contributions and related company matches are proportional between highly compensated employees (HCEs) and non-highly compensated employees (NHCEs).
A third test called the top-heavy test focuses on key employees and whether they own more than 60 percent of the value of the plan’s assets.
Highly Compensated vs. Non-Highly Compensated Employees
Employers must include all eligible employees in the compliance tests, even if they don’t contribute to the plan. For ADP and ACP testing, employees are separated into two groups: HCEs and NHCEs. The averages from the groups’ deferrals and contributions are compared to determine whether a plan is in compliance with IRS rules. To pass the tests, HCE deferral rates and employer contributions must fall within certain acceptable ranges designated by the IRS.
According to the IRS, an HCE is defined in one of the following two ways:
- Owned more than 5% interest in the business at any time during the year or preceding year, regardless of their compensation
- Family attribution rules apply, therefore, a more than 5% owner’s spouse, child, grandparent or parent are also treated as an owner and HCE, regardless of compensation
- For the preceding year, received compensation from the business of more than $135,000 if the preceding year is 2022, and $130,000 if the preceding year is 2021 or 2020, and, if the employer so chooses, was in the top 20 percent of employees when ranked by compensation
It is important for plan sponsors to provide complete census data to their service provider, including all ownership and family relationships, in order to determine HCEs accurately.
Testing Failures and Potential Remedies
The IRS realizes that failures happen, especially in the ADP and ACP tests, and there are several options that plan sponsors can use to remedy the testing failures. The most common correction is for a plan to refund money to HCEs to meet IRS requirements. Refunds are taxable at the employee’s personal income tax rate, therefore it is important to clearly communicate with HCEs who are receiving refunds. Employers may be able to make a corrective contribution called a qualified non-elective contribution (QNEC) to the NHCEs. Employers have the option of using a combination of these strategies to correct testing failures, as allowable in the plan document. The IRS also provides voluntary corrections through the Employee Plans Compliance Resolution System (EPCRS). Regardless of how an ADP or ACP failure is corrected, plan sponsors have 2 ½ months after the end of each plan year to address. If corrections are made after this date, an excise tax of 10% may apply on 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:
- Plan sponsors can adopt a safe harbor plan and be deemed to pass testing requirements altogether (although safe harbor plans are still subject to nondiscrimination testing in certain circumstances, including when they offer profit-sharing plans)
- If a lack of plan participation from NHCEs is causing issues, features like automatic enrollment and automatic escalation of annual deferral contributions can help to improve outcomes
Insight: Keep Your Service Provider in the Know
As your company continues to evolve, your nondiscrimination testing results will change as well.
Events such as mergers and acquisitions, large new client contracts, and human capital changes can have a huge impact on nondiscrimination testing.
To help avoid any unpleasant surprises, plan sponsors should work with a service provider with expertise in plan design. Plan sponsors can avoid being caught off guard at the end of a plan year with additional tax bills, government filings, and frustrated plan participants by keeping their service provider updated.
Plan sponsors need to understand that ensuring plan compliance is an important part of their fiduciary duty.
If you have questions or need more information about employee benefit plans, contact Kevin Hamaker.