The 401(k) plan has emerged as the most popular form of retirement plan in
the United States. This trend will likely continue for some time for a number of
reasons. One is the cost savings to employers, since deferral contributions are
paid by employees. Another is the fact that 401(k) plans are more easily
understood than traditional retirement plans and consequently more appreciated
One aspect of 401(k) plans that is not so easily understood is the annual
contribution nondiscrimination testing. This article will review the mechanics
of this required testing and correction methods for failed tests.
Highly Compensated Employees
Every 401(k) plan, other than "SIMPLE" plans, "Safe Harbor" plans or
"Qualified Automatic Contribution Arrangements," requires an annual test to
prevent discrimination in favor of the group of employees referred to as "highly
compensated employees" (HCEs). Employees who fall into the following two
categories are considered to be HCEs:
- An owner of more than 5% of the employer in the testing year or the
previous year (family stock attribution rules apply which treat an
individual as owning stock owned by his spouse, children, grandchildren or
- An employee who received compensation in excess of a specified limit from
the employer in the previous year (e.g., employees who earned more than
$100,000 in 2007 will be considered HCEs in 2008). The employer may elect
that this group be limited to the top 20% of employees based on
401(k) Nondiscrimination Testing
The nondiscrimination rules require average deferrals and average
contributions for the HCE group to be within a certain range of the average
deferrals and contributions for the "non-highly compensated employee" (NHCE)
Testing of employee deferrals is referred to as the ADP test (Average
Deferral Percentage). The ACP test (Average Contribution Percentage) includes
the employer match contributions, employee voluntary after-tax contributions and
certain forfeitures allocated on the basis of deferrals or matching
Each participant’s deferral or contribution percentage is determined by
dividing the applicable deferral or contributions by the compensation defined in
the plan document. Averages are then determined for the HCE and NHCE groups by
dividing the sum of the deferral or contribution percentages by the number of
employees in the group. Below is an example of the ADP determination:
|HCE Average (11.00% ÷ 2):
|NHCE Average (17.00% ÷ 4):
The HCEs’ average may only exceed the NHCEs’ average (for both the ADP and
ACP tests) by specific limits summarized as follows:
|2% or less
||NHCE % x 2
|2% - 8%
||NHCE % + 2
|more than 8%
||NHCE % x 1.25
In the above example, the maximum ADP of the HCE group is 6.25% (the NHCE
average of 4.25% plus 2%). The test passes since the ADP of the HCE group is
5.50% which is less than the 6.25% maximum.
Catch-up contributions (available to participants who are age 50 or older if
permitted by the plan) that exceed a statutory limit or plan-imposed limit are
not included in performing the ADP test. Also, compensation for plan purposes is
subject to an annual limit ($225,000 for 2007 and $230,000 for 2008). For
example, assume Harry earned $300,000 in 2007 and deferred $20,500 (the maximum
deferral of $15,500 for 2007 plus the maximum catch-up contribution of $5,000).
His deferral percentage is calculated by dividing $15,500 (his deferral without
the catch-up contribution) by $225,000 (the compensation limit for 2007).
Employees Included in Testing
In performing the ADP test, all active and terminated employees eligible to
defer at any time during the plan year are included, whether or not they
actually made a deferral.
The following employees are included in the ACP test, regardless of whether
they received matching contributions or made after-tax contributions:
- Active employees who have met the plan’s requirements to receive a match
as of the plan year-end being tested (e.g., if the plan requires active
employees to have more than 500 hours of service during the plan year in
order to receive matching contributions, employees with less than 501 hours
are not included);
- Employees who terminated during the plan year being tested if they met
the plan’s requirements to receive a match (e.g., if the plan requires 1,000
hours of service and/or employment on the last day of the plan year,
employees who have not met these requirements are not included); and
- All employees eligible to make voluntary after-tax contributions at any
time during the plan year.
Plans that allow employees to participate before they reach age 21 or
complete one year of service are permitted to exclude such employees from the
test if they are NHCEs.
If the plan covers both union and non-union employees, each group must be
Employees who work for a "related" company may also have to be considered.
Related companies are either part of a "controlled group of corporations" or an
"affiliated service group." Whenever an individual who owns any portion of the
sponsoring employer buys into another business, the plan’s advisors should be
notified so a controlled group determination can be made. The same applies if
another company works together with the employer to provide services to each
other or to third parties which could constitute an affiliated service group.
These circumstances create important issues that could affect the qualification
of the plan.
Two testing methods are permitted. The first method is current year testing
where current year deferral and contribution percentages are used to compare the
percentages of both HCEs and NHCEs.
The other method is prior year testing where the deferral and contribution
percentages for NHCEs in the prior year are compared with HCE deferral and
contribution percentages in the current year. The prior year testing method
gives employers the ADP and ACP limits for the HCEs in advance, which reduces
the chance of a failed test at year-end and the need for taxable refunds or
other corrective measures.
Whichever testing method is chosen, regulations require it to be specified in
the plan document. The testing method may only be changed by amendment, subject
to certain restrictions on changing from current year to prior year testing.
Mechanics of Prior Year Testing
In the first year of a 401(k) plan, or the first year 401(k) provisions are
effective in an existing plan, a special rule applies since there are no prior
year percentages to use for the test. The employer can assume a prior year
percentage for the NHCEs of 3% for both the ADP and ACP tests or use the actual
results of the first year’s test.
The second year, the maximum HCE percentage will be based on the NHCE
percentage from the first year. At the end of the second year the test will be
performed which will be used for two purposes:
- The average HCE percentage will be compared to the maximum permitted
average percentage (based on the NHCE percentage from the first year) to
verify that the maximum was not exceeded, and
- The NHCE average percentage will be used to determine the maximum average
HCE percentage for the third year.
Correcting Test Failures
Plans that do not pass the ADP and/or ACP tests must take some action, such
as making corrective distributions or additional employer contributions.
Refund Deferrals/Matching Contributions
The most common method used to correct a failed ADP or ACP test is to make
corrective distributions of the excess deferrals or contributions, plus earnings
(in some cases, forfeiture of matching contributions may be required).
Corrective distribution amounts (determined by a required leveling method)
are allocated among the HCEs based on the dollar amount of their deferrals or
contributions. If the plan permits catch-up contributions and the participant is
50 or older and has unused catch-up contributions remaining, the ADP refund is
first offset by the unused catch-up contributions.
These distributions must be made within 2½ months of the plan year-end in
order to avoid a 10% penalty (this deadline is extended to six months for plans
that meet the eligible automatic contribution arrangement requirements). The
final deadline for making corrective distributions with the penalty is the last
day of the following plan year. For plan years beginning on or after January 1,
2008, these distributions are taxable in the year in which they are distributed
(for plan years prior to 2008, distributions made before the 2½-month period are
taxable in the prior year).
QNECs and QMACs
In some situations, a failed nondiscrimination test can be corrected by
having the employer make a "qualified nonelective contribution" (QNEC) or
"qualified matching contribution" (QMAC). These additional employer
contributions are made to NHCEs to increase their ADP or ACP to the level needed
for the HCEs to pass the test. QNECs and QMACs are required to be immediately
100% vested and subject to withdrawal restrictions. These contributions must be
deposited by the last day of the following plan year.
Nondiscrimination testing sounds complex--and it is. Gaining a better
understanding of this testing should help plan sponsors appreciate the
importance of providing complete and accurate census data to their advisors.
Census information, including all employees, should be compiled as soon as
possible after the plan year ends so that nondiscrimination testing can be
performed accurately and any corrective distributions can be made in a timely
manner in order to avoid the 10% penalty.
It is also important for business owners to be aware that related companies
may impact nondiscrimination testing and to disclose to their advisors any and
all ownership interests or service affiliations. This will help ensure that the
plan maintains its qualified status.
[top of page]