A plan sponsor offered a safe harbor 401(k) plan using the basic match formula and wanted to redefine compensation to exclude commissions for deferral and safe harbor match purposes. The retirement advisor and third-party administrator (TPA) advised against the change because of possible compliance testing complications. Ultimately, the plan sponsor decided to move forward with the compensation definition change subjecting the plan to an annual Compensation Ratio Test under Internal Revenue Code section 414(s).
To avoid discriminatory plan designs and practices by plan sponsors, the Internal Revenue Service introduced certain compliance testing rules. The six most common types of compliance tests affecting participant-contributory retirement plans such as 401(k) and 403(b) plans include:
• Actual Deferral Percentage (ADP) test
• Actual Contribution Percentage (ACP) test
• Top Heavy test
• Coverage test
• Annual Additions test
• Maximum Deferral Limit test
Often called the non-discrimination tests, the ADP and ACP tests compare the deferral and matching contribution ratios, respectively, of highly compensated employees (HCE) to the non-highly compensated (NHCE). If either or both tests fail, the plan sponsor must take action to correct the failure, often resulting in removing some portion of contribution and related earnings from the affected HCE.
The Top Heavy test ensures that your key employees’ benefits do not exceed 60% of your non-key employees’ benefits. If this test fails, the plan sponsor may need to contribute as much as 3% of eligible compensation to non-key employees.
The Coverage test ensures that a sufficient ratio of your NHCEs benefit under your retirement plan. In a 401(k) plan, an employee is considered to benefit if the employee has a right to make a salary deferral. The Annual Additions test caps the contributions and forfeitures a participant may receive annually at the lesser of 100% of a participant’s compensation or the amount established by the IRS ($66,000 for 2023, excluding catchup). The Maximum Deferral Limit test ensures that participants do not defer an amount greater than permitted on a calendar basis ($22,500 for 2023; $30,000 if age 50+).
Additional compliance tests exist, in addition to these six. The purpose of all compliance testing is to ensure fairness among all plan participants, not just a select few. Failure to comply with the testing requirements and/or failure to correct matters when testing does not pass can result in a retirement plan losing its tax-qualified status.
Does your plan pass all its annual compliance testing?
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