Financial advisors, like me have encouraged people who participate in their 401(k) plan to contribute as much as possible. In many cases, your retirement plan platform offers you online tools to assist in projecting how much you need to save to achieve your desired income replacement level when you get to retirement age. However, it may be surprising to find out that business owners and highly compensated employees (HCEs) are shocked to hear that they are not permitted to contribute as much as they wanted. Unfortunately many employees and business owners receive a refund otherwise known as a 1099-R for corrective distributions when their employer’s 401(k) plan fails the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. This often leaves the participant confused.
- Actual Deferral Percentage Test (“ADP Test”).
A 401(k) plan must perform an ADP test as of the last day of each plan year to confirm that the highly compensated employees do not contribute disproportionately more to the plan than the non-highly compensated employees. The other alternative to an ADP Test is for the plan to qualify as a safe-harbor plan by making a certain level of employer contribution to the participants.
- Actual Contribution Percentage (ACP Test).
Plans which accept employee post-tax contributions or employer matching contributions must perform an ACP test as of the last day of each plan year to confirm that the highly compensated employees do not disproportionately benefit from such contributions. A safe harbor plan may also avoid an ACP Test.
For 2014 a HCE is defined as earning compensation of $115,000 or having at least 5% ownership. The IRS wants to ensure that the contributions of non-highly compensated employees (NHCEs) are proportional to contributions made for HCEs. The nondiscrimination rules apply to the elective 401(k) deferrals that they contribute out of their own salary (ADP test) as well as to the match contributions they receive from the employer (ACP test).
As the NHCEs contribute more into the plan, the HCEs are allowed to contribute more into the plan, up to the legislative maximum limits. For example,
If the Average Deferral Percentage of NHCEs is:
Less than 2%, then the maximum average ADP of HCEs is 2 times the average for the NHCEs.
Between 2% and 8%, then the maximum average ADP of HCEs is the average for the NHCEs plus 2%.
More than 8%, then the maximum average ADP of HCEs is 1.25 times the average NHCEs ADP.
Discrimination Test Refunds
The plan distributes the excess contributions to HCEs, to lower their average percentage contribution until the ADP test is passed. The distributions are made first to HCEs who deferred the highest dollar amounts, not the highest percentage, and they must include earnings. If distributed within 2 ½ months of the end of the plan year, there is no tax penalty to the employer. If returned after 2 ½ months, the employer is subject to a 10% excise tax. HCEs report the distribution as taxable income in the year in which the excess is distributed. The recipients of the excess contributions receive a Form 1099-R to facilitate their tax reporting.
Plans can base the ADP and ACP percentages for NHCEs on either the current or the prior year contributions. A plan can change from prior year testing to current year testing during any plan year, but once current year testing is elected, the employer cannot change back to prior year testing except under limited circumstances.
Good news…it doesn’t end here. Corrections can be made and we can help. SMA Services, Inc. provides TPA services to plan sponsors who offer a 401(k) plan.
Our goal is to provide retirement solutions designed with a client’s needs in mind. In an unbundled environment TPA services is our core competency. We provide a broad suite of retirement plan services — helping reduce your burden and potentially saving you money. Plan design is more than choosing from a list of features. It requires getting to know your organization and understanding the unique challenges your participants face. It also requires specialized expertise in managing the compliance testing, government filings and other reporting requirements that you’ll face. Call us