The plan has 21 participants and assets of $1,234,567. 5. So, why would you go from usually passing the test to failing it? One that doesnt entail your company making additional contributions to the plan nor HCEs receiving a large refund check with possibly confusing tax consequences? In fact, from one perspective, it can actually be a sign that the company's highly compensated employees (HCEs are generally company owners and those earning more than $125,000 per year) received the maximum advantage of the plan. API. However, if the excess aggregate contributions consist of matching contributions that arent fully vested then reallocate the unvested portion to the accounts of the other plan participants or put them in an unallocated suspense account to use to reduce future contributions. Contracts. A common operational failure for retirement plans is when plan sponsors fail to apply the correct definition of compensation for retirement plan testing and benefit allocation purposes. What Are Controlled Groups and Controlled Group Rules?Controlled group rules exist to prevent business owners from subdividing their company into two separate companies - one employing highly compensated employees (HCEs) with a retirement plan and the other employing Jan 10, 2022 | 401(K) Plans, Retirement Plans. While we are not planning administrators, we are experienced in designing first-class retirement plans that can be what they were intended to be: a benefit for all your participants, regardless of income level. All content is provided for informational purposes only and is not intended to be tax or legal advice. Several strategies can be discussed with your TPA. Joan provides Roger with the following amounts needed to correct the failed coverage test: However, if they over-compensate, then they are receiving less of a benefit than they could have. About. Communicate with plan administrators to ensure proper employee classification and compliance with the plan terms. The failed ADP and/or ACP test can be corrected by: Note:If the plan returns the excess contributions to the HCEs, it must also return any income (or offset any net loss) allocable to the excess contributions, and there may be tax consequences to the HCEs. ADP/ACP Testing If NHCE ADP percentage is less than two percent, then allowable HCE ADP percentage is NHCE ADP multiplied by two . Problems may happen when theres a communication gap between the employer and plan administrator regarding what the plan document provides and what documentation is needed to ensure compliance. An important aspect of performing the ADP and ACP tests is to properly identify the HCEs, who are generally any employee who: Family attribution rules treat an employee who is a spouse, child, grandparent or parent of someone whos a 5% owner, as a 5% owner. Removing that high deferral rate from the non-HCE group reduces that groups average, which could cause the test to fail. Because company ownership is attributed to certain family members, that child is treated as an owner and HCE, pushing the average HCE deferral rate out of the passing range. Dictionary. Leverage service providers to help your 401(k) plan run more smoothly. Contact Watkins Ross to discuss testing solutions to optimize your employee retirement savings. For mistakes corrected within three years after the end of the 12-month correction period: For mistakes corrected more than two years after the end of the 12-month correction period: A 401(k) plan fails the ADP test for the plan year ending December 31, 2017. G must make these contributions for each eligible NHCE (if the contribution doesn't cause the 415 limit to be exceeded). at the thought of failing the ADP/ACP testing. Retirement Plan Compensation Considerations. That is not ok under any method I have ever heard of. A properly drafted document is the foundation of achieving the company's objectives and keeping the plan in operational compliance. What on earth did we do wrong to cause the plan to fail? The participant in question always has deferrals returned due to failed testing. If the compensation amounts sent to the plan administrator don't meet the plan definitions, the ADP and ACP tests will be inaccurate and will provide false results. These tests occur after the plan year for plans under the current year testing format. {A bit of poetic justice for the lower level earners.}. That means if the plan failed the ADP/ACP using one of those alternative testing methods, the tests must be re-run without those special methods, and correction must be made based on the more negative results. Under current regulations, testing failures are required to be corrected within 12 months after the close of the plan year. Page Last Reviewed or Updated: 31-Oct-2022, Request for Taxpayer Identification Number (TIN) and Certification, Employers engaged in a trade or business who pay compensation, Electronic Federal Tax Payment System (EFTPS), Form 14568, Model VCP Compliance Statement, Treasury Inspector General for Tax Administration. Of your 50 employees, 8 are considered HCEs. By increasing the NHCE participation, you will increase the amount the HCE group can defer. Excess contribution amounts are determined. If the spread between the HCEs and non-HCEs is more than two percentage points, the company must close the gap by: Most plans elect to refund the excess deferrals to the HCEs to avoid dipping into the company pocketbook to fund additional employer contributions, but that is a decision that is up to each individual company. This means that if a plan: Failed the ADP test for the 2021 plan year; and; Chose to use the refund method to correct the failure; and; Had corrective distributions timely processed by March 15, 2022; If either or both tests fail, the failed tests must be corrected. The IRS has created a series of tests that must occur on an annual basis to ensure retirement plan benefits do not disproportionately favor highly compensated employees (HCEs)[1] over non-highly compensated employees (NHCEs). The ADP test compares the actual deferral ratio (ADR) the amount of compensation the employee defers into the plan of all eligible HCEs with the ADR of all NHCEs. If an employee does not meet the definition of HCE, the employee is an NHCE. So, what does timely mean? The good news is that there is no penalty for failing the ADP test as long as timely corrections are made. What Are Controlled Groups and Controlled Group Rules? Failure is defined as a lack of success so, we get it, no one likes to fail. To expand on the last point, the IRS requires the corrective ADP refund distributions to be included as taxable income in the year the check is received. Part#1 has already used up all of his catchup limit and would receive a $3,000 . Skip to content . Both require the employer to make a qualified nonelective contribution to the plan for NHCEs. Were glad you asked, and like almost every question in the 401(k) world, it depends. The ADP test is performed to determine if the plan is allowing HCEs to contribute via salary deduction in too great an amount when compared to NHCEs, while the ACP test looks at whether employer matching contributions favor HCEs when compared to NHCEs. Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. The Actual Deferral Percentage (ADP) test compares the 401(k)deferralsof the HCEs to thedeferralsof the NHCEs. 401(k) Plan Checklist ADP/ACP Tests. If correction is made after the first 2 months, but before the end of the 12-month period, in addition to making the correction, the employer must pay a 10% excise tax on the amount of the excess contributions. Matching contributions (and earnings) related to the excess contributions distributed to the HCEs are forfeited. One way to avoid this type of mistake is by establishing a safe harbor 401(k) plan or by changing an existing plan from a traditional 401(k) plan to a safe harbor 401(k) plan. In other words, testing is capped at $18,500 worth of employee deferrals. DWC's extensive experience with both the IRS and Department of Labor voluntary correction programs allows us to help you address just about any accident that might happen. However, the Internal Revenue Service provides a self-correction program that can be used within 36 months of the close of the plan year, but the costs can be significantly more than if the failure is corrected timely. But, its important to remember that the goal of a 401(k) plan is to provide your employees with an opportunity to save the maximum amount legally allowed for retirement. Its important to know whether compensation is: Determined using a different computation period (for example, plan year vs. calendar year). This can be quite confusing, so lets look at an example to bring the topic to life. To meet this objective nondiscrimination testingwas born. Several main areas where these communication problems may occur: In summary, you should ensure that you're familiar with your plans terms, and provide your plan administrator with the information needed to make a proper determination of each employees status. However, both of these options involve companies forking over additional funds to the NHCEs to ensure the HCEs can keep their contributions in the plan. If either the ADP or the ACP test fails, to avoid correcting under EPCRS, implement procedures to ensure that you correct excess contributions timely. Clauses. For ADP and ACP tests, the correction can be a return of excess contributions plus interest to HCEs by 2-1/2 months after plan year end, according to Ouellette. When you say "refund one participant," what I'm hearing is that there are multiple HCEs and you want to just pick one to eat a refund. Join Greenspring Advisors as we host Sarah Sawyer, Esq., Principal at Offit Kurman, P.A., on a topical discussion regarding employee engagement and management in todays job market. Lets first take a step back and outline what nondiscrimination testing is and how it relates to this time of year. There are various methods for correcting testing failures, and whenyou correct the failure impacts the cost of the action, including whether a tax must be paid. Of course, there are other financial factors that can come into play, leading to a similar result. Past performance is no guarantee of future results. Correction could involve one of two methods: If G determined the mistake to be significant, it must make the correction by the end of the correction period. The highly paid employees and owners cannot save too much more, on average, than the lower paid employees. It's especially important to consider family members of owners. For example, if a calendar year plan fails the test for the 2018 plan year (performed in early 2019), correction must be completed no later than December 31, 2019. However, the Internal Revenue Service provides a self-correction program that can be used within 36 months of the close of the plan year, but the costs can be significantly more than if the failure is corrected timely. Learn faster with spaced repetition. G could make QNECs to the NHCEs to raise the ADP to a percentage that would enable the plan to pass the test. For more information on nondiscrimination testing in general and the ADP test more specifically, please visit our Knowledge Center here and here. The EPCRS revenue procedure defines this as an operational error. If correction is made after the first 2 months, but before the end of the 12-month period, in addition to making the correction, the employer must pay a 10% excise tax on the amount of the excess contributions. contributing additional amounts to the NHCEs. The amount is assigned to HCEs and adjusted for earnings and this total amount is distributed to the HCEs. Being selected for an audit can feel overwhelming, but the process doesn't have to be. DWC, For example, a mid-year test can be used to estimate if the plan is going to pass or fail ADP/ACP testing for the year. These refunds (called corrective distributions) can cause confusion and tax issues to the employees and possible penalties to your organization (i.e., 10% excise tax) if not handled appropriately nor in a timely fashion. The next step calculates the dollars which would be refunded if the excess percentages were refunded first to The next step . Many financial advisors and plan sponsors want to maximize deferrals for the Highly Compensated Employee (HCE) group, yet feel stressed (and even panicked!) This rule states that the ADR of the HCEs cannot be more than 2% of those of the NHCEs. If the ADP and/or ACP testing correction is not made within the permitted 12-month correction period, the plan could lose itstax-qualified status. Determine the amount necessary to raise the ADP or ACP of the NHCEs to the percentage needed to pass the tests. Knowing that your owners do not want to receive money back, nor do they want to make any additional contributions to the plan (as money is tight this year), the next step is to review their catch-up contributions. Resources. Many financial advisors and plan sponsors want to maximize deferrals for the Highly Compensated Employee (HCE) group, yet feel stressed (and even panicked!) It is important to note that this recharacterization method may not be available if the HCEs have already utilized their catch-up contributions or if the refund amount exceeds the remaining amount available for a catch-up. Ideally, you want to make corrections within the first 2 months of this correction period to avoid paying an excise tax. Its that time of year again, the time weve all been waiting for nondiscrimination testing for your corporate 401(k) plan. While there are some nuances, the general rule is that in order for the plan to pass the test, the HCE average cannot exceed the NHCE average by more than two percentage points. During this review, G discovered one participant, identified as an NHCE, was the child of a 5% owner. Maintaining Retirement Plan and Participant Records: Whos Responsible and for How Long? The correction steps for distributions made after 12 months are: The failed test may be corrected by either (1) making a fully . We work with business owners and investment advisors to determine what makes the most sense by providing a detailed cost benefit analysis. Dont assume that once a nonhighly compensated employee, always a nonhighly compensated employee. If the NHCE % is 0 to 2%, the HCE % cannot exceed, If the NHCE % is greater than 2%, but no more than 8%, the HCE % cannot exceedthe NHCE percentage, If the NHCE % is more than 8%, the HCE% cannot exceed, returning the excess HCE contributions that are causing the plan to fail the test back to the HCEs, or. Excess contributions (adjusted for earnings) are assigned and distributed to the HCEs. (HCE ADP % - 2) - NHCE ADP % = Required QNEC Correcting Plan Errors, ComplianceDashboard has been a welcome addition to our service offerings to our clients. However, since Catch-up is not included in the ADP test, how is it treated when there is an excess deferral due to a failed test? Employer G and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction. For example, if Peggy was in the upper group (age 21 and one year of service) the Plan would use the NHCE ADP of the upper group to determine the QNEC. and more. 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