Without question, compliance testing is one of the most misunderstood aspects of a 401(k) plan. In today's class we're going to review the two primary tests plan sponsors should understand before pursuing the Traditional 401(k) Plan. Let's roll up our sleeves and dive into the world of compliance testing.
The first thing we need to ask ourselves is "What is compliance testing and why is it necessary?". Compliance testing exists to make sure the retirement plan isn't favoring certain members of the organization over others. One of the requirements of offering a qualified tax-deferred retirement plan and its associated tax benefits is that the program cannot discriminate against certain employees. In order to make sure this doesn't happen, the government requires that the plan passes certain tests every year.
If you attended our last two classes, you know that we covered the differences between the Traditional 401(k) and the Safe Harbor 401(k) Plans. In general, Safe Harbor 401(k) Plans get an automatic pass on the two compliance tests we’ll discuss today as a result of the mandatory company contributions, eligibility requirements, and the immediate vesting associated with the plan. However, if you opt for the Traditional 401(k), your plan will be subject to compliance testing which may limit the benefit for both you and the participants you are targeting in your group. Neither of the two tests we’ll discuss today are overly-complicated once you understand the language and the formulas.
The first test you should understand is known as the Nondiscrimination Test. This test will divide all of the eligible employees into two groups: Highly Compensated Employees (HCE’s) and Non-highly Compensated Employees (NHCE’s). HCE’s are classified as those employees who make over $130,000 and owners who have a more than 5% interest in the business. Likewise, certain family members of these owners are also classified as HCE’s regardless of their level of compensation. All other eligible employees are, therefore, categorized as NHCE's. First, we need to add up the deferral percentages of the HCE’s to determine their average deferral rate. For example, let's say your company has three eligible employees classified as HCE’s who defer 10%, 5% and 0% of their pay into the Traditional 401(k) Plan. The average deferral percentage of the HCE’s is 5%. We will do the same for the NHCE's to determine their average deferral percentage as well. The rule states that the HCE’s average deferral percentage cannot be more than the lesser of (1) two times the NHCE’s average deferral percentage or (2) 2% above the average deferral percentage of the NHCE’s. Any differential of more than this figure will results in a failed Nondiscrimination Test. Now, one of the biggest things that trips up plan sponsors is the fact that any eligible employees who do not participate in the plan will count as a 0% towards the average deferral percentage. Since most HCE’s have a rate of compensation which allows them to participate in the 401(k), we tend to see a higher average deferral percentage among this group. Conversely, since many NHCE's believe that they don't have the ability to contribute to the Traditional 401(k), this group may have lower deferral rates and many more people opting out of the plan resulting in more 0% deferrals. This is what you need to be aware of when considering the Traditional 401(k) Plan.
The Top-Heavy Test has a similar concept of dividing the eligible participants into two groups but defines the groups differently. This test will weigh Key Employees against the Non-Key Employees. Key Employees are defined as (1) employers with over 5% ownership in the business, (2) employers with over 1% ownership in the business and have an annual salary greater than $150,000, and (3) any officer making over $185,000 for 2020 and for 2021. Just like the previous test, certain family members of these individuals are also classified as Key Employees regardless of their level of compensation. This test states that the Key Employee group cannot represent more than 60% of the total plan balance of the Traditional 401(k). There is a slight caveat on the definition of “total plan balance” as we are only considering the dollars which have been contributed from the participants’ deferrals in your plan and your company’s contributions (i.e., rollovers from other plans would not be factored into this calculation) . Just like the nondiscrimination testing method, you can see how the Key Employees’ accounts can quickly cross this 60% threshold and make the plan top-heavy. If the plan fails this test and is deemed top-heavy, the plan sponsor has two options to get the plan back into compliance. First, the Key Employees could take a taxable distribution of their balances to get the plan back into the required 60% ratio. If this option is not feasible, the second corrective measure would be to make a contribution to all eligible Non-Key Employees in an amount of the lesser of the highest key employee deferral rate or 3% of their total compensation regardless of whether they participate in the plan or not.
If you do not see either of these tests being an issue for your particular group of employees, the Traditional 401(k) maybe the right fit for your company. However, if you believe that you may encounter some compliance issues, I would either recommend you consider the Safe Harbor 401(k) or proceed with the Traditional 401(k) knowing that some participants may not be able to maximize their deferrals each year.
Since both of these compliance tests only factor eligible employees into the calculation, join us for next week’s class when we discuss eligibility options and how to target the employees you wish to participate in the retirement benefit.