Did Your 401(k) Plan Fail Its Compliance Test?

Compliance Failure Q&A

Q: First issues first: what precisely is 401(okay) compliance testing and when is it carried out?

Typically known as “non-discrimination” testing, compliance testing is performed shortly after the shut of a plan yr, so roughly mid-January by way of mid-April for calendar yr plans. Briefly, a 401(k) plan should cross these checks every year to confirm that it doesn’t profit extremely compensated workers (HCEs) on the expense of non-highly compensated workers (NHCEs) unfairly. Though there are a number of compliance tests, probably the most necessary is the “precise deferral share,” or ADP, take a look at.

Q: What precisely does the ADP take a look at have a look at?

With the ADP take a look at, we evaluate the common 401(okay) deferral share for HCEs to the common 401(okay) deferral share of NHCEs. If the distinction is bigger than a sure margin (as proven within the desk under), the plan is alleged to have “failed” the ADP take a look at.

It’s necessary to notice that the common deferral fee for testing functions takes into consideration all eligible workers, together with each lively and terminated workers for the plan yr. As a aspect word, this may differ from how the common deferral fee is outlined for plan well being functions, which often seems to be on the common deferral fee solely of these members who’re actively contributing.

Q: What precisely are the implications of failing the ADP take a look at?

It’s most likely scarier than it sounds as a result of it may be pretty simply corrected. There are two methods to appropriate the failure. One is to refund extra 401(okay) contributions to the impacted HCEs. The refund quantity relies on the scale of the failure, however it’s taxable to the affected workers (typically homeowners and senior managers) who will probably be unpleasantly stunned by this flip of occasions. It’s by no means a straightforward dialog for the plan administrator to have.

The second methodology is to make a corrective contribution (equal to the failed margin) often called a Certified Non-elective Contribution (QNEC) to all the non-highly compensated workers. This can be pricey to the employer, but when the failed margin is small and the corporate is on the smaller aspect, this can be a superb different to appropriate the failure. Usually, this correction must be accomplished by two and a half months after the tip of the plan yr being examined (March 15 for calendar yr plans).

Q: OK, earlier than we go any additional, let’s ensure everyone seems to be on the identical web page with respect to the definitions of HCE and NHCE.

Ah, and that’s the place a few of the 401(okay) enjoyable is available in as a result of there are literally completely different ways in which these classes of workers may be outlined. And the plan sponsor has some flexibility in selecting the definition which will make it simpler for the plan to cross compliance testing. However one factor that’s necessary to know is that you just solely must outline who falls inside the HCE class since NHCEs are simply the residual (i.e., everybody else).

Compensation is understandably one think about figuring out whether or not somebody is an HCE or not. Nevertheless it’s based mostly on prior yr compensation information. So if we’re in February of 2021, doing 2020 compliance testing on a plan, we’d want 2019 compensation information from the plan sponsor. That may trigger numerous confusion at first, particularly for plans that simply began up. For instance, a plan that began in June 2020 will understandably query why they should present us with firm compensation information —earlier than the 401(okay) plan was even in existence. It’s as a result of we have to decide who was an HCE, and that’s based mostly on the prior yr, also called a “lookback yr.” Clearly, if the corporate wasn’t even in existence within the prior yr, we might then must depend on more moderen information. And in reality, in such a case, we wouldn’t depend on compensation to outline HCEs, however simply the possession definition, which we’ll get into.

Q: So it seems like the subsequent logical query then is: what are the completely different HCE definitions?

Certain. Sure kinds of workers are routinely outlined as HCEs no matter their compensation. This may be difficult for companies, particularly these which might be small and/or household run. An HCE is an worker who meets one of many following standards:

• Possession in Present or Prior Yr – no matter compensation, owns over 5% of (1) excellent company inventory, (2) voting energy throughout company inventory, or (3) capital or income of an entity not thought of a company. This contains relations.
• Prior yr compensation exceeds IRS definition of HCE. That is no matter present yr compensation. In 2019, this quantity was $125,000.

Q: I suppose this results in different strategies of defining HCEs and NHCEs.

Precisely. Alternatively, bigger plans particularly might want to outline HCEs utilizing the Prime-Paid Group Election (TPG) methodology that permits them to restrict the variety of HCEs to their prime 20% of workers based mostly on prior yr compensation. This have to be outlined within the plan doc and might be helpful if excessive earners who aren’t in that prime 20% are contributing considerably, which in flip will help increase the common contribution fee of the opposite 80%.

One factor to notice is that any workers who’re thought of extremely compensated below the possession definition will nonetheless be handled as HCEs, no matter compensation. So the precise share of HCEs utilizing the TPG methodology may very well exceed 20%.

Q: So what are some components that contribute to ADP testing failures?

Some of the frequent challenges we see occurs when plans begin late within the yr. Typically, HCEs who’ve extra discretionary earnings are so excited concerning the plan and the power to maximise their financial savings and their tax deferrals. So even with just some payroll intervals left within the yr, they maximize their contributions, contribute at a lot greater charges than NHCEs, and trigger the plan to fail.

Plans that begin late within the yr ought to pay attention to this potential drawback. In the event that they don’t need to delay beginning the plan, they need to talk to HCEs that they are going to be unlikely to contribute the utmost annual quantity (and should danger receiving a taxable refund of contributions after the yr ends).

Our message to plan directors, although, is that this: if the only focus for beginning a 401k plan is to permit the proprietor or different HCEs to max out their contributions, be forewarned that your plan might fail the ADP take a look at. Keep in mind that as a fiduciary, you need to function the plan within the pursuits of your entire workers.

Q: Every other issues to be careful for?

Different plans which will must be extra cautious embody small plans, particularly the place the proprietor stands out as the solely HCE. If different workers aren’t contributing or contributing sufficient, that may be tough.

One other wrinkle can happen when there are HCEs who’re incomes lower than the statutory most compensation quantity. Amongst different issues, that is the utmost quantity that can be utilized when performing the take a look at calculations. Take into account an HCE below age 50 who’s contributing the utmost annual 401(okay) contribution of $19,500. If they’re incomes the statutory most compensation quantity of $285,000 for 2020, that’s the equal of 6.8% of wage. Nevertheless, if they’re incomes simply $150,000 (which additionally qualifies them as an HCE), that very same $19,500 interprets right into a 13% contribution fee. So the vary of HCE compensation can have a huge effect on that HCE ADP.

Q: How can plans be sure that they don’t fail the ADP take a look at?

For many who aren’t conscious, there’s one very simple resolution. The ADP compliance take a look at may be bypassed altogether if the plan adopts a Safe Harbor plan design, which requires a compulsory contribution. In fact, the corporate must weigh the added expense towards the advantages of lowered compliance complications and probably higher funded retirements for his or her workers. However for plans who’re beginning late within the yr, adopting Secure Harbor is a good way to keep away from potential testing failures and having to refund contributions to HCEs.

Q: And what if the Secure Harbor plan design is simply too pricey?

Wanting adopting a Secure Harbor plan design, there are different issues plans can do to scale back the chance of failing the take a look at. As an illustration, implementing automatic enrollment for all workers at a fee that’s sufficiently excessive can go a great distance. Most individuals don’t opt-out of the plan or change their default contribution quantity. So if the plan contributes everybody at, say 6%, there’s most likely a a lot better probability that the plan will cross ADP testing.

As well as, typically (however not at all times) a matching contribution can actually inspire workers to avoid wasting extra. As an illustration, if workers must contribute 6% to earn the utmost employer contribution, they are going to be extra more likely to contribute that quantity. Typically this requires clear and constant communication to make certain that workers newly eligible for the plan are additionally conscious of the matching function and the way they will earn the utmost quantity. That mentioned, if an employer is keen to tackle the expense of an identical contribution, then a Secure Harbor plan design might make extra sense since that eliminates the uncertainty related to compliance testing altogether.

Plans may resolve to make use of the Prior Yr testing methodology, which permits them to restrict HCE plan contributions going ahead based mostly on the outcomes of the prior yr checks. This isn’t a assure that the plan will cross the ADP take a look at, nevertheless it reduces the chance.

Q: What’s your recommendation to plans which have failed the ADP take a look at?

Initially, don’t panic. It’s not unusual for plans to fail the ADP take a look at. That mentioned, it’s price analyzing what else is occurring with plan design that might be negatively impacting participation or contribution charges. As an illustration:

• Is the eligibility requirement limiting from contributing to the plan who in any other case may thereby serving to increase NHCE engagement?
• Is the plan being made accessible to all workers who’re eligible in response to the plan doc? Except it’s written within the plan doc that part-time and/or seasonal workers corresponding to interns can’t contribute to the plan till they meet sure eligibility necessities (particular to this worker class), they have to be given the chance to contribute to the plan.
• Are definitions of plan compensation (excluding pre-participation compensation as an example) skewing the common contribution percentages and impacting testing in surprising methods?

In fact, we warning everybody that testing can change from yr to yr, particularly for brand spanking new plans or firms simply beginning out, so it’s not one thing that’s one and performed. New plans who cross their first yr ought to particularly guard towards getting too complacent in considering they gained’t have any issues sooner or later.

As well as, plans ought to monitor plan engagement, paying consideration not simply to the participation fee however the common contribution fee of various worker teams, and proceed to speak the advantages of the plan, notably to these teams who want to listen to it most. Betterment can work with plans to develop a technique for reaching out to their workers.

Q&A was performed in 2021 and is supposed to be academic in nature.