Compliance December 1, 2014

401(k) Nondiscrimination Tests Explained

With acronyms like ADP, ACP, NHCEs, and HCEs, the technicality of 401(k) plan nondiscrimination testing may seem overwhelming.
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Even though nondiscrimination testing is likely performed by a plan’s recordkeeper or third-party administrator, plan sponsors need to understand the basics of the tests, including the types of contributions that are tested, the methods used and the consequences of failing.

The Tests

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The Employee Retirement Income Security Act (ERISA) requires several tests each year to prove 401(k) plans do not discriminate in favor of employees with higher incomes.

For some of the tests employees are divided between non-highly compensated employees (NHCEs) and highly compensated employees (HCEs). The Internal Revenue Service (IRS) defines highly compensated employee as an individual who:

  • Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
  • For the preceding year, received compensation from the business of more than $115,000 (if the preceding year is 2013 or 2014; $120,000 if the preceding year is 2015), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.

The compensation used for determining whether an employee is an HCE is indexed each year.

Robert Richter, vice president with SunGard’s Wealth and Retirement unit, breaks the nondiscrimination rules into three parts. First, he explains, there are rules to ensure there is broad coverage of employees, which is tested by the 410(b) coverage test.

Next, once you have a sufficient number of NHCEs covered, you look at the benefits, rights, and features of the plan to ensure they are nondiscriminatory. This is tested by the ADP and ACP tests.

ADP stands for actual deferral percentage, explains Robert Kaplan, national retirement consultant for Voya Retirement Solutions. This test compares the average of salary deferral percentages for HCEs to the average of salary deferral percentages for NHCEs. The ADP test applies to pre-tax and Roth elective deferrals. Kaplan states the purpose of this test is to ensure all participants, both HCEs and NHCEs, are benefitting from the plan.

Richter adds that if an HCE wants to maximize his or her deferrals, then NHCEs will also need to make deferrals. So, it is an incentive for the employer to encourage participation by NHCEs. The most common incentive is to provide for matching contributions.

The ACP, or actual contribution percentage test, compares the average of the percentage of matching contributions and after-tax employee contributions for HCEs verses NHCEs. Matching contributions and voluntary employee after-tax contributions (different from Roth elective deferrals) are included in this test. The purpose of this test is to ensure that the actual usage of the plan feature is widespread and not only used by the HCEs. “Plans subject to testing only work if employees across the entire income spectrum participate,” Kaplan adds.

Richter explains: “For example, if I give the HCEs $50,000 and all NHCEs $1, I will pass coverage, but the actual benefits will be discriminatory. Similarly, if I establish a 401(k) plan and let all NHCEs participate, I will pass the coverage tests. However, if the rate of deferrals of the NHCEs isn’t sufficient, then the HCEs will be limited in the amount they can defer.”

Finally, there is a test to ensure the 401(k) plan is not top-heavy which looks at overall benefits that have been accumulated by key employees. Generally, if more than 60% of the overall assets in the plan are attributable to key employees (different from HCEs) then the plan is top-heavy and certain minimum benefits may need to be provided to the non-key employees. Defined by the IRS, a key employee is any former or deceased employee who at any time during the plan year was an officer making more than $170,000 (this is indexed each year); an owner of more than 5% of the business; or an owner of more than 1% of the business and making more than $150,000 for the plan year.

“So the first two, coverage and nondiscrimination of benefits, are annual tests looking only at contributions for a specific year, whereas the top-heavy rules are a test based on total accumulated benefits,” Richter explains.

Methods

Basically, the coverage test looks at the percentage of eligible HCEs who are benefitting from the plan and compares that to the percentage of eligible NHCEs who are benefitting from the plan. If the ratio obtained by dividing the average percentage of NHCEs benefitting from the plan by the average percentage of HCEs benefitting from the plan is greater than 70%, the plan passes the coverage test. If the ratio of the two falls below 70%, then the test looks at the average benefit of the NHCEs compared to the average benefit of the HCEs to see if that ratio is 70% or greater.

There are two methods for performing the ADP and ACP tests in which the average of the applicable ratios of the HCEs is compared with the average of the ratios of the NHCEs. A plan needs to satisfy one of the two tests and may generally use either the prior year or current year percentage for the NHCEs in applying the tests.

The first method provides that the ratio of the contribution average of HCEs to that of the NHCEs cannot be more than 125%. For example, if the average NHCE contribution is 3%, then the average HCE contribution cannot be more than 3.75%.

Under the second method, the average contribution for the HCEs cannot exceed the lesser of the average contribution of the NHCEs plus 2% or the average contribution of the NHCEs times 2. For example, if the average contribution for the NHCEs is 3%, then the average contribution for the HCEs cannot exceed 5% (the average contribution of the NHCEs plus 2%). If the average contribution for the NHCEs is 1%, then the average contribution for the HCEs cannot exceed 2% (because 1% times 2 is less than 1% plus 2%).

Repercussions of Failing

If the 410(b) coverage test is failed, plan sponsors must bring the plan into retroactive compliance by the end of the plan year, either by extending coverage to a broader group of NHCEs or by modifying contribution allocations or benefit accruals. According to information on the Employee Benefit Research Institute website, if the plan fails to bring the plan into compliance (leaving the failed coverage test not corrected), HCEs will have to report as income their vested accrued benefit that has not been previously reported as income on their income tax returns.

For the ADP and ACP tests, Kaplan says, “If the plan fails either test the employer must take corrective action in the 12-month period following the close of the plan year in which the oversight occurred.”

The IRS explains two methods for correcting a failed ADP or ACP test:

  • Determine the amount necessary to raise the ADP or ACP of the NHCEs to the percentage needed to pass the tests, and make a qualified non-elective contribution (QNEC) to all eligible NHCEs in that amount.
  • Distribute excess contributions, adjusted for earnings, to the HCEs. If any excess matching contributions are not 100% vested for the participant, the applicable percentage must be forfeited. Kaplan notes that for calendar year plans, distributions must be done by March 15 (2 ½ months following the plan year) to avoid excise taxes.

If a plan is found to be top-heavy in a plan year, the plan sponsor must make a minimum contribution to non-key employees. The contribution is generally 3% of compensation.

Kaplan notes that SIMPLE 401(k) and safe harbor 401(k) plans are not subject to either the ADP or ACP tests because in lieu of testing, they deposit mandatory fully vested contributions.

“Congress prefers increased benefits for NHCEs or non-key employees. That is why there are provisions in the law to give employers an exemption from the ADP and ACP tests and the top heavy rules,” Richter adds. “Specifically, safe harbor 401(k) plans can be designed to avoid these tests. That is the carrot. The cost is that safe harbor plans require certain minimum contributions for NHCEs.”

Data & Research December 1, 2014

Uncertainty Drives Preference for Income Guarantees

Many retirement savers are focused on income guarantees and establishing a level of protection against market volatility, according to the Allianz Life 2014 Market Perceptions Study.
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Rising markets for much of 2014 were largely offset by significant downturns in August and October, tempering Americans’ attitudes about risk and investing aggressively for retirement, the study finds. The vast majority of investors polled for the study said they prefer financial products with guarantees (78%) over products with higher growth potential but the possibility of losing value (22%).

This opinion aligns with Americans’ current attitude about retirement strategies, Allianz says, as four in five respondents (80%) agreed that it’s important to have a guaranteed source of income in retirement, well ahead of those who indicated they are comfortable with current market conditions and are ready to invest now (28%). When asked what factors would prevent the investing of “extra cash,” four in 10 respondents pointed to “fear of market uncertainty,” ahead of “lack of reliable financial advice/guidance” (26%) and “today’s low interest rates” (22%).

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“Hands down, Americans are saying their retirement savings strategy must include products and choices that offer guarantees, even though equity markets have performed well this year,” observes Katie Libbe, vice president of consumer insights at Allianz, an annuity provider. “It appears that the recent threat of volatility is enough to keep many consumers away, particularly those who are focused on saving for retirement.”

Notably, Allianz found 39% of American investors would put extra cash into a product that offers a balance of potential growth and some level of income protection. Another 19% said they would put extra cash into a product with modest potential growth (2% to 3% growth) and no potential loss—the same number that would put extra cash into a savings account earning little or no interest.

Despite warnings against trying to time the markets, 12% would hold their extra cash and “wait for the market to correct” before purchasing a financial product for their retirement. Finally, 11% would put extra cash into a product with high growth potential and no protection from loss, the study finds.

When asked about the most important action to take in the longer-term approach to retirement, more than four in 10 (41%) cited putting some of the money into a financial product that provides a guaranteed stream of income in retirement. According to Allianz, only 12% of respondents said the best strategy is to put some of their money into equities to build up retirement assets.

Given the choice between two financial products—one offering an 8% return with the possibility of losing value and one with a 4% return but guaranteed not to lose value—a strong majority (78%) of respondents chose the guaranteed product, Allianz says.

On the question of investors’ biggest concerns surrounding retirement, not being able to cover basic living expenses (34%) and outliving sources of income (20%) were the top responses. Other issues that respondents noted they fear in retirement include “paying for health care costs” (17%), “seeing retirement savings drop significantly in value” (12%), “keeping up with inflation” (12%) and “managing any tax increases” (4%).

The Allianz Life 2014 Market Perceptions Study was conducted by Ipsos via its online iSay/Ampario Panel from September 12 to 16, 2014, with 791 panel respondents ages 18 and older who identified as “not retired,” and was commissioned by Allianz Life Insurance Company of North America.

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