Providing your employees with the opportunity to save through a 401(k) retirement plan is a valuable benefit that helps them build financial security for retirement. Any company that provides a 401(k) needs to be aware of mandatory government compliance tests that ensure a company's plan does not discriminate in favor of highly compensated or key employees. Compliance testing ensures that companies administer their 401(k) plans fairly and equally, in accordance with the rules established by the Employment Retirement Income Security Act (ERISA) of 1974.
Compliance testing is crucial for maintaining the tax-qualified status of 401(k) plans. These tests, mandated by the IRS, ensure that plans do not disproportionately benefit highly compensated employees (HCEs) or key employees (such as company owners) and meet coverage requirements. Failing to comply with these tests can result in plan disqualification, penalties, and adverse consequences for both employers and employees.
Companies must test their plans each year and address any compliance errors exposed by the tests. Typically a third-party plan administrator (TPA) or the plan recordkeeper helps plan sponsors carry out the tests.
Companies apply three different compliance tests to the plan each year. These tests look at how much income employees defer into the plan, how much the employer 401(k) match adds up to, and what percentage of assets in the plan belong to key employees and highly compensated employees versus what belongs to non-highly compensated employees.
The ADP tests pre-tax and Roth elective deferrals - not including catch-ups - for nondiscrimination. To pass the ADP test, the average contribution rate of HCEs for the year cannot exceed the greater of:
This test reveals how much the employer contributes to each participant’s plan as a percentage, based on their W-2 income. Companies pass the Actual Contribution Percentage test if the ACP for the eligible highly compensated employees doesn’t exceed the greater of:
Companies may run both the ADP and ACP tests using prior year or current-year contributions.
The Top-Heavy test targets key employees within an organization who contribute to qualified retirement plans. The IRS defines a key employee as any current, former or deceased employee who at any time during the plan year was:
Top-Heavy Timing: Under IRS rules, a plan is top heavy if on the last day of the prior plan year the total value of plan accounts for key employees is more than 60% of the total value of plan assets. If the plan is top heavy, the employer must contribute up to 3% of compensation for all non-key employees still employed on the last day of the plan year. This is designed to bring plan assets back into a fair balance.
A safe harbor 401(k) plan exempts an employer from annual nondiscrimination testing that is required with a traditional 401(k) plan. A safe harbor plan requires employers to provide, among other things, contributions to employees' accounts that are fully vested when made.
According to the Internal Revenue Service (IRS), the safe harbor contribution can be either employer-matching contributions (limited to employees who defer) or contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. Those contributions can benefit the employees, the company, and the business owner in the following ways:
When compliance tests reveal failures, employers must take prompt corrective action to remedy the situation. Options include returning excess contributions to HCEs, making qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs) to NHCEs, or amending plan provisions to meet compliance requirements.
401(k) compliance test failures can have significant implications for plan participants. HCEs may face limitations on their contributions or unexpected tax liabilities, while NHCEs may experience reduced benefits or delayed retirement savings growth. Employers must strive to minimize the adverse effects on all participants through transparent communication and equitable corrective actions.
To navigate the complexities of 401(k) compliance testing effectively, companies should implement best practices such as:
Please refer to our compliance calendar for due dates for compliance testing and various other relevant deadlines.
Final Thoughts
401(k) compliance testing is a critical aspect of plan administration that requires careful attention and proactive management. By understanding the key compliance tests, leveraging safe harbor provisions if appropriate, and implementing best practices, companies can maintain the tax-qualified status of their plan and support the retirement security of their employees.