Understanding Your Plan’s Annual Compliance Testing
2 November 2021
As a plan sponsor, you are responsible for ensuring that the annual compliance tests are performed. Since offering an employee benefit plan comes with significant tax advantages, the IRS requires a series of tests to be performed annually to ensure plans benefit employees of all income levels and do not discriminate in favor of Highly Compensated Employees (“HCE”). Highly Compensated Employees are generally defined as a 5% owner of the plan sponsor in either the prior year or current year and or any employee earning in excess of the HCE limits per the IRS. This limit is adjusted and determined annually by the IRS. For the 2021 plan year, an employee who earns more than $130,000 in 2020 is considered an HCE.
The annual compliance testing is performed after year-end by the plan’s third-party administrator and generally falls into four major categories:
Actual Contribution Percentage (“ACP”)/Actual Deferral Percentage (“ADP”) Nondiscrimination Test
Section 402(g) and 415 Limitation Testing
IRC section 410(b) Minimum Coverage
In order to determine if your plan discriminates in favor of HCEs, there are two tests that must be completed. The ADP test tests employee elected deferrals and the ACP test tests after tax and employer contributions, if applicable. These tests are designed to limit the extent to which contributions made on behalf of HCEs may exceed the contributions made by the Non-Highly Compensated Employees (“NHCE”).
The ADP test compares the average salary deferral of HCEs to that of NHCEs. Each participant’s deferral percentage is the percentage of compensation that has been deferred to the plan. The deferral percentages of the HCEs and NHCEs are then averaged to determine the ADP of each group. Essentially, it measures the level of engagement of HCEs vs. NHCEs to make sure that high-income earners are not saving at a significantly higher rate than the rest of the employees. To pass the test, the ADP of the HCE group may not exceed the ADP for the NHCE group by 1.25 percent or the lesser of 2 percentage points and two times the NHCE ADP. The ACP test is determined in the same manner; however, the ACP instead compares the employer contributions of HCEs to that of NHCEs if the plan allows for employer contributions.
If your plan fails the ACP/ADP tests, you will need to correct the imbalance by returning applicable excess employee deferral amounts to each HCE or by making additional employer contributions to your NHCEs. The corrections will need to be completed by March 15 of the following year of excess deferrals.
Another category of the annual compliance test is the Top-Heavy Testing. This test evaluates whether or not the total value of the plan accounts of key employees is more than 60% of the value of all plan assets. The plan is deemed as being top heavy when the total value of the owners and most highly paid employees (“key employees”) accounts are greater than 60% of the total value of plan assets as of the end of the prior plan year.
If testing results indicate a plan is top-heavy for the plan year (ratio exceeds 60%), the plan sponsor will be required to make a contribution to the accounts of the non-key employees. The top-heavy minimum contribution is the lesser of 3% of compensation or the highest percentage contributed for key employees.
In addition to plans being subject to completing the nondiscrimination testing discussed above, the annual contributions made to the plan are also subject to IRS limitations. Section 402(g) and Section 415 of the Internal Revenue Code set limits on annual additions (contributions) that can be allocated to a participant under an employee benefit plan. The 415 limitation or annual addition is generally defined as the sum of the following: 1) Employee contributions, 2) Employer contributions, and 3) forfeitures. For plan year 2021, the annual addition made to a participant’s account may not exceed the lesser of $58,000 or 100% of the participant’s compensation. If your plan fails this testing, you can correct a 415-limitation violation by refunding employee deferrals or any excess employer contributions.
The fourth category of the required annual compliance testing is the Minimum Coverage and Participation Testing. The Minimum Coverage Test is designed to ensure that plan eligibility is not disproportionally concentrated on HCEs. There should be a sufficient number of NHCEs covered under the plan. If the percentage of NHCEs is at least 70% of the proportion of HCEs covered, the test is satisfied. Your plan’s coverage ratio is determined by dividing the ratio of NHCEs by the ratio of HCEs. If the plan fails the ratio percentage test, it may still pass under a more complex testing procedure called the Average Benefit Testing. In addition to the minimum coverage requirement, your plan must also meet a minimum participation requirement. The minimum is equal to the lesser of 50 employees or 40% of total employees. To satisfy the requirement, your plan must pass the test on each day of the plan year.
The annual compliance testing can be a complex area for a plan sponsor to understand. Although these testing procedures are completed by the Plan’s third-party administrator, to better fulfill your fiduciary responsibility, it is important for plan sponsors to understand how the testing works as well as the corrective measures that may be required.