If you are responsible for your company’s 401(k) plan, you may have started receiving requests from your service providers for information needed to perform annual testing on the plan. Many plan sponsors find these requests confusing or do not understand why this is necessary. A client recently told us that he quit taking tests when he graduated and does not want to start back!
However, the year-end testing is extremely important for your plan. The tests are required by IRS and DOL regulations, as they show whether the plan is meeting the requirements to remain tax-deferred. There are many different tests required for qualified retirement plans, depending on the type of plan and features offered within the plan. Here are a few of the most common ones that apply to defined contribution 401(k) plans:
- Excess Deferral Test—you will often see this test called the 402(g) Test, after the section of the Internal Revenue Code, that outlines deferral limit rules. The test is performed to make sure that no employee is allowed to defer more than the allowable annual limit. For 2017, employees under age 50 were allowed to defer up to $18,000, and in 2018, the limit is $18,500. If a plan allows for catchup contributions, employees who are at least age 50 are allowed to defer an additional $6,000. If an employee has deferred over the annual limit, the plan will need to distribute the excess amount to the employee. This should be completed by April 15 of the following plan year.
- Minimum Coverage Test—a retirement plan is not required to cover an employer’s entire workforce, but there are very specific rules that define which employees can be left out. The minimum coverage test is one way that a plan verifies that it is providing benefits for at least the minimum number of employees. Generally, a plan must cover at least 70% of its eligible workforce. If the minimum coverage test is not met, the employer may be required to provide contributions for employees who were not initially covered under the plan.
- Top-Heavy Test—the IRS and DOL intend for qualified retirement plans to be set up to provide retirement benefits to rank-and-file employees. Sometimes, through a variety of circumstances, the owners and “key” employees will end up with a majority of plan funds in their retirement accounts. If the owners and key employees have 60% or more of plan assets in their accounts, the plan will be declared “top-heavy.” A top-heavy plan must meet more stringent contribution and vesting requirements than one that is not top-heavy. Top-heavy status is determined as of the beginning of a plan year, and there are strategies that a plan sponsor can use to avoid having to make unplanned contributions at the end of the year.
- ADP/ACP Tests—like the top-heavy test, these tests are performed to make sure that highly compensated employees (HCEs) are not benefitting disproportionately to non-highly-compensated employees (NHCES). The tests compare the rates at which HCEs defer and receive a match to the same rates for NHCEs. If it is determined that the HCEs are deferring at higher rates and receiving a higher corresponding match, the plan may be required to distribute deferrals to effected HCEs and to distribute or forfeit corresponding match amounts. Therefore, the HCEs may be limited in their use of the plan if the NHCEs do not participate adequately. If this is a problem, there are several strategies a plan sponsor can use to make sure that all employees can participate at their desired level. Safe-harbor plan design, auto-enrollment, and auto escalation are all valuable tools that a sponsor may consider.
These are only a few of the tests that your service providers will be performing on your plan. It is critical that they have complete, accurate information to use in the testing. In many cases, the plan sponsor will be submitting employee information throughout the year and will be asked to review the information at the end of the year. This gives the plan sponsor the opportunity to make sure that all information is correct and that there have been no changes to basic employee information during the year. In most cases, the employer is the only entity that will have access to complete data for their employees. Please take the time needed to review your year-end testing data so that your plan testing can be completed quickly and correctly.
If you have any questions about what is needed for your plan’s testing, the test results, or about strategies that you can use to improve the quality of your retirement plan, please contact one of the retirement plan professionals at Pinnacle Trust.
Kristy Launius serves as Vice President, Director of Retirement Plan Services at Pinnacle Trust. You can reach her by calling the office at 601-957-0323 or by emailing her at firstname.lastname@example.org.