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401(k) Plan Compliance Testing: A Quick Refresher

The passage of SECURE 2.0 at the end of 2022 brought with it numerous changes and enhancements for 401(k) and other retirement plans. As a result, it is likely that many plan sponsors and plan administrators are reviewing their plans and considering the incorporation of some or all of the revisions. It may also be a good time for these parties to review the basics of annual compliance testing.

Compliance tests, which are also known as nondiscrimination tests, are required to confirm that 401(k) plans do not favor highly compensated employees in comparison to non-highly compensated employees.

Failing an annual test may result in possible refunds, fines, and/or tax penalties. It is vital that an employer understands how the testing works to better fulfill its fiduciary responsibilities. Below, we’ve outlined the most common tests that are performed each year.

Top Heavy Testing

A plan with 60% or more of plan assets in the accounts of Key Employees is considered top heavy. In a top heavy plan, if contributions are allocated to the accounts of Key Employees, including elective deferrals, the regulations require that top heavy minimum contributions be allocated to the accounts of Non-Key Employees.

Coverage Testing

A qualified plan must benefit a minimum number of non-highly compensated employees. To see if a plan satisfies the minimum coverage requirement, either of two tests can be performed: the Ratio Percentage Test or the Average Benefits Test. The plan doesn’t need to pass the same test each year, as long as it passes at least one of the tests. Each contribution structure must pass coverage separately. Failure to satisfy coverage for a plan year can result in disqualification, even if the plan has met the minimum coverage tests in all prior years.

Excess Deferral Testing

In no event may an employee who is a 401(k) plan participant make an elective deferral that exceeds $20,500 for the 2022 calendar year ($27,000 if age 50 or older). For the 2023 calendar year, a participant can contribute up to $22,500 ($30,000 if age 50 or older).

Annual Additions Limit

Participants are subject to an annual combined contribution limit of what they and their employer can contribute, excluding catch-up contributions. This amount may not exceed the lesser of $61,000 or 100% of pay for 2022. The amount increases to $66,000 for the 2023 calendar year.

Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Testing

These tests are required each year for non-safe harbor 401(k) plans to demonstrate satisfaction of the nondiscrimination rules related to 401(k) and employer matching contributions. The salary deferral and matching contributions made on behalf of the Highly Compensated Employees (HCEs) cannot exceed the salary deferral and matching contributions made on behalf of the Non-Highly Compensated Employees (NHCEs) by more than a specified amount. If either or both tests fail, the plan generally must correct the failure by either (1) distributing the excess contributions to the HCEs or by (2) making an additional fully vested contribution to the plan on behalf of the NHCEs. Usually, the least expensive option is to distribute the excess amounts to the HCEs.

Nondiscrimination in Benefits, Rights, and Features

The actual contributions, plan benefits, rights, features, and definitions of pay used in allocating contributions must also satisfy tests that show the plan does not unduly favor the highly paid employees. Also, it must be determined that the plan’s definition of “compensation” (used in determining a participant’s share of company contributions) is not discriminatory.

Passing annual compliance testing is a crucial part of a 401(k) plan’s administration. Though compliance testing is typically performed by a third-party plan administrator, it is recommended that plan sponsors and plan administrators understand the basics and deadlines because the consequences for late testing and/or correction(s) can be severe – including IRS penalties, missed tax deductions, and even plan disqualification.

Please contact us if you have questions about the information outlined above, our seasoned and experienced employee benefit plan professionals are here to help. You can also learn more about our Employee Benefit Plan Audit services by visiting our website.

About the Author

Steph Kramer

Steph joined McKonly & Asbury in 2016 and is currently a Manager in the firm’s Audit & Assurance Segment. Steph audits a broad spectrum of employee benefit plans, including 401(k), 403(b), retirement, profit sharing, health and… Read more

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