Non-Discrimination Rules
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NON-DISCRIMINATION RULES
Like all other qualified programs, 401k plans may not discriminate in favor of highly compensated employees regarding the plan's coverage, contributions or benefits. In order to satisfy the rules governing nondiscrimination in coverage, a 401k plan must meet either a:
percentage test orratio test. While a plan may appear nondiscriminatory on paper, it may prove to be discriminatory in operation. In many 401k plans, lower-paid employees elect to take their contributions in cash rather than defer them. To ensure the plan is not discriminatory in operation, it may not discriminate with respect to actual deferrals. This is measured by the "actual deferral percentage" (ADP) test. Plans that include voluntary and matching contributions, must also satisfy an "actual contribution percentage" (ACP) test.
Highly Compensated Employees
The tax code currently defines an employee as highly compensated if he or she:
owned more than 5% of the employer at any time during the current year or the preceding year, orhad compensation from the employer in excess of $80,000 during the preceding year. This is adjusted for inflation (in 2007 the "adjusted" amount is $100,000). The employer may elect to designate these persons as highly-compensated only those earning more than "$80,000" who are also in the top 20% of employees by compensation of the employer for the preceding year.Employers electing to treat employees in the top 20% of compensation as highly compensated (i.e.. "top paid group election"), are required to include fewer employees in the highly compensated employee group. As a result, employees who receive relatively high pay may be categorized as nonhighly compensated. This increases the plan's chances of passing the nondiscrimination tests. The same is true for employees in the same general salary range. An employer may be able to designate those employees with higher benefit percentages as being in the nonhighly compensated group, which may also enable it to pass the nondiscrimination tests more easily.
Coverage Requirement
The tax code grants "qualified" tax status to retirement plans that extend broad coverage to an employer's workforce. In order to "qualify", 401k plans must satisfy either the percentage test or the ratio test - and then pass the "50 / 40" test..
In applying these "coverage" tests, employers may exclude certain categories of employees:
employees not meeting the plan's age and service requirements, (age 21 and one year of service)nonresident aliens who earn no income within the U.S., oremployees covered under collective bargaining agreements.All employees eligible to make elective contributions must be counted, regardless of whether they actually contribute. To determine whether a plan is non-discriminatory using the average benefits test, all eligible employees (except "excludable employees") must be taken into account, even though they may not benefit under the plan.
Percentage Test
Under the percentage test, at least 70% of all nonhighly compensated employees must be covered by the plan.
Example: Able Manufacturing has 100 employees eligible to participate in its 401k plan, of which ten are considered highly compensated. Under the "percentage test" at least 63 of the non-highly compensated employees (70% of 90 non-highly compensated employees) must be covered by Able's 401k plan to be non-discriminatory.
Ratio Test
Under the ratio test, the percentage of nonhighly compensated employees covered by the plan must be at least 70% of the percentage of highly compensated employees covered.
Example: Able Manufacturing has 100 employees eligible to participate in its 401k plan, of which ten are considered highly compensated. Of these ten highly-compensated employees , eight are covered by the company's 401k plan - resulting in a coverage ratio of 80% for the highly compensated employees. Under the "ratio test" at least 51 of the non-highly compensated employees must also be covered (70% of the 80% ratio applied to 90 non-highly compensated employees: 70% x 80% x 90 employees = 50.4 employees)
If only six of the ten highly compensated employees (60%) were covered by the plan, then only 38 of the non-highly compensated employees would have to be covered to comply with the "ratio test". (70% x 60% x 90 employees = 37.8 employees)
50/40 Test
Once a plan has passed one of the nondiscrimination tests discussed above, it still has one more hurdle to clear to retain qualified status. At all times, the plan must benefit the lesser of 50 employees or 40% of all eligible employees. For purposes of this test, those employees who have not met the age and service requirements, union employees, etc., may be excluded.
The intent of this rule is to have each qualified plan of the employer "stand on its own feet." Employers can aggregate their plans in order to meet the first series of tests. But the 50/40 test is applied to each plan separately.
Example: Example. Suppose that a company has 35 employees. Of that number, 5 failed to meet the age and service requirements, leaving 30 eligible employees. To satisfy the 50/40 test, at least 12 of the employees (40% of the 30 eligible) must be covered by the plan.
Non-Discrimination in Contributions
Actual Deferral Percentage (ADP) Test
The "coverage" rules above indicate whether a 401k plan is open "fairly" to all employees: both highly and non-highly compensated. Even though the plan may be open to lower-paid employees, does not mean that they will take advantage of it. The tax code requires that 401k plans be non-discriminatory in operation as well as on paper. For this purpose, the plan must satisfy the actual deferral percentage (ADP) test. This test compares the monies set aside for highly compensated employees versus those set aside for non-highly compensated employees. As a rule, the ADP test addresses elective contributions only (employers may include matching and non-elective contributions in this calculation if these are subject to the same vesting requirements and withdrawal restrictions as elective contributions. The examples that follow will consider elective contributions only). Only elective contributions relating to compensation earned by the employee during the plan year may be used in the ADP test. The ADP test allows a maximum "differential" between the two groups based on the ADP of the lower-paid group. To pass this test, the ADP of the highly compensated group must not exceed the ADP of the non-highly compensated group by more than:
1.25 times: if the ADP of the non-highly compensated group is 8% or more2 times: if the ADP of the non-highly compensated group is under 2%2 percentage points if the ADP of the non-highly compensated group is between 2% and 8%Permissible ADP differentials
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||
Non-Highly Paid ADP
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|
Highly Paid ADP
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0.5
|
x 2
|
1.0
|
1.0
|
x 2
|
2.0
|
1.5
|
x 2
|
3.0
|
2.0
|
+ 2
|
4.0
|
3.0
|
+ 2
|
5.0
|
4.0
|
+ 2
|
6.0
|
5.0
|
+ 2
|
7.0
|
6.0
|
+ 2
|
8.0
|
7.0
|
+ 2
|
9.0
|
8.0
|
+ 2
|
10.0
|
9.0
|
x 1.25
|
11.25
|
10.0
|
x 1.25
|
12.50
|
11.0
|
x 1.25
|
13.75
|
To apply this test, find the individual average deferral percentage of each employee, then find the group average percentage for both highly and non-highly compensated groups and compare with the table above (both employee and "group" ADPs are calculated to the nearest 1/100 of 1% or 0.01%). The ADP of an eligible employee who makes no elective contribution is zero.
Example:
April Shower & Bath Inc. maintains a 401k plan and all six of its eligible employees are covered. Compensation, elective contributions, and individual ADPs for the year were as follows:
Clauser and Fike each own 40% of the company and Webster owns the remaining 20%. Since each owns at least 5% of the company (and the others earn less than $80,000), the highly compensated group consists of Clauser, Fike, and Webster. The average ADP for this group is 8.60% ((9.10% + 8.50% + 8.20%) / 3). The average ADP of the low-paid group (Fields, Jovin, and Randum) is 5.27% ((6.20% + 4.50% + 5.10%) / 3). Since the ADP of the lower-paid group is between 2% and 8%, the maximum permissible "differential" is 2 percentage points between the groups. In this case, the plan fails the ADP test - the ADP of the highly-paid group exceeds the maximum of 7.27% (5.27% + 2%). This plan is discriminatory in favor of highly compensated employees.
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Example: Assume the same situation as above, except that Webster, did not make any elective contributions to the plan during the year.
The average ADP for the highly paid group would be 5.87% [(9.10% + 8.50% + 0.00%) / 3]. This average ADP is less than the permissible maximum of 7.27% (5.27% +2%), so the plan would be considered non-discriminatory - even though the individual ADPs of two highly paid employees exceeded the "maximum".
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Please note: 401k plans do not automatically fail the ADP test merely because all of the eligible employees for a year are highly compensated. For example, a corporation's employees may all be shareholders, or all employees may earn more than $80,000 (inflation adjusted) during the year. In these instances, the the non-discrimination rules do not apply, since there are no lower-paid employees to discriminate against.
Employers must limit the amount of compensation they may take into account when determining contributions and ADPs - the inflation adjusted limit is $225,000 for 2007. This results in larger ADPs for very highly paid employees, because they are computed on the basis of the lower compensation ceiling. It is more difficult for 401k plans to meet this test when there are very highly paid employees.
Pinehurst Management maintains a 401k plan for its employees on a calendar-year basis. None of the employees are owners of the firm. The plan provides only for elective contributions of up to six percent of compensation or the applicable annual 401k maximum contribution. During 2002, the employees' compensation, elective contributions and individual ADPs were as follows:
For 2007, the limit on compensation that may be taken into account in determining contributions to employee plans on behalf of an employee is $225,000. Therefore, for the 2007 plan year, the Andrews' ADP is 4.44% - computed by dividing his $10,000 elective contribution by $225,000 - rather than by his actual compensation of $300,000 for the year (which would have resulted in an ADP of 3.33%).
Andrews and Miles are the highly paid employees for 2007 -- both earned more than $80,000. Using the ADPs determined above, the Pinehurst's 401k plan would not pass the nondiscrimination test because the 5.22% average ADP rate for the highly paid employees [(4.44% + 6.00%) / 2] exceeds the maximum of 5% (2 percentage points higher than the 3% average ADP rate for the low-paid group). Had Andrews' entire compensation been allowed, the highly paid group's ADP would have been only 4.67% [(3.33% + 6.00%) / 2] -- well below the allowable maximum of 5%.
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Reclassification of Nonelective and Matching Contributions
Usually, only employee-provided elective deferrals are used in the ADP test. In some cases, the tax code allows employer-provided non-elective and matching contributions to meet the ADP test under certain circumstances:
these employer-provided contributions are "qualified". This means the contributions vest fully and immediately with the employee and the employee is subject to restrictions on premature distributions (prior age 59½, death, disability, etc.), andthese contributions do not favor highly compensated employees.If an employer uses qualified matching contributions are used to meet the ADP test, they may not be used to satisfy the special nondiscrimination test for employee contributions and matching contributions (the ACP test discussed below).
Actual Contribution Percentage (ACP) Test
If a 401k plan provides for matching contributions made by the employer or voluntary after-tax contributions made by the employee, the plan must satisfy the Actual Contribution Percentage (ACP) test as well as the ADP test, discussed above. The ACP test is essentially the same as the actual deferral percentage (ADP) test, except that it is applied to employee voluntary contributions and employer matching contributions made during the year, rather than to elective contributions. Only an employer's matching contributions (not non-elective contributions) are included in this test. To be included, the matching contributions must actually be allocated to the employee's 401k account during the plan year -- and be based on the amount of the employee's elective contribution.
Example: An employee with compensation of $50,000 defers 4% of his compensation, or $2,000, as an elective contribution. The employer matches the elective contributions 50 cents-on-the-dollar, or $1,000. In addition, the employee makes voluntary contributions of $5,000. The employee's ACP is 12% [($5,000 plus $1,000) divided by $50,000].
As with the ADP test, the employer calculates an ACP for each participating employee, the average ACP of the highly compensated group is then compared with the average ACP or the non-highly compensated group. (Please note: the ACP test, unlike the ADP test, only considers employees who are eligible for matching contributions. If an employee does not make an elective contribution, and therefore is not entitled to a matching contribution, will not be included in the ACP test. In contrast, the ACP test includes all eligible employees regardless of whether they make elective contributions.)
The same "differentials" apply to the ADP and ACP tests. The ACP of the highly compensated group cannot exceed:
1.25 times: if the ADP of the non-highly compensated group is 8% or more2 times: if the ADP of the non-highly compensated group is under 2%2 percentage points if the ADP of the non-highly compensated group is between 2% and 8%Permissible ACP differentials
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||
Non-Highly Paid ACP
|
|
Highly Paid ACP
|
0.5
|
x 2
|
1.0
|
1.0
|
x 2
|
2.0
|
1.5
|
x 2
|
3.0
|
2.0
|
+ 2
|
4.0
|
3.0
|
+ 2
|
5.0
|
4.0
|
+ 2
|
6.0
|
5.0
|
+ 2
|
7.0
|
6.0
|
+ 2
|
8.0
|
7.0
|
+ 2
|
9.0
|
8.0
|
+ 2
|
10.0
|
9.0
|
x 1.25
|
11.25
|
10.0
|
x 1.25
|
12.50
|
11.0
|
x 1.25
|
13.75
|
The "$150,000" compensation limit (adjusted for inflation, $225,000 in 2007) also applies when determining the ACP. Thus, the ACP of an employee whose compensation is $300,000 in 2007 is calculated as though the employee earned $225,000.
Reclassification of Elective Contributions
In cases where the plan passes the ADP test (based on elective contributions) but fails to pass the ACP test (based on matching and voluntary contributions), the employer may -- under certain circumstances -- reclassify some of the employee's elective contributions as matching contributions. This gives the employer a "cushion" to satisfy the ACP test and maintain the plan's qualified tax status.
Plan Aggregation
If two groups of employees are eligible for separate 401k plans under the same plan, the two 401k plans are treated as a single 401k plan, even if they have significantly different features such as greatly different limits on elective contributions.
Generally speaking, all of an employer's 401k plans are treated as a single plan for purposes of the ADP test, ACP test, and rules such as the special test described above. One exception permits separate testing of a portion of a plan that benefits employees who have not satisfied the greatest minimum age and service requirements (age 21 and one year of service). Thus, an employer may treat a plan that benefits employees including otherwise includable employees as two separate plans (one for the otherwise excludable employees and one for other eligible employees).
If a highly compensated employee is eligible to participate in more than one 401k plan of the same employer, the actual deferral ratio (ADP) is calculated by treating all 401k plans for which the employee is eligible to participate as one 401k plan.
Example: Andy Harris has $100,000 in compensation. Harris is eligible to make elective contributions under two separate 401k plans of his employer. He elects to defer 5% of his compensation into Plan A and 4% into Plan B. His individual ADP under each 401k plan is calculated by dividing his total elective contributions under both arrangements by his compensation, i.e. ($5,000 + $4,000) / $100,000 or 9%. Please note: An employee's participation in more than one plan of different employers may also raise problems for the employee in dealing with the annual limit on elective deferrals.
Some employers establish different plans for different levels or classes of employees, e.g. unionized vs. non-unionized, one location vs. another, etc. Such plans must provide "equal" benefits between levels or classes of employees. A plan would violate this rule if it results in a higher rate of matching contributions for highly compensated employees than for nonhighly compensated employees.
Excess Contributions
A 401k plan that contributes "too much" on behalf of highly-compensated employees will fail the non-discrimination tests discussed above. If not corrected, plans with "excess contributions" will lose their tax-qualified status. Employers have several options to "correct" the excess and preserve the plan's status:
matching or voluntary contributions can be reclassified as "elective",
elective contributions can be recharacterized as "voluntary", or
excess contributions can be distributed to highly-compensated employees.
The details of these options are quite complex - and beyond the scope of this course. The IRS enforces the excess contribution rules strictly and the penalties for non-compliance can be severe - including disqualification of the plan if they are not "corrected" within 12 months of the plan year. (A 10% excise tax applies to the employer if not corrected within 2½ months of the end of the plan year.)
Excess contributions that are distributed to employees are subject to income taxation - but not subject to the 10% premature penalty.
Safe Harbor 401k
So-called "Safe Harbor 401ks" take advantage of alternative methods to satisfy the ADP and ACP tests. Congress provided these alternatives as a way to simplify plan administration and encourage employers to adopt 401k plans. Employers are not required to adopt these alternatives or to use the alternatives for a minimum number of years. However, use of these alternatives may eliminate the need to apply the ADP and ACP tests. These alternatives require employers to make a mandatory contribution to the 401k plan. Employers who adopt the alternative methods must provide written notice to each employee eligible to participate in the plan of their rights and obligations under the plan. The notice, provided annually, must be written in a manner that can be understood by the average employee.
ADP alternative
As an alternative to the ADP test, an employer may make either a:
non-elective contribution of at least 3% of compensation for all eligible, nonhighly compensated employees, or
matching contribution for nonhighly compensated employees of: a dollar-for-dollar match for elective contributions up to 3% of an employee's compensation, and
a 50¢-per-dollar match on employees' elective contributions between 3% and 5% of their compensation.
The match rate for highly compensated employees may not exceed the match rate for lower-paid employees, at any level of elective contributions.
The alternative ADP matching or non-elective contributions must be fully and immediately vested, and subject to the 10% penalty on premature withdrawals. In other words, these employee contributions are treated as elective contributions for vesting and withdrawal purposes.
ACP alternative
This method for meeting the employer matching contributions (but not employee voluntary contributions) part of the ACP test, requires the employer to:
meet the requirements that apply under the ADP alternative discussed above, and
limit matching contributions. Employers may not match any employee's elective contribution in excess of 6% of the employee's compensation. This alternative does not eliminate the need for the plan to apply the ACP test if the plan permits voluntary contributions from the employee. After-tax employee contributions must still be tested separately under the ACP test. Employer matching and non-elective contributions used in the alternative method may not be considered in calculating the ACP test.
Qualified Automatic Enrollment Plan
Congress has amended The Employee Retirement Income Security Act of 1974 many times. The latest major revision to ERISA is The Pension Protection Act of 2006. Passed in the wake of the Enron scandal and other corporate abuses, this law bolsters the funding of private sector pension plans and assists the Pension Benefit Guaranty Corporation in assuring that benefits will be available to retirees. While most of this law concerns defined benefit plans offered by large corporations, it does address several provisions affecting 401k plans: continuation of increased contribution levels, easing of restrictions on distributions, and accelerated vesting of benefits to name a few.
The Pension Protection Act includes one seemingly small, but major, change to cash or deferred arrangements. Prior to 2007, employees had to notify their employers that they wanted to participate in the 401k plan - in other words, they had to "opt-in" to the plan. Beginning in 2007, employers may automatically enroll eligible employees in their 401k plan, unless employees notify the employer otherwise - in other words, employees will have to "opt-out" of the plan. While is it uncertain how this will affect plans, the premise of the new law is that under the "opt-out" regime more lower-paid employees will participate in 401k plans and fewer plans will be disqualified as favoring highly-compensated employees.
Starting in 2008, the Pension Protection Act simplifies compliance with the nondiscrimination rules for plans with an automatic opt-out feature. Under a "qualified automatic enrollment program", all eligible employees automatically defer to the plan a certain stated percentage of compensation - unless an employee affirmatively elects a different percentage or to forgo withholding altogether. Under this new law, plans with a "qualified" automatic enrollment feature would:
automatically satisfy the ADP and ACP tests; and not be subject to rules for top-heavy plans. To qualify, the plan must provide for an initial automatic deferral rate of between 3% and 10%, of compensation and the employer must provide a match of:
100% match the first 1% of deferrals, and 50% on the next 5% of deferrals (or alternatively, the employer may provide a 3% non-elective contribution to all eligible employees.) The goal of this change is to cover more lower-paid workers and remove the administrative hassles of complying with the non-discrimination rules.