Plan Administration
Retirement Plan Administration
401(k) and 403(b) administration is the process of maintaining a retirement plan and keeping it compliant with the Employee Retirement Income Security Act of 1974 (ERISA). This means that the plan must complete multitude of tasks annually from distributing required notices, performing non-discrimination testing to filing certain government forms. At first these undertakings can seem daunting to a 401(k) or 403(b) plan fiduciary. However, when they are broken down into pieces, it’s vivid that the tasks are manageable, especially when you consider that many of the more complex and time consuming tasks will be handled by a retirement plan expert.
Annual 401(k) & 403(b) Testing
Even though nondiscrimination testing is likely performed by your retirement plan expert, employers need to understand the basics of the tests, including the types of contributions that are tested, the methods used and the consequences of failing.
Who is considered an HCE?
ERISA requires several tests each year to prove 401(k) and 403(b) plans do not discriminate in favor of employees with higher incomes.
For some of the tests, employees are divided between non-highly compensated employees (NHCEs) and highly compensated employees (HCEs). The Internal Revenue Service (IRS) defines “highly compensated employee” as an individual who:
- Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
- For the preceding year, received compensation from the business of more than $130,000 (if the preceding year is 2020), and if the employer so chooses, was in the top 20% of employees when ranked by compensation.
Nondiscrimination Testing
There are a few tests that the plan must pass to show the plan does not discriminate in favor of high-ranking employees.
410(b) coverage testing
The purpose of this test is to make sure adequate number of non-HCEs are covered by a 401(k) or 403(b) plan. The minimum coverage test is one of several nondiscrimination tests a plan must meet in order to remain in compliance with the IRS rules. There are two versions of the test: the ratio percentage test and the average benefits test.
The ratio percentage test compares the percentage of covered non-highly compensated employees to the percentage of covered highly compensated employees. A plan satisfies the ratio percentage test if the plan covers a percentage of nonexcludable non-highly compensated employees that is at least 70 percent of the covered nonexcludable highly compensated employees. The coverage percentage of each class is calculated simply by dividing the number of covered employees from that class by the total number of nonexcludable employees of that class. After these calculations are performed, the percentage of covered non-highly compensated employees divided by the percentage of covered highly compensated employees equals the plan’s ratio percentage test. If this percentage is at least 70 percent, the retirement plan satisfies the ratio percentage test.
Example
A 401(k) plan covers 60 of the 100 (60%) nonexcludable non-HCE employees and 40 of the 50 (80%) nonexcludable HCE employees. This 401(k) plan’s ratio percentage is 75 percent (60%/80%), and, thus, satisfies the ratio percentage test.
|
Ratio Percentage (%) Test |
|||||
|
|
Nonexcludable Employees |
|
Covered Employees |
|
(%) Covered Employees |
|
Non-HCE |
100 |
60 |
60% |
||
|
HCE |
50 |
40 |
80% |
||
|
Total |
150 |
100 |
|||
|
Ratio % Test |
% of non-HCE Covered |
= |
60% |
= |
75% > 70% Pass |
|
% of HCE Covered |
80% |
||||
How can we make sure we pass our coverage testing?
Plan sponsors should be vigilant of normal changes in their workforce that might impact testing. If turnover suddenly increases, or there is a growth spurt, it is ideal to run some projections to remedy any potential testing issues in advance.
The ratio percentage test emphasizes in ensuring that at least 70% of the Non-HCEs benefit and that means that up to 30% can be excluded. While it is generally a positive to expand plan coverage to as many employees as possible, sometimes business realities are such that it would be cost effective to exclude certain groups of employees. By working with experts who understand this important test, it may be possible to further maximize the cost-effectiveness of your plan.
Actual Deferral Percentage (ADP) Test
The purpose of this test is to ensure that the plan is not discriminating against the rank-and-file employees (non-highly compensated employees). For 401(k) plans, the ADP test limits employee elective deferrals for the HCEs based on the elective deferrals of Non-HCEs. For example, if the non-HCEs on average deferred 4%, then the HCEs on average can only defer 6% (Non-HCE average 4% plus 2% HCE cushion) without failing the test.
The ADP test does not apply to 403(b) plans.
ADP Schedule | |
If the ADP for Non-HCEs is: | The Permissible ADP for HCEs is: |
0% to 2% | 2 times ADP for Non-HCEs |
2% to 8% | 2% plus ADP for Non-HCEs |
8% and over | 1.25 times ADP for NHCEs |
What if the ADP test fails?
If the ADP test does not pass, then there has been an excess elective deferral contribution by the HCEs. An excess contribution occurs when the HCEs defer more than is permitted under the ADP test. When this happens, there are four alternative remedies that the plan may use to bring the plan into compliance:
- Refund contributions to certain HCEs,
- Recharacterization,
- Make qualified nonelective contributions (QNEC), or
- Make qualified matching contributions (QMAC)
If a plan does not meet the ADP test, there are two explanations on why the plan did not meet the nondiscrimination test:
- the highly compensated employees deferred too much, or
- the non-highly compensated employees deferred too little (or some combination of the two)
This is a question of whether the “glass is half full or half empty.” Automatic enrollment is often used to entice participation and increase the deferral for the non-HCE. In either case, the plan must be corrected to meet the ADP test by either reducing the HCE employees elective deferral contributions or by increasing the Non-HCE employees elective deferral contributions. Corrective distributions and recharacterizations are methods to reduce the HCE employees elective deferrals, while QNECs and QMCs are methods to increase the ADP of the Non-HCE employees.
When must test corrections be made?
When there are excess contributions, the 401(k) plan must process refunds within 2-1/2 months after the plan year for which the contributions were made (by March 15 for calendar year-end plans). If the correction is not made timely, the employer is subject to a 10 percent penalty on the excess deferral contribution amount. In addition, if the correction is not made within 12 months, the plan may be deemed disqualified.
If the employer chooses to use a QNEC or QMAC, then these contributions can be made beyond the 2-1/2 month period.
Tax treatment of corrective distributions
The correction distribution (or refund) may be taxable in the year in which the deferral was taken or the following year, depending on when the distribution is received by the HCE. If the distribution is received within 2-1/2 months after the plan year end, then the distribution will be taxable to the HCE in the year in which the deferral was taken. In effect, it is as if the HCE deferred the proper amount. However, if the distribution is processed after the 2-1/2 month period, then it is taxable in the following year. Thus, the HCE would have received a larger deduction than should have been allowed in one plan year and more income the next.
Actual Contribution Percentage (ACP) Testing
The ACP test is calculated the same way as the ADP test except that instead of testing the employee salary deferrals, the ACP test calculates a contribution percentage based on the sum of the following:
- Employee after-tax contributions
- Employer matching contributions
After calculating the ACP for both Non-HCE and HCE employees, the two are compared using the same scale as the ADP test. If the plan does not pass the ACP test, the same corrective measures as used for the ADP test are used to either reduce the ACP of the HCE or increase the ACP of the Non-HCE. The ACP does apply to 403(b) plans, unlike the ADP test.
Top Heavy Testing
The top-heavy rules were designed to ensure that qualified plans that significantly benefit owners and executives of the company must provide some minimum level of benefits for the rank-and-file employees. The top-heavy requirements are most commonly applicable to small employer plans, age-based profit sharing plans, and any other plans that provide owners and executives with a disproportionate level of benefit from the plan.
A plan is top-heavy when, as of the last day of the prior plan year, the total value of the plan accounts of key employees is more than 60% of the total value of the plan assets.
When a qualified retirement plan is determined to be top-heavy, the plan must: (1) use top-heavy vesting schedules and (2) provide a minimum level of funding to non-key employees. These top-heavy provisions attempt to ensure that non-key employees are actually benefiting from the qualified retirement plan and that the key employees are not benefiting in a disproportionate way.
Who is a key employee?
To determine if your plan is top-heavy, you must first identify key employees. A key employee is any employee who is any one or more of the following:
- A greater than five percent owner, or
- A greater than one percent owner with compensation in excess of $150,000 (not indexed), or
- An officer with compensation in excess of $185,000 for 2020 as determined last year
A non-key employee is everyone else. 403(b) plans and certain safe harbor 401(k) plans aren’t subject to top heavy rules.
IRS Form 5500 return/report
The IRS Form 5500 is an annual report, filed with the Department of Labor (DOL), that reports information about a 401(k) or 403(b) plan’s financial conditions, investments, and operations. In general, all retirement plans must file a Form 5500 for every year the plan exists.
Generally, the Form 5500 and applicable schedules must be filed by the last day of the seventh month following the close of the plan year. For calendar year plans, this date is July 31. If the filing deadline falls on a Saturday, Sunday, or a federal holiday, the due date is the following business day.
Yes. An employer can apply for an additional 2-1/2 month extension of time to file their Form 5500 by filing IRS Form 5558. For calendar year end plans, this extends the filing deadline to October 15. The Form 5558 must be filed before the initial due date of the Form 5500.
Yes. Beginning in 2020, plan sponsors face much stiffer IRS penalties for not complying with plan reporting requirements as a result of law changes. The government may impose penalties or fines if a plan sponsor fails or refuses to file a complete return or if the Form 5500 is rejected for insufficient information. Additional penalties may be incurred for willful violations, which include making false statements. The penalty for non-filing has increased ten-fold by the SECURE Act to $250 per day up to $150,000 per plan year.
Failed to file Form 5500 and have yet to be notified by the DOL? Good news is that you can file the return using the DOL’s Delinquent Filer Voluntary Compliance Program (DFVCP). According to the DOL, the DFVCP provides “plan administrators with the opportunity to pay reduced civil penalties for voluntarily complying with the annual reporting requirements.”
Under the DFVCP, the maximum penalty for small plan filer (generally less than 100 participants) is $750, while the maximum penalty for large plan filer is $4,000 per plan.
Yes. The public can view electronically-filed Form 5500s using the DOL’s Form 5500/5500-SF Filing Search.
Yes. Every year, plan sponsors are required to provide a Summary Annual Report (SAR). The SAR is an IRS mandated document that summarizes the information reported on the Form 5500 and schedules. The SAR must be distributed to each participant and their beneficiaries receiving benefits under the plan no later than two months following the Form 5500 filing deadline, unless the plan filed for an extension, in which case they have until December 15 (for calendar year end plans).
Since a retirement plan expert will prepare (and sometimes even file) the Form 5500, fulfilling this requirement is generally pretty simple. At the same time, however, not filing the 5500 by the deadline is one of the most common error made by plan sponsors.
It pays for employers to understand the Form 5500 filing requirements, as it can prevent paying stiff penalties and avoid triggering a DOL or IRS investigation.
Find the Right Plan for Your Business or Nonprofit
NESA Plan Consultants (NESA) is a retirement plan provider working with advisors, recordkeepers and CPAs to offer customized 401(k), 403(b) and 457(b) plans. NESA offers modern solutions and provides resources to employers and employees to secure a brighter financial future.