What is 410(b) coverage testing?
Updated over a week ago

Coverage testing is a type of compliance test certain 401(k) plans must undergo each year to ensure their plan doesn’t overly favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs) when it comes to who is eligible to participate in the plan.

The test calculates the percentage of eligible HCEs to eligible NHCEs benefiting under the plan. If your plan is part of a legally related group, all employees across the related entities must be considered.

When is 410(b) coverage testing required?

Whether your plan must undergo coverage testing depends on the plan design and whether any related entities have different retirement plan designs.

If all employees (other than certain non-resident aliens and union employees) who are at least age 21 and have completed 1 year of service (including all related entities) are receiving all plan benefits, 410(b) testing is not required.

Guideline plans do not allow for service requirements greater than 1 year or age requirements beyond 21 years, so most Guideline plans do not require 410(b) testing. However, there are some exceptions.

You can learn more about when coverage testing is required here.

The difference between “eligible” and “benefiting” employees

Eligible employees are those who have met the plan’s minimum age and service eligibility requirements (including those employees in any related entities). Benefiting employees are those who actually receive any applicable contributions.

Each plan contribution type is analyzed separately:

  • Elective deferrals: Participants benefit from elective deferrals if they are eligible to contribute to the plan (even if they never do). Plans at Guideline that are not part of a legally related group (LRG) will always pass 410(b) coverage for elective deferrals. However, if not all members of an LRG have the same plan design or if some don’t have a plan at all, 410(b) coverage testing will be needed. All employees of related entities who meet the minimum age and service requirements for elective deferrals would be included as “eligible” while only employees who have the right to contribute are considered as “benefiting.” This type of testing may be available from Guideline on a fee-for-service basis.

  • Profit sharing: Participants are benefiting employees in a profit-sharing plan if they receive a profit-sharing contribution.

  • Matching contributions: In general, any participant eligible to contribute is typically considered benefiting from a matching contribution. Plans at Guideline that are not part of a legally related group (LRG) will always pass 410(b) coverage for matching contributions. However, if not all members of an LRG have the same plan design or if some don’t have a plan at all, 410(b) coverage testing will be needed. This type of testing may be available from Guideline on a fee-for-service basis.

Allocation conditions are provisions where an eligible participant would need to meet additional requirements each year to be eligible for an employer contribution. These are typically based on service (e.g., work 500 hours in the plan year) or employment (e.g., be employed on the last day of the plan year). Please note that Guideline does not allow for service-based allocation conditions on matching or profit sharing contributions or employment-based allocation conditions on matching contributions. Employment-based allocation conditions may be allowed on certain new comparability profit sharing allocation formulas.

Ratio percentage test

Step 1:

Calculate the ratio of NHCEs and HCEs who are benefiting under the plan for each source. Note that this description has been simplified based on required provision in all plans at Guideline:

  • NHCEs who benefit / NHCEs who are eligible = NHCE ratio

  • HCEs who benefit / HCEs who are eligible = HCE ratio

Step 2:

Compare the benefiting ratio of NHCEs to that of HCEs to find the ratio percentage.

(NHCE ratio)/(HCE ratio) = Ratio percentage

If the ratio percentage is 70% or higher, your plan passes the ratio coverage test and 410(b) coverage. If the ratio percentage is lower than 70%, then the 401(b) coverage test fails. The next step that needs to be taken will depend on the plan design.

If the ratio percentage test fails because of a last day allocation requirement for profit sharing, Guideline plans include a fail-safe provision. The fail-safe provision requires the plan to waive allocation requirements for the minimum number of eligible participants that are needed to pass the test.

At the time a profit sharing contribution is calculated with a last day requirement, Guideline will determine if the plan can pass coverage testing. If the plan cannot pass, Guideline will automatically expand the group of the NHCEs who are eligible for profit sharing by waiving the last day allocation requirement, starting with eligible participants who have completed the greatest amount of service in the plan year.

If the ratio percentage test does not pass because related entities do not offer the benefit, the average benefits test might be available to rescue the plan.

Average benefits test

The average benefits test is more complicated and consists of two parts: the non-discriminatory classification test and the average benefits percentage test. Both parts must be passed in order to pass the overall test.

Non-discriminatory classification test

The classification test has several parts. First, the classification established by the employer must be “reasonable,” which generally means it must be established under objective business criteria that identify the category of employees who benefit under the plan. Note that since Guideline does not allow plans to exclude employees based on classification, this portion of the test will always pass for Guideline plans that have operated according to their plan documents.

Second, the test compares the ratio percentage obtained above to a table of safe and unsafe percentages that depend on the number of NHCEs compared to HCEs in the plan. If the plan’s ratio percentage is greater than the plan's safe harbor percentage, the classification test passes.

Average benefits percentage test

The average benefits percentage test is similar to the ratio percentage test in that it compares a ratio of HCEs to NHCEs and must be at least 70% to pass. However, instead of comparing the numbers of benefiting participants, this test compares the actual benefit percentages received (as a percentage of compensation).

All non-excludable employees are taken into account for this purpose, even if they are not benefiting under any plan that is taken into account.

What happens if you fail a coverage test?

Failing a coverage test can be costly. If you do not pass, corrective measures must be taken to bring the plan into compliance. This can be done by either extending coverage to more NHCEs or by modifying contributions to them.

A coverage failure must be corrected within 9 ½ months of the end of the plan year in which the failure occurred. If left uncorrected, your plan could experience adverse consequences, including but not limited to penalties, taxes, and even disqualification.

To avoid this, it is important that we have all the information needed to accurately complete the test. This is particularly important for entities that are part of a controlled group or affiliated service group.

Guideline will need to be made aware of all plans of related entities and will need information about those plans and entities. When other entities have a 401(k) plan, Guideline can only complete coverage testing if all 401(k) plans in the controlled group are identified and administered by Guideline.

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