One of the most critical tasks 401(k) plan sponsors are faced with every year is compliance testing. Compliance testing is required by the Internal Revenue Service (IRS) after year-end to ensure a company’s 401(k) plan does not unfairly favor owners and highly compensated employees (HCEs) and that the plan stays within IRS-required limits.
For employers offering 401(k) retirement plans to their employees, it’s important to understand the compliance testing required, as failing these tests could result in penalties and added costs.
Types of compliance tests
Nondiscrimination tests are designed to ensure 401(k) plans are accessible to all employees and that the benefits provided are fairly distributed.
These requirements give employers incentive to encourage even lower-paid employees to start contributing toward their retirement nest egg. The following are key nondiscrimination tests that your plan may be required to undergo each year:
Actual Deferral Percentage Test (ADP): The ADP test compares the average deferral (payroll reduction contribution) percentage of HCEs against the average deferral percentage of non-highly compensated employees (NHCEs).
Actual Contribution Percentage Test (ACP): The ACP test compares the average employer matching contribution percentage of HCEs against the average of NHCEs.
Top-Heavy Test: The goal of Top-Heavy testing is to ensure that if “key employees” hold more than 60% of the total account balances by value in a 401(k) plan, that non-key employees receive a minimum contribution under the plan.
Limits tests are completed to ensure the plan stays within the following IRS-required limits:
Note that this is not a complete list of tests. Guideline applies other limits and nondiscrimination tests throughout the year and when contributions are calculated.
What happens if my plan exceeds a limit or fails a test?
If a 401(k) plan fails any compliance testing, corrective actions must be taken within a prescribed timeline. Failure to address the issues can lead to possible penalties, including the disqualification of the plan, adverse tax consequences for employers or employees, and loss of tax advantages associated with the plan.
In the event that limits are exceeded, Guideline may automatically process the excess contributions depending on overage type. Generally, excess employee deferrals will be processed as a refund to the employees. Excess employer contributions will be processed as a forfeiture to the plan and will be used to offset future employer contributions until depleted.
If your plan fails any nondiscrimination tests, Guideline will contact you with details on how to correct the issue and the deadlines to do so. Note that if Guideline doesn’t receive compensation data in a timely manner, it can mean additional costs – particularly if your plan fails the ADP or ACP tests.
You should pay careful attention to your compliance dashboard, so your plan is in the best possible position to pass compliance testing.
How Guideline helps make compliance testing easier
Compliance testing can be a daunting process for employers. Testing may conjure up unpleasant images of IRS oversight, plan corrections, and tons of paperwork.
With Guideline, however, we’ve automated the compliance testing process, freeing you up to focus on your business and your employees.
Throughout the year, Guideline’s system helps your plan remain compliant by using data you provide us to generate projected test results. These test results are made available to you via the Compliance section of your Guideline dashboard, where you can actively monitor your plan’s current compliance status.
Please note that these reports will only provide projections. The actual test results won’t be known until after the end of the plan year when all contributions are made and full plan year compensation and final census data is known. It is critical to provide Guideline with employee compensation so these tests can be calculated timely.
Throughout the year, you should review your Compliance dashboard to monitor your risk of falling outside IRS compliance limits. If you have any questions, our specialists can discuss your correction options with you.
How to avoid most nondiscrimination requirements
The best way to support your employees’ retirement, while avoiding the hassle of most nondiscrimination testing is to elect a safe harbor plan design. Safe Harbor 401(k) plans generally satisfy most nondiscrimination requirements, thus automatically exempting your plan from most of the nondiscrimination tests.