401(k) Discrimination Tests -- Did Your Plan Pass? Part 2
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401(k) Discrimination Tests — Did Your Plan Pass? Part 2

In my last article, I discussed some of the 401(k) types , and the discrimination tests run on traditional 401(k) plans to ensure highly paid employees aren’t getting more of a tax break than then non-highly paid group.  The IRS requires that 401(k) plans be tested every year.

Here is a brief, over-simplified explanation of some of the other 401(k) discrimination tests:

Minimum Coverage Test — The test requires that the percentage of Non-Highly Paid employees who benefit from the plan is equal to 70% or more of the percentage of Highly Paid who benefit under the plan.  In other words, the IRS does not want a disproportionate number of Highly Paid employees to be eligible for benefits under the plan.

Catch-Up Contributions — Any participant 50 years or older can make additional contributions to their 401(k) account.  The maximum additional amount for 2010 is $5500.  The plan is tested to make sure that no one exceeded the catch-up contribution limit.

Maximum Annual Additions — The IRS sets a limit on the total amount of money that can be contributed from employees and the employer for the year.  The maximum amount for 2010 is $49,000 or 100% of compensation, whichever is less.  The plan is tested to make sure that no one exceeded this limit.

Top Heavy Test — A top heavy plan happens when the balances favor Key Employees too heavily.  The IRS defines Key Employees as either of the following:

  • Owners of the company (at least 5%)
  • Officers of the company with compensation of at least $160,000

The plan is tested annually to make sure that the account balances of the Key Employees are not more than 60% of the total plan balance.  If this is the case, the company has to pay all Non-Key Employees a minimum contribution to their accounts, which is generally 3% of their compensation.

Safe Harbor and SIMPLE Plans — No Testing Hassles

Safe Harbor Plans

Before each plan year begins, a company can decide to give a “Safe Harbor” contribution to eligible employees for the next year.  A Safe Harbor plan automatically passes the discrimination tests.  The company contributes a certain minimum amount to the employees’ accounts.  The employer has two options for giving safe harbor contributions:

  1.  The employer can choose to make a contribution only to those employees who are deferring their own money. The employer contributes 4% of the employees’ compensation.
  2. The employer can also choose to make a contribution to all eligible employees, regardless of whether the employees defer their own pay.  In this case, the employer contributes 3% of the employees’ compensation.

The IRS has specific requirements about notices that need to be given to the employees if the employer chooses to give a safe harbor contribution.

The main advantage of a Safe Harbor plan is that the ADP, ACP, and Top Heavy tests are automatically satisfied.  There isn’t the risk of Highly Paid employees receiving a taxable refund from the plan.  One possible negative consideration of a Safe Harbor plan is that it can be more expensive for the company, as the company is obligated to give a contribution for that year.  The Safe Harbor contributions become vested immediately, meaning the employee can take the employer contribution with them without having to satisfy a length of service if they leave employment with your company.

SIMPLE 401(k) Plan

A SIMPLE (Savings Incentive Plan for Employers) 401(k) plan is similar to a Safe Harbor plan, in that the employer is required to make a contribution that is immediately vested, and is not subject to the annual discrimination tests.  However, this plan is only available for employers with 100 or fewer employees who made at least $5000 in the previous year, and this plan cannot be combined with any other employer savings plans.  A SIMPLE plan also has lower annual deferral and catch-up contribution limits, so not as much money can be contributed in a SIMPLE plan compared with a traditional or Safe Harbor plan.

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