If your 401(k) plan runs on a calendar year, now is the time of year you will receive the results from your discrimination testing from the 2009 plan year. Plans must be tested by March 15th.
Plan testing is required each year in order to make sure your 401(k) plan is in compliance with IRS regulations and to maintain its qualified, tax advantaged status. The IRS allows employees to get a tax benefit by not having to pay taxes on contributions or the earnings from contributions until they withdraw the money. However, in order to get this tax break, the IRS wants to make sure that highly paid employees are not getting a better tax break than everyone else. In other words, Uncle Sam puts a limit on how much tax can be deferred until later.
The tests themselves are rather complex (the IRS wouldn’t have it any other way!) and there are many different tests depending on your plan. If you have a Safe Harbor or SIMPLE 401(k) plan, your plan automatically meets some of these tests, which I’ll cover in a future article.
Two of the tests we plan sponsors tend to pay the most attention to are the ADP and ACP tests.
Actual Deferral Percentage (ADP) Test- compares the amount contributed by employees between two eligible groups: Highly Paid and Non-Highly Paid. The IRS defines Highly Paid employee as someone who is either a 5% owner of the company, or made at least $110K in 2009 (limit subject to change). The Highly Paid group’s average contribution cannot be substantially more than the Non-Highly Paid group average.
Actual Contribution Percentage (ACP) Test – same principle as above, but it compares the average percent contributed by the employer for each eligible person between the Highly Paid and Non-Highly Paid employees.
What happens if the ADP or ACP test fails?
If it is determined that your Highly Paid employees have contributed significantly more than the Non-Highly Paid group, money from the plan will need to be refunded to certain employees. The method to correct the test failure is also too complex for this article, but in short, those who contributed the most money to the plan are first in line to receive a refund. The kicker is that the employee must then claim the refunded money as taxable income the following year.
If you are concerned about failing the tests, you as a plan sponsor have some options to ensure these two tests pass. You can limit the percentage that your Highly Paid group contributes, or you can give a Safe Harbor contribution.