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www.401k-video.com includes comprehensive 401(k) information in an online 401k Enrollment Slideshow. Topics covered include: --What is a 401(k) plan--Why you should consider joining your company's 401k(k) plan--The significant tax and saving advantages of saving in a 401(k) vs. traditional savings outside the 401(k) environment--The 3 Principles of Smart Investing.

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www.401k-plan-blog.com is a public blog sponsored by Pension Trade Association, non-profit business organization dedicated to helping workers save for their retirement through expanded coverage of 401k -type defined contribution pension plans.

www.401keasy.com is for small businesses to large, new and already-existing 401k plans. Employers save thousands of dollars every year by handling their 401k plan administration in less than 15 minutes a month, using money-back guaranteed, plan-specific 401k administration software. Small businesses bypass all third-party middlemen and interact directly with the mutual funds and/or 401k self-directed discount brokerage accounts you select for your plan.

www.smallbusiness401k.com is designed from the ground up for small businesses that are looking for an affordable, complete and easy to us 401kwith unlimited investment flexibility. It's a secure, web-based 401k plan setup, administration and participation center developed to meet the budgetary and human resources benefits needs of small companies.
 

Commentary

Introduction

Minimum Standards of Coverage

Nondiscrimination Requirements
-- Actual Deferral Percentage (ADP) Testing
-- Actual Contribution Percentage (ACP) Testing
-- Top Heavy Testing

Using Your Plan Administration Software to Run Compliance Tests
-- End of Year Top Heavy Testing

Correcting ADP or ACP Test Failures
-- Correction BEFORE the End of the Plan Year
-- Correction AFTER the End of the Plan Year

Option to Plan Testing: The Safe Harbor Method of Plan Administration
-- Decision Deadlines
-- 1,000 Hours/Last Day Rules
-- Quitting the Safe Harbor Method

Excluding Recent Hires in Nondiscrimination Testing

A Note About Plan Testing and Auto Enrollment




Introduction

401k plans were created by the U.S. Government to allow persons, especially middle- and lower-income persons, to save for retirement. Therefore, the Government was particularly concerned that 401k plans not favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs), and established nondiscrimination rules to promote fairness. There are four basic nondiscrimination requirements:

1. The 401k plan must meet certain minimum standards concerning coverage of employees.

2. The plan must not discriminate in favor of highly compensated employees with respect to contributions, benefits, or other rights and features of the plan.

3. A plan that is top heavy must meet additional rules concerning the vesting of benefits and minimum contributions or benefits.

4. The amount of compensation considered by a plan in calculating contributions or benefits for a participant is limited. These limits are set annually -- for 2001, for instance, the limit was $170,000 and for 2002 it was $200,000 -- and are part of your year-specific plan administration software.

Minimum Standards of Coverage

The minimum coverage rules require the employer to make the plan available to a cross-section of employees. Your 401k plan must satisfy either of two tests: the ratio percentage test or the average benefits test

A plan meets the ratio percentage test for a plan year if the percentage of NHCEs benefiting under the plan is at least 70% of the percentage of HCEs benefiting under the plan.

A plan meets the average benefits test if it satisfies two sub-tests: the nondiscriminatory classification test and the average benefit percentage test. The nondiscriminatory classification test is satisfied if the 401k plan benefits a class of employees established by the employer that is both reasonable and nondiscriminatory. The average benefit percentage test is satisfied if the average benefit percentage of the 401k plan for the plan year is at least 70%.

As a practical matter, all employees who are eligible to participate in a 401k plan, whether or not they join the plan, are considered to be "benefiting" under the plan. It is a rare situation where less than 70% of the non-highly compensated employees are not eligible to participate in a plan.

401(k) Facts:

According to HR Investment consultants in Towson, MD, publisher of the "401k Provider Directory, "the cost of running a 401k plan with 25 participants and $750,000 in assets can range from as little as $6,750 per year to as much as $20,000, depending on which 401k vendor you select. (Sources: Nation's Business, September 1998, Myers, Randy "Your 401k Plan May Cost You Too Much." Business Week Online, July 2000, Brenner, Lynn " A Wealth of Choices."). By comparison, a 401(k) Easy or Easy Online system costs only $995 per year for a 25-person plan--a savings of between 60% and 80% in plan administration fees.. The employees of Target Laboratories (www.targetlab.com) a small company, are maximizing the benefits of the company's 401k, by saving for retirement in tax-advantaged accounts.

Nondiscrimination Requirements

The IRS requires that testing be conducted annually to ensure that highly compensated employees are not benefiting substantially more than non-highly compensated employees. A plan must pass the tests as of the last day of each plan year.

The definition of a highly compensated employee changed in 1997. A highly compensated employee is now defined as an employee who is a member of either of two groups:

• A 5% owner at any time during the determination or lookback year (see the Glossary for definitions of determination and lookback years)

• An employee who earned more than $85,000 (in 2001) during the lookback year and is in the top 20% of all employees ranked by W-2 compensation in the lookback year

A non-highly compensated employee is any eligible employee who does not meet the definition of a highly compensated employee.

To ensure that a 401k plan conforms to the nondiscrimination requirements, two tests must be performed: the actual deferral percentage (ADP) test, which is performed on the employee salary deferrals, and the actual contribution percentage (ACP) test, which is performed on the employer matching contributions. There are also "safe harbor" options that eliminate the need for ADP and ACP testing (see Safe Harbor Options at the end of this chapter).

The amount of salary deferrals HCEs may make and the amount of matching contributions HCEs may receive is based on the amount of deferrals and matching contributions made and received by NHCEs. The averages for the HCE group may not exceed the averages of the NHCE group by more than a specified amount, as follows:

If the NHCE average is… The HCE maximum average may equal the NHCE average…
0 - 2% times 2
2 - 8% plus 2%
8% or greater times 1.25

The averages are determined by adding the deferral or matching percentages for all eligible employees in the group and dividing by the number of eligible employees in the group. As a result, eligible employees who do not choose to defer will reduce the average. In the NHCE group, a reduction in the average deferral amount reduces the amount that HCEs may defer.

Fortunately, your plan administration software runs the ADP and ACP tests for you (along with top heavy tests) as often as you wish, and allows you to see the results any time during the plan year, so that if a problem trend appears, your company can do something about it before the end of the year. Failure to correct a failed year-end test by the close of the following plan year can result in penalties and possible disqualification of your company's plan.

Actual Deferral Percentage (ADP) Testing

Any eligible employee can contribute up to the maximum amount allowable by law per year, but how much each actually contributes is the thing that interests the IRS. Specifically, the agency does not want to see highly compensated employees contributing substantially higher portions of their income than do lower compensated employees. The contributions used for ADP testing include 100% vested contributions.

The ADP test passes if the ADP for the highly compensated employees does not exceed the greater of:

• 1.25 times the ADP of the non-highly compensated group, or

• Two percentage points above the ADP of the non-highly compensated employee group, not to exceed two times the ADP of the non-highly compensated employee group.

The ADP for each group of employees (highly compensated and non-highly compensated) is the average of the actual deferral ratios (ADRs) for the employees in that group. The ADR is calculated by dividing each participant's salary deferral contributions made during the plan year by his or her gross compensation for the plan year. An employee who is eligible but chooses not to defer a portion of salary is included in the calculation with an ADR of zero.

The maximum ADP for the highly compensated employee group for the current year may be determined by reference to the ADP for the non-highly compensated employee group calculated for the "preceding plan year." The individuals taken into account in determining the preceding year's ADP for non-highly compensated employees are those individuals who were non-highly compensated in the preceding year, even if their status has changed in the current year.

Based on information input into your plan administration software, the system calculates whether or not the plan passes the ADP test. During the first nine months of the plan year, your plan administration software uses estimated data, and during the last quarter of the year, actual data. See below, Using Your Plan Administration Software to Run Compliance Tests.

Actual Contribution Percentage (ACP) Testing

The ACP is performed in the same way as the ADP test, and the parameters for passing are the same. The ACP for each group of employees (highly compensated/non-highly compensated) is the average of the actual contribution ratios (ACRs) for the employees in that group. The ACR for each employee is the ratio of his or her employer match to their compensation for the year, expressed as a percentage. As with the ADP test, an employee who is eligible but receives no match is included in the calculation with an ACR of zero.

NOTE... If your company is making employer matching contributions and having them immediately fully vested to participants' accounts, your plan administration software will categorize the contributions as "qualified matching contributions" and correctly include them in the ADP test rather than ACP test.

The maximum ACP for the highly compensated employee group for the current year may be determined by reference to the ACP for the non-highly compensated employee group calculated for the "preceding plan year." The individuals taken into account in determining the preceding year's ACP for non-highly compensated employees are those individuals who were non-highly compensated in the preceding year, even if their status has changed in the current year.

Based on information input into your plan administration software, the system calculates whether or not the plan passes the ACP test. During the first 9 months of the plan year, your plan administration software uses estimated data, and during the last quarter of the year, actual data. See below, Using your plan administration software to Run Compliance Tests.

Top Heavy Testing

Certain plans that do not have discriminatory benefit formulas may still provide the majority of plan benefits to highly paid employees or owners of the company because, for example, they are the only participants with long service. These plans run the risk of being categorized as "top heavy plans." The IRS considers a plan "top heavy" if the account values for key employees exceed 60% of the account values for all employees; it is "super top heavy" if the percentage exceeds 90%. (See the Glossary for a definition of key employee.)

If a plan becomes top heavy it is required to provide a minimum contribution to all non-key employees. The minimum contribution amount is based on how much key employees have contributed to the plan -- out of their own salary OR in the form of employer contributions -- during the year:

• If key employees are contributing 3% or more, a 3% (of salary) contribution must be made to each eligible non key employee.

• If key employees are contributing less than 3% but more than 0%, a contribution equal to the highest contribution percentage of any key employee must be made to each eligible non key employee.

• If the key employees do not contribute anything for a full year, then there is no contribution requirement to non key employees for the year.

• An appropriate top-heavy vesting schedule must be applied to any top-heavy contributions. Please consult your 401k Adoption Agreement item E4: Top Heavy Testing if you do not remember the vesting schedule chosen for your plan should it become top heavy.

• If an employee is hired during a year that the plan becomes top heavy and the employee is not eligible to participate in the plan for the full year, their full salary IS still considered in the top heavy calculations.

Salary deferrals made by key employees are counted in determining their contribution percentage. But salary deferrals made by non-key employees are not counted in determining if a non-key employee has received a top heavy minimum contribution.

Generally, employer matching contributions may not be used to satisfy the minimum contribution requirement; however, qualified nonelective and employer discretionary profit sharing contributions may be.

Once you have identified the key employees, your plan administration software calculates whether or not your plan passes the top heavy test (see below).

Accelerated vesting is required for top heavy plans. If yours is a new plan, the available vesting schedule meets the top heavy requirements. If your plan is a restatement of an existing plan, a vesting schedule that complies with the top heavy requirement will have to have been elected in the adoption agreement in case the plan becomes top heavy. Please refer to your 401k Adoption Agreement for specifics.

Once a plan becomes top heavy, the top heavy vesting schedule will continue to apply until the plan is amended, even if the plan later stops being top heavy.

Top heavy testing must take into account all the plans your company maintains. If necessary, this complex issue should be discussed with your company's tax or legal advisor.

Using Your Plan Administration Software to Run Compliance Tests

Your plan administration software performs the following critical IRS-mandated tests:

• Top heavy testing

• ADP compliance test of employee contributions

• ACP compliance testing of employer matching contributions

• Multiple use testing (which, as of January 1, 2002, is no longer required and will be phased out in post-2002 versions of the software)

Testing results are based on employees' actual wage data input by you each month combined with actual monthly contribution data. Testing can be performed as frequently as you wish. The capability for frequent ad hoc compliance tests helps you anticipate the year-end results and head off problems.

IMPORTANT!!! The first year you use your 401k administration software to run your plan, you'll need to supply the system with payroll data for the previous December to give the system the prior year's wage data it needs to determine which employees are highly-compensated, a critical determination for running of compliance tests. See the end of Chapter 3 for instructions on how to do this.

Compliance testing is accessed through the Reports button in the "Welcome. . ." window: At the "Welcome..." window, click on Reports, then, on the resulting scrren, on Compliance Testing in the left panel, and Compliance Testing Reports in the right panel, choose a year from the pull-down menu at the top of the window, and then click Print.

The Compliance Testing Preprocessing Grid will appear. If you designated the current year in the previous step, the report will give year-to-date data as of the last month processsed; if you designated a prior year, the data will be as of the end of that year.

For each eligible employee the grid displays prior year salary, current year estimated salary, actual year-to-date earnings, actual contributions to date, actual matching contributions to date, estimated total contribution for the year, estimated matching contribution for the year, estimated account value, actual current account value, and whether the employee is eligible, a highly compensated employee, and/or a key employee.

Estimated contributions, earnings, and account values can be used to run the top heavy tests DURING the year, whereas actual values are used for the year-end top heavy test. Please see below, End of Year Top Heavy Testing, for instructions about supplying your software with actual values.

Press Print and four reports are displayed or printed out:

• ACP Test Results, which shows the employer matching contribution as a percentage of employee compensation for two groups: I. Highly Compensated Employees and II. Non-Highly Compensated Employees, plus the average contribution percentage for each group

• ADP Test Results -- Data Out, which shows the employee contribution as a percentage of his or her contribution for the same two categories: I. Highly Compensated Employees and II. Non-Highly Compensated Employees, plus the average contribution percentage for each group.

• Top Heavy Test Results, which lists separately for key employees and non-key employees the individual's name, social security number, and estimated (or, if actual account values have been entered, the actual) plan assets for that individual and the group as a whole.

• Compliance Testing Summary, which tells you whether or not you pass the top heavy, ADP, and ACP tests

(When you press Print, you will first see the ACP results; to view the others, click on the Close button: the ADP results will appear; click on Close again, and the top heavy results will appear, and, in turn, the compliance testing summary.)

End of Year Top Heavy Testing

For your year-end top heavy test, you need to supply the software with the actual current account value for each eligible employee. The value figure is contained in the year-end statement you'll receive from the investment company(ies) housing your plan's investments.

To enter the information into your software, click on Reports at the "Welcome..." window, then on Compliance Testing in the left panel of the resulting screen, and Compliance Testing Reports in the resulting right panel, choose a year from the pull-down menu at the top of the window, then click Print; the Compliance Testing Preprocessing Grid will appear.

Scroll to Actual Contributions & Earnings in the pull down menu at the top right hand section of the window. The Current Acct. Value column will change from greyed-out to normal white.

Enter each employee's current account value from the information provided by the investment company(ies). Make sure to EXCLUDE any rollovers from the value. (To check for rollovers, print the year's Auditor's Worksheet -- Reports, Yearly 401k Activity Reports, Year End Auditor's Worksheet, Print, (year), Print -- to see if any employees had any Net Rollovers for the year).

Click Print.

Correcting ADP or ACP Test Failures

Failing the ADP or ACP test does not necessarily mean disqualification of your 401k plan. Failed ADP/ACP tests can be corrected in any of a variety of ways. See below: Correction BEFORE the End of the Plan Year and Correction AFTER the End of the Plan Year.

Correction BEFORE the End of the Plan Year

Failed ADP/ACP tests can be corrected in either of two ways: one, the sponsor can either contribute a sufficient amount to the NHCEs to pass the test, or two, the sponsor can return excess contributions to the HCEs. The latter is the more common method.

However, because the latter alternative results in unhappy HCEs and the former alternative in extra expense to the employer, it is highly advisable to conduct preliminary tests during the year -- your plan administration software allows you to do it monthly if you wish, or quarterly. If the tests show that the ADP or ACP of the group of eligible highly compensated employees is likely to be too high compared to the ADP/ACP of the group of non-highly compensated employees, the employer can limit, before the end of the plan year, the prospective elective contributions of its highly compensated employees and possibly avoid the need for corrective measures later.

Correction AFTER the End of the Plan Year

If, at the end of the plan year, the ADP or ACP test is not satisfied, the employer must correct the excesses within 12 months or the plan will be disqualified.

To correct an excess your company can make additional qualified nonelective or matching contributions to the accounts of non-highly compensated employees, or your company can, before March 15 of the new year, distribute the excess aggregate contributions made by highly compensated employees.

METHOD 1: Make Additional Contributions to Non-Highly Compensated Employees
Because the ADP and ACP are not weighted averages, an employer might make additional contributions only for the lowest-paid employees. This often can increase the non-highly compensated employees' ADP or ACP at the lowest cost. (Unfortunately this approach can also create discontent among those employees who receive no contribution.) An employer might prefer to make additional contributions to all eligible non-highly compensated employees sufficient to pass the test. Such contributions would be 100% vested and would be subject to the same distribution restrictions as salary deferrals.

METHOD 2: Distribution of the Excess
This is probably the most commonly used method. If the plan returns the excess contributions to the highly compensated employees, it must also return any income (or offset any net loss) allocable to the excess. An employer may calculate the income allocable to the excess under any reasonable method as long as the method is consistent with that used to allocate income under the plan.

The plan must distribute or forfeit matching contributions related to elective contributions that the plan distributes as excess deferrals or excess aggregate contributions.

The method of correction is reduction of the contributions of highly compensated employees, starting with the highest dollar amount contributed, until the ADP or ACP reaches the permissible level.

After the initial correction based on contribution reduction, the employer may have to use that method again to correct "multiple use" to the extent that multiple use exceeds the permissible.

NOTE... The multiple use test is repealed as of January 1, 2002 and thus irrelevant from that date forward.

EXCISE TAXES:
If the ADP or ACP excess is not corrected by March 15, the employer is subject to a 10% excise tax on the amount of the excess, unless the employer corrects it by making additional QNECs within 12 months after the end of the plan year. The penalty must be reported to the IRS on Form 5330 and filed with the company's tax return. If the excess contribution is not returned by the end of the year following the year of the excess, the plan is disqualified.

INCOME TAX CONSEQUENCES:
Taxation of distributions depends on the timing of such distributions. Distributions of excess contributions made within the 2 1/2 month period following the close of the plan year (March 15 for calendar year plans) are taxable:

• In the case of an excess contribution, in the employee's taxable year in which the amount would have been received in cash if he or she had not elected to contribute it to the plan

• In the case of an excess aggregate contribution, in the employee's taxable year ending with or within the plan year for which the excess aggregate contribution was made.

If the corrective distributions are made following the 2 1/2 month period after the close of the plan year, they are taxable in the year distributed. All distributions totaling, without related income, less than $100 are treated as distributed after the 2 1/2 month period.

The employer must provide the affected employee(s) with correct W-2s with compensation totals increased to reflect the addition of the excess.

Option to Plan Testing: The Safe Harbor Method of Plan Administration

There is a safe harbor option that allows an employer to omit ADP testing. The reasoning behind this safe harbor is that if a plan provides certain minimum benefits that ensure broad participation, the company ought not to have to prove yearly that the plan is nondiscriminatory

To qualify for the safe harbor option, a 401k plan sponsor must satisfy three criteria:

1. The plan sponsor (employer) must make either a 3% non-elective contribution to all eligible employees each year, or a dollar-for-dollar matching contribution to non-highly-compensated employees on salary deferrals up to 3% of compensation and a 50-cents-to-the-dollar matching contribution to non-highly-compensated employees on salary deferrals of 3% to 5% of compensation, making sure not to exceed these rates in any matching contributions made to highly compensated employees. (Non-elective contributions are made to all eligible employees, regardless of whether they participate in the plan or not. Matching contributions, on the other hand, being based on salary deferral amounts, are made only to active plan participants.)

2. The safe harbor contributions must be 100% vested, regardless of the length of service of the employee. However, only the amount of contribution necessary to satisfy the ADP safe harbor need be 100% vested. Any amount above this minimum contribution (for example, if the employer offers both a matching and a non-elective contribution) can be subject to a vesting schedule. The safe harbor contributions may not be distributed before termination of employment, age 59 1/2, or disability, nor are they eligible for financial hardship withdrawal.

3. The employer must provide annual information to employees to make sure they understand the safe harbor 401k plan and its benefits.

Decision Deadlines

Employers can wait up to December 1 of the testing year to adopt a safe harbor non-elective contribution of 3% of compensation.

For example, a calendar-year plan could wait as late as December 1 2001 to amend its 401k plan to provide the safe harbor contribution and to avoid ADP/ACP testing for 2001. However, the employer must provide participants with a notice prior to January 1, 2001 that the plan might be amended to provide the 3% safe harbor non-elective contribution for the plan year. (The notice in Appendix A is a sample of such a communication.) Also a supplemental notice must be provided to eligible employees no later than 30 days before the last day of the plan year notifying them of the safe harbor amendment.

This rule is of particular importance to your plan administration software plan employers who periodically test during the year and discover that significant refunds will be required to pass the ADP or ACP test. Such employers can take advantage of the nonelective contribution safe harbor and avoid year-end refunds.

1,000 Hours/Last Day Rules

Some employers require participants to have 1,000 hours in the plan year or to be employed on the last day of the plan year in order to be eligible for a contribution. These rules cannot be imposed for safe harbor contributions.

Quitting the Safe Harbor Method

An employer is not required to continue using the nonelective contribution safe harbor for future plan years and is not limited in the time that it can take advantage of the December 1 amendment process.

Excluding Recent Hires in Nondiscrimination Testing

Another option for ADP/ACP testing as of 1999 is relevant to plans that allow employees to participate at an earlier age or with less service hours than the law requires. Many companies now allow employees to become participants the day they're hired, regardless of age.

A problem with immediate eligibility is that younger, short-service employees tend to have lower deferral rates, particularly in the lower-paid group, adversely affecting ADP/ACP testing. The new option allows all non-highly compensated employees with less than a year of service or under age 21 to be excluded from testing. The rationale is that the plan sponsor should not be penalized for allowing employees to join the plan earlier than required.

A Note About Plan Testing and Auto Enrollment

Some companies have found that immediately and/or automatically enrolling employees in the 401k plan have had positive benefits connected with passing the ADP test. One company found its participation rates increased from 70% to 85% when it eliminated the waiting period and went to immediate enrollment upon hire. With negative election (a.k.a., automatic enrollment), each employee is automatically enrolled in the plan as soon as he or she meets the plan's age and length of service requirements, whether or not he or she has made any active effort at joining the plan. Passively enrolled employees participate at whatever salary deduction rate and into whatever 401k investments the company's published passive enrollment policy stipulates. If your company uses passive enrollment, its policies are explained in both your plan's Summary Plan Description (as supplied in hard copy format at your plan's outset) and in your plan's 401k Enrollment Pac (from the "Welcome..." screen, go to Reports, All Reports, Enrollment Pac, Print).

INFORMATION AND NON-PROFIT PUBLIC WEBSITES CONTAINING CURRENT USEFUL INFORMATION ABOUT 401K PLANS:

Turnkey 401k plans for small business and bundled 401k plans for small business 401k plans at www.401k-office.com . Small business 401k providers and bundled 401k plans for small businesses that use 401k mutual funds at www.401k-providers.com . 401K ADMINISTRATION REPORTS AND THE IMPORTANCE OF 401K REPORTS FOR RECORDKEEPING AT www.401kclassroom.com . Answers to 401k questions at www.401k-questions-and-answers.com . Small business 401k software administration at www.easytec-systems.com . Retirement savings programs and 401k at www.employer-retirement-savings-account.org . Small business 401k salary deferrals for small businesses 401k plans using automatic enrollment, passive elections and 401k negative elections at www.web-ira.com . Eco-friendly 401k investments at www.green-401k.com



401k Plan Operations: 401k Plan Participant Issues

Q: What does the term "constructive receipt" mean?

A: "Constructive receipt" is an income tax principle under which money or property must be included in income at the time the person has an unrestricted right to receive the money or property, even if the person does not decide to actually claim or receive the money or property. 

 

Q: I am self-employed. How much can I contribute to my 401(k) plans? -TOP

A: Under the TRA '97, the self-employed (including sole proprietorships and partnerships) may make both deductible employer matching contributions and the maximum employee deductible elective deferrals. Elective deferrals the self-employed can contribute are subject to the same limits and testing applied to regular employees.

 

Q: Can a 401(k) plan be offered as part of a cafeteria plan? -TOP

A: Although a cafeteria plan generally cannot include any plan or option that provides for deferred compensation, this restriction does not apply to 401(k) plans. Thus, elective deferrals and after-tax contributions may be made to a separate 401(k) plan through a cafeteria plan. The rules on change-in-family-status changes under a cafeteria plan cannot be applied to 401(k) plan contributions, and elective deferrals to a 401(k) plan should not be included in the benefits amounts that are tested under the Section 125 nondiscrimination test.

 

Q: May a 401(k) plan exclude part-time employees from plan participation? -TOP

A: No. In a field directive issued in November 1994, the IRS take the position that the exclusion of part-time employees is, in effect, service requirement that is subject to the limitations described here. According to the field directive, it does not matter that a 401(k) plan will satisfy the minimum coverage requirements after excluding part-time employees. 

Example. GHI Company sponsors a 401(k) plan that require one year of service (1,000 or more hours of service in an eligibility computation period) and excludes any employee who is regularly scheduled to work fewer than 30 hours per week. Bob has been a part-time employee (fewer than 30 hours per week) for five years but has completed more than 1,000 hours during each eligibility computation period. The 401(k) plan's exclusion of part-time employees has prevented Bob from becoming a plan participant even though he has completed five years of service. Because the part-time employee exclusion is treated as an indirect service requirement, GHI Company's 401(k) plan is subject to disqualification since it contains a length of service requirement in excess of that permitted under Code Section 410 (a) (1).

 

Q: What should a 401(k) plan investment policy cover? -TOP

A: Investment policies need to be flexible enough to adapt to an employer's specific situation and reflect the fiduciaries' attitudes and philosophies. For a typical 401(k) plan that allows participants a choice among investment funds, the policy should also recognize the participants' needs and goals. Further, the policy should deal with the number and types of funds to be made available. How many choices are enough? How many choices are too many? 

The policy should also cover how any loan program will affect investments and whether the withdrawal program is consistent with the types of funds selected. For example, if participants are expected to access funds through loans or withdrawals, do the investment funds allow for such withdrawals without penalty? 

Finally, the policy should deal with the regulatory issues, specifically the requirements of ERISA Section 404(c).

 

Q: Can an employer reduce or eliminate its fiduciary liability for investment decision making by giving participants investment control? -TOP

A: ERISA Section 404(c) says that if a participant is given control over the investment of his or her account, plan fiduciaries will not be held responsible for investment losses resulting from that exercise of control. There are very specific requirements, discussed more fully in chapter 6, that must be met before Section 404(c) can be claimed as a defense. 

Even if a plan satisfies the requirements of Section 404(c), plan fiduciaries cannot completely eliminate liability for investment decision making. Plan fiduciaries in a Section 404(c) plan typically remain responsible for the selection and monitoring of funds available for investment, for prompt and accurate execution of transactions, and for providing adequate disclosure.

 

Q: Who is an officer? -TOP

A: An officer is an individual who serves in any one of the following capacities for the parent organization: president, vice president, general manager, treasurer, secretary, comptroller, or any other individual who performs duties corresponding to those performed by individuals in those capacities. 

 

Q: What happens if a plan fails to make a corrective distribution of excess aggregate contributions and allocable income? -TOP

A: If a plan fails to make a corrective distribution during the 12month period following the plan year in which the excess aggregate contribution arose, the plan will be disqualified for that plan year and for all subsequent plan years in which the excess aggregate contribution remains in the plan. If a corrective distribution is made before the end of the 12-month period but more than 2 1/2 months after the end of the plan year, the employer will be subject to a 10 percent excise tax on the amount of the excess aggregate contributions. The excise tax can be avoided, however, if the employer makes QNECs enabling the plan to satisfy the ACP test. To be taken into account in performing the ACP test, QNECs must be made no later than 12 months after the plan year to which they relate. Thus, in 401 (k) plans using the prior-year testing method in performing the ACP test, QNECs must be made no later than 12 months after the end of the prior plan year.

 

Q: What is a discretionary nonelective contribution? -TOP

A: A discretionary nonelective contribution in a 401(k) plan is an employer contribution that is allocated on the basis of compensation or in some manner other than on the basis of elective contributions or employee after-tax contributions. Discretionary nonelective contributions do not need to be included in any of the special nondiscrimination tests for 401(k) plans, but they are subject to the general nondiscrimination rules under Code Section 401(a)(4). Discretionary nonelective contributions may sometimes be used to satisfy the ADP and ACP test. A participant's right to receive an allocation of a discretionary nonelective contribution cannot depend on whether he or she has made elective contributions. 

 

Q: Who is highly compensated employees? -TOP

A: An employee is a highly compensated employee (HCE) for a plan year only if the employee performs services for the employer during the determination year. In addition, the employee must be a member of at least one specified employee group (see here, and here). 

 Q: What must be included in a SAR? -TOP

A: 1. name of the plan and employer ID number 
    2. the period covered by the annual report 
    3. a basic financial statement of the plan 
    4. a notice advising the participant that a copy of the full annual report is available on request, that the individual may obtain additional info regarding the annual report, and that the individual may inspect the annual report at a designated location of the employer or at the DOL.

 

Q: What is the maximum amount of combined employee/employer funding that can be deferred on a pre-tax basis in a participant's 401(k) on an annual basis? -TOP

A: Maximum contribution funding in 401(k) from all employee and employer sources is $35,000, using a 401(k) combined with a money purchase plan. Without a money purchase plan the maximum is $22,500. Maximum annual employee 401(k) contribution: $10,500 Maximum annual employer 401(k) contributions: $12,000.

 

Q: Are some business owners prohibited from taking out 401(k) loans? -TOP

A: Yes. Non-owner employees are always eligible for 401k loans if the business owner(s) authorize loans in the company's plan. Business owners who are sole proprietors, or own 5% (or more) of a s-corporation, LLC, or partnership may not be eligible for 401k loans. Shareholders of traditional c-corporations are eligible for 401k loans. We suggest consulting with a qualified advisor for guidance if you are a business owner and intend taking out a 401k loan.

 

Q: Who does the 401(k) audit and what are the problems targeted in a 401(k) audit? -TOP

A: In the past, the IRS conducted the majority of 401(k) plan audits. Recently, however, the DOL has become a major player in the audit arena. Although there is some overlap, the IRS is primarily interested in plan documentation and plan operational compliance, while the DOL focuses on compliance with ERISA, particularly to ensure that plan participants' rights are not violated.

IRS Audits
The IRS recently issued a compliance profile of 401(k) plans. From 1995-1997, the agency's field offices audited 472 plans, 44% of which had defects.

Based on the law of averages, the chance of any plan having a violation is substantial.

DOL Audits

There are three primary areas the DOL currently has targeted for 401(k) audits:

Plan Investments -- The DOL is interested in the prudence and propriety of the plan's investments and wants to ensure that each investment is examined thoroughly by the plan administrator and/or trustee before it is made and that it is reviewed on a regular basis.

Timely Deposits of Plan Assets  -- The DOL has begun to examine how plan sponsors determine who pays various plan-related expenses. This area has been fraught with difficulties for plan sponsors because the agency previously provided little formal guidance as to which expenses are payable by the plan and which expenses must be paid by the employer or plan sponsor. The DOL recently issued new guidance, which should help employers in the determination, though complying with it will not necessarily be easy.

As part of the question of who pays for what, 401(k) plan sponsors in particular need to be aware of the fees being charged for plan administration, fees that might include more than just a base recordkeeping fee. For example, recordkeeping fees hidden in asset management fees might result in costs to the participant that are more than the industry standard. Plan sponsors must understand how their fee structure works and be able to show that these fees are being monitored on a regular basis.

Additional non-profit websites that include relevant unbiased information about 401k plans include: www.401k-services.com and www.401k-fees.com. 

 

Q: What are the two different 401(k) correction programs? -TOP

A: 401(k) Correction Programs

Because plan disqualification has a significant adverse affect on participants and sponsors, the IRS and DOL have implemented comprehensive programs for plan sponsors to identify defects and violations and to make corrections.

* The IRS recently issued a revised 90-page procedure for its Employee Plans Compliance Resolution System (EPCRS). The EPCR's programs provide for self-correction (SCP), voluntary correction with IRS approval (VCP), and corrections when the violation is found upon an audit (Audit CAP). The SCP does not require a fee or impose a monetary sanction, but it is not foolproof against a future audit. The VCP requires a submission fee and Audit CAP assesses a monetary sanction against the plan sponsor. But under both programs, the correction is approved by the IRS.

Therefore, the issue will not be raised in a subsequent audit covering actions that occurred prior to the correction date.

* The DOL's Voluntary Fiduciary Correction Program, a mere 34 pages, does not require a fee nor does it impose a monetary sanction. Under this program, plan fiduciaries may voluntarily apply for relief from civil or criminal penalties under ERISA--but not under the tax code--as a result of certain fiduciary violations. It covers violations such as delinquent employee contributions, prohibited loans, improper valuation of assets, and payment of excessive plan expenses.

Both programs require adherence to specific procedures, detailed documentation, and possibly negotiations with either the IRS or DOL (or both). Plan sponsors may wish to consider using the services of benefits compliance experts to help navigate a corrections program.

 

Q: What do we say when we are asked about Payroll Interface? -TOP

A: For companies of less than 25 persons, our testing shows that it is actually faster for the employer to key-in the monthly payroll and 401(k) contribution data directly into 401(k) Easy. We offer a money-back guarantee to small companies that they can completely run their 401(k) Easy in 20 minutes a month of the company's time, and that includes the time it takes to enter the payroll and contribution data.

Larger companies have been asking us for a Payroll Interface, and it is on our agenda to be included in the Year 2002 release of 401(k) Easy.

 

Q: How much money can the employer contribute the employee's 401(k)? -TOP

A: Beginning in 2002, an employee can elect to have up to 25% (as opposed to 15%) of his/her salary deferred to a 401(k) up to $11,000. This is regulated under 402(g). In addition, the employer can provide matching and/or non elective contributions up to the lesser of 100% of the employee's compensation, less the employee's voluntary contribution, OR $40,000 less the employee's voluntary contribution. In no case may more than $40,000 from all sources be added to the employee's account annually. This is regulated under 415(c).

Current 415 maximum DC contribution is the lesser of $35,000 (soon to be $40,000) or 25% of employee' compensation. In the future the 25% limit will be removed, allowing the employer to put up to $40,000 in matching contributions or non-elective deferrals into each employee's 401(k), so long as the employee earns $40,000+ annually. What the employer contributes to the employee's account is limited by how much the employee contributes. The employee's contribution plus the employer's contribution cannot exceed $40,000.

 

 Q: What is the separate accounting rule? -TOP

A: Under IRS regulations, a 401(k) plan must maintain "acceptable" separate accounting systems for elective contributions and for all other contributions. To be acceptable, the separate accounting system must allocate, on a reasonable and consistent basis, all gains, losses, withdrawals, credits and charges to each of the separately-tracked categories.

 

 Q: Do we have to allow employees to enroll as soon as they become eligible?

A: No, although there is a limit on the time that may elapse before an eligible employee is allowed to enroll. Eligible employees must be permitted to begin participating in the plan no later than the earlier of two deadlines: 

(1) the first day of the first plan year beginning after the date on which the employee becomes eligible; or 
(2) six months after the date on which the employee becomes eligible. Most plans meet this requirement by providing monthly, quarterly or semi-annual entry dates.

 


50 Answers to 401k Compliance Testing Questions

 

Q: What is a highly compensated employee (HCE)? 

A: The definition of an HCE has been simplified, effective for plan years beginning on or after Jan. 1, 1997 . Under the new definition, an employee is an HCE if, at any time during the previous plan year, he or she: (1) was a 5-percent owner; or (2) received more than $80,000 (adjusted to account for inflation) and, at the election of the plan sponsor, was one of the top-paid 20 percent of the work force. 

 

Q: Do contributions to a 401(k) plan count as compensation? -TOP

A: Yes. All salary reduction contributions, including pre-tax contributions to a 401(k) plan or a Section 125 cafeteria plan, must be included in an employee's compensation. 

 

Q: Must a 401(k) plan have a minimum number of employees participating? - TOP

A: No. The "minimum participation" test that requires a plan to cover at least 50 employees or 40 percent of all employees does not apply to defined contribution plans after 1996.

 

Q: Can I set up a qualified 401(k) plan in which only executives can enroll? -TOP

A: Probably not. A 401(k) plan intended solely for highly compensated executives is unlikely to pass the minimum coverage tests that apply to 401(k) plans (the ratio/percentage test and the average benefit test). A plan must pass at least one of these two tests. 

 

Q: I am self-employed. How much can I contribute to my 401(k) plans? -TOP

A: Under the TRA '97, the self-employed (including sole proprietorships and partnerships) may make both deductible employer matching contributions and the maximum employee deductible elective deferrals. Elective deferrals the self-employed can contribute are subject to the same limits and testing applied to regular employees 

 

Q: Our 401(k) plan failed the ADP test. Is there a way to adjust the plan so that it passes the test?-TOP

A: Yes. You may take one of four steps to eliminate (or "correct") any contributions that caused a 401(k) plan to fail the ADP test (called "excess contributions") within the 12-month period following the plan year in which the plan failed the test: cease or reduce contributions for HCEs before the end of the year (see 1'351); "recharacterize" the elective contributions of HCEs as after- tax contributions if the plan otherwise permits after-tax contributions (see p353); distribute the excess elective contributions and related earnings to HCEs (see f354); or make additional contributions on behalf of NHCEs.

 

Q: What about correcting a 401(k) plan that failed the ACP test? -TOP

A: As with plans that have failed the ADP test (see above), you may correct any excess employer matching contributions (called "excess aggregate contributions") within the 12-month period following the plan year in which the plan failed the test. There are three ways to correct such excess contributions:* make additional qualified matching contributions to NHCEs;* distribute the excess matching contributions and related earnings to HCEs; or * reclassify actual deferral contribution percentages as actual contribution percentages. 

 

Q: We're a Taft-Hartley plan. How do we run the nondiscrimination tests?-TOP

A: Taft-Hartley plans. (plans that involve more than one employer and one or more unions) are subject to the same principles that govern collectively bargained plans (see previous question). 

 

Q: Does an employer have to report an employee's 401(k) distribution to the IRS? -TOP

A: Yes. All distributions from a 401(k) plan must be reported to the IRS on Form 1099-R, "Statement for Recipients of Total Distributions From Profit-Sharing, Retirement Plans, Individual Retirement Accounts, Etc." The employee must be provided with a copy of the 1099-R form as well. 

 

Q: Can Year end "True-Up" Contributions Can Be Avoided? -TOP

A: Year end "True-Up" Contributions Can Be Avoided. A "true-up" of matching contributions (otherwise made on a periodic basis throughout the year) at the end of the year in order to take into account a participant's full-year compensation will no longer be required. Now, if the 401(k) plan specifically provides for a separate determination of matching contributions on a payroll, monthly, quarterly or annual basis, no year-end "true-up" matching contributions are needed. In addition, a plan can require employee deferrals to be made using whole percentages of pay or whole dollar amounts and still satisfy the safe harbor. This recognition of actual plan administration greatly simplifies safe harbor compliance.

 

Q: Can plans use electronic media to satisfy the 401(k) Safe Harbor Notice Requirement? -TOP

A: Plans Can Use Electronic Media to Satisfy the 401(k) Safe Harbor Notice Requirement. Like other sanctioned electronic notices, a participant must be told he/she can receive a written paper copy of the notice at no charge.

 

Q: May a 401(k) plan exclude part-time employees from plan participation? -TOP

A: No. In a field directive issued in November 1994, the IRS take the position that the exclusion of part-time employees is, in effect, service requirement that is subject to the limitations described here. According to the field directive, it does not matter that a 401(k) plan will satisfy the minimum coverage requirements after excluding part-time employees. 

Example. GHI Company sponsors a 401(k) plan that require one year of service (1,000 or more hours of service in an eligibility computation period) and excludes any employee who is regularly scheduled to work fewer than 30 hours per week. Bob has been a part-time employee (fewer than 30 hours per week) for five years but has completed more than 1,000 hours during each eligibility computation period (see Q 2:89). The 401(k) plan's exclusion of part-time employees has prevented Bob from becoming a plan participant even though he has completed five years of service. Because the part-time employee exclusion is treated as an indirect service requirement, GHI Company's 401(k) plan is subject to disqualification since it contains a length of service requirement in excess of that permitted under Code Section 410 (a) (1).

 

Q: What is the maximum deferral percentage in a 401(k) plan? -TOP

A: If the 401(k) plan will consist only of elective contributions, the maximum deferral percentage is 25 percent (see Limits on Elective Contributions in the previous section). For limitation years beginning before January 1, 1998 , the maximum percentage in this case would have been 20 percent. The lower maximum percentage for pre-1998 limitation years reflected the Code's requirement that elective contributions be subtracted from compensation for purposes of applying the annual additions limit. Thus, the 25 percent limitation was applied after reducing compensation by the amount of the elective contribution. 

Example. For the limitation year beginning January 1, 1997 , Alfred's annual pay was $40,000. Alfred elects to defer 20 percent of pay into the 401(k) plan, or $8,000 ($40,000 x 20 %). For purposes of computing the Section 415 limit, Alfred's compensation was $40,000 less the $8,000 elective contribution, or $32,000. The maximum annual additions limit was the lesser of 25 percent pay or $30,000. Computing this limit for Alfred yielded a limit $8,000 ($32,000 x 25%).

 

Q: What is the maximum annual amount deductible for a 401(k) plan? - TOP

A: In general, the maximum deductible amount for a taxable year of the employer is 15 percent of the compensation paid during the taxable year to the participants under the plan. [IRC § 404 (a) (3) (A) (i)] If an employer maintains two or more profit sharing plans, they will be treated as a single plan for purposes of applying the 15 percent limit.

Example. Employer XYZ maintains a 401 (k) plan as well as a profit sharing plan covering the same employees. Contributions to the 401 (k) plan amount to 7 percent of participant compensation. If Employer XYZ wishes to contribute the maximum deductible amount, it can make a contribution to the profit sharing plan equal to 8 percent of compensation.

 

Q: Is there a limit on the amount of compensation that may be taken into account in determining the maximum deductible amount? -TOP

A: Under Code Section 404(l), the amount of compensation that taken into account with respect to any participant is to $150,000 ($160,000 for taxable years beginning after This limit is adjusted in increments of $10,000.

In addition, for taxable years beginning before 1997, an HCE see Chapter 9) who is a 5 percent owner or one of the ten most highly compensated HCEs and his or her spouse and any child who has not reached age 19 before the close of the taxable year will be treated as a single employee for purposes of this limit. This is known as family aggregation. Note that family aggregation has been repealed for tax years beginning after 1996. 

Example. Claire owns 100 percent of ABC Company, which sponsors a 401(k) plan. The compensation of the employees of ABC Company for its taxable year beginning July 1, 1996 , is as follows:

Employee

Relationship 
to Claire

Compensation

Subject to Family Aggregation

Claire

 

$180,000

Yes

Dave

Husband

75,000

Yes

Derek

Son (over 19)

75,000

No

Danny

Son (under 19)

5,000

Yes

Vincent

None

100,000

No

N1

None

30,000

No

N2

None

25,000

No

N3

None

24,000

No

N4

None

23,000

No

N5

None

20,000

No

 Claire's compensation of $180,000 is aggregated with Dave's and Danny's compensation ($180,000 + $75,000 + $5,000 = $260,000) and limited to $150,000 for the 1996 tax year. Hence, the maximum deductible amount for the 1996 tax year is $67,050 [($150,000 + $75,000 + $100,000 + $30,000 + $25,000 + $24,000 + $23,000 + $20,000) x 15%]. If the compensation amounts are identical for the taxable year beginning July 1, 1997 , the maximum deductible amount is $80,550 [($160,000 + $75,000 + $75,000 + $5,000 + $100,000 + $30,000 + $25,000 + $24,000 + $23,000 + $20,000) x 15%]. This amount is greater than the 1996 maximum deductible amount on account of the elimination of family aggregation.

  

Q: How are the limits coordinated if the employer has a money purchase or target plan? -TOP

A: An employer that maintains a money purchase or target plan with modest contributions of 10 percent of pay or less may be able to add a 401(k) plan. However, considerable care should be exercised in reviewing the individual Section 415 limits.

 

Q: Who is an officer? -TOP

A: An officer is an individual who serves in any one of the following capacities for the parent organization: president, vice president, general manager, treasurer, secretary, comptroller, or any other individual who performs duties corresponding to those performed by individuals in those capacities.

 

Q: What happens if the ADP test for a plan year is not satisfied? -TOP

A: If the ADP test for a plan year is not satisfied, the portion of the 401(k) plan attributable to elective contributions-and, most likely, the plan in its entirety-will no longer be qualified. The regulations, however, provide several mechanisms for correcting an ADP test that does not meet the requirements of the law. These mechanisms are as follows: 

1. The employer makes QNECs or QMACs that are treated as elective contributions for purposes of the ADP test and that, when combined with elective contributions, cause the ADP test to be satisfied. 

2. Excess contributions are re-characterized. 

3. Excess contributions and allocable income are distributed. 

4. The portion of the 401(k) plan attributable to elective contributions is restructured. A A plan may use any one or more of these correction methods. 

 

Q: What is the tax treatment of corrective distributions to employees? -TOP

A: The tax treatment of corrective distributions to employees depends on when the distribution is made. A corrective distribution made within 2 1/2 months after the end of the plan year is includible, to the extent at attributable to matching contributions, in the employee's gross income for the taxable year of the employee ending with or within the plan year in which the excess aggregate contribution arose. A corrective distribution made more than 2 1/2 months after the end of the plan year will be includible, to the extent attributable to matching contributions, in gross income for the taxable year in which distributed. The same rules apply to any income allocable to excess aggregate contributions. However, if the total amount of excess contributions and excess aggregate contributions for a plan year is less than $100, excess aggregate contributions and any allocated income will be includible in the year distributed regardless of when the corrective distribution is actually made. 

 

Q: What happens if a plan fails to make a corrective distribution of excess aggregate contributions and allocable income? - TOP

A: If a plan fails to make a corrective distribution during the 12month period following the plan year in which the excess aggregate contribution arose, the plan will be disqualified for that plan year and for all subsequent plan years in which the excess aggregate contribution remains in the plan. If a corrective distribution is made before the end of the 12-month period but more than 2 1/2 months after the end of the plan year, the employer will be subject to a 10 percent excise tax on the amount of the excess aggregate contributions. The excise tax can be avoided, however, if the employer makes QNECs enabling the plan to satisfy the ACP test. To be taken into account in performing the ACP test, QNECs must be made no later than 12 months after the plan year to which they relate. Thus, in 401 (k) plans using the prior-year testing method in performing the ACP test, QNECs must be made no later than 12 months after the end of the prior plan year.

 

Q: What eligibility requirements may be imposed on a 401(k) participant for purposes of receiving a discretionary nonelective contribution allocation? -TOP

A: A minimum hours requirement of up to 1,000 hours may be posed. 

For example, if a plan requires 1,000 hours of service, an active or terminated participant who works fewer than 1,000 hours will not be entitled to an allocation of discretionary nonelective contributions. 

A requirement that the participant be employed on the last day of the plan year may also be imposed. This requirement would generally preclude any terminated employees from receiving a portion of the nonelective contribution.

 

Q: How much compensation can be used for calculation plan contributions or benefits? -TOP

A: There is a limit on the amount of compensation that can be taken into account for computing plan contributions and benefits and for applying nondiscrimination tests. The 1998 limit is $160,000. This amount will be adjusted for inflation in $10,000 increments. 

 

Q: What are the basic limits for a 401(k) plan? -TOP

A: The amount of annual additions allocated to a participant cannot exceed the lesser of $30,000 or 25 percent of the participant's com­pensation.

 

 Q: Is the amount of elective contribution to a 401(k) plan subject to limitation? -TOP

A: Yes. However, before 1987 there was no limit on the amount of elective contributions that an employee could make to the plan other than the limits on annual additions imposed by Code Section 415 (see here). Consequently, participants could defer up to the lesser of $30,000 or 25 percent of compensation. The Tax Reform Act of 1986 (TRA '86) placed an annual cap on the amount of elective deferrals that can be made by any individual. That cap, originally $7,000 but adjusted periodically to reflect cost-of-living increases, is $10,000 for 1998.

 

 

 Q: What happens if the participant's elective deferrals for the taxable year exceed the annual cap? -TOP

A: If a participant has excess deferrals (the amount by which a participant's elective deferrals exceed the annual cap) based only on the elective contributions made to a single 401(k) plan, then the plan must return the excess deferrals to the participant. It could happen, however, that a participant has excess deferrals as a result of making elective contributions to 401(k) plans, SARSEPs, SIMPLE retirement plans, and 403(b) annuity contracts of different employers. If the 401(k) plan so provides, the participant may notify the plan of the amount of excess deferrals allocated to it no later than April 15 (or any earlier date specified in the plan). The plan is then required to distribute to the participant no later than April 15 the amount of the excess deferrals allocated to the plan by the participant.

 Q: What is the income allocable to excess deferrals? -TOP

A: The income allocated to excess deferrals is the amount of the allocable gain or loss for the taxable year of the participant. If the plan so provides, it also includes the allocable gain or loss ,for the gap period, which is the period between the end of the participant's taxable year and the date of distribution.

 

Q: What happens if excess deferrals are not corrected? -TOP

A: It depends on how they arise. If excess deferrals arise out of elective deferrals made to one or more plans maintained by the same employer (see definition of employer in chapter 9), then the qualification of the plan is at risk. This is because Code Section 401(a)(30) provides that a plan cannot accept elective contributions in excess of the annual cap. If, on the other hand, the excess deferrals arise out of elective deferrals made to plans maintained by unrelated employers, the excess deferral will be included in gross income twice: in the taxable year in which the excess deferral was contributed, and in the taxable year in which the excess deferral is ultimately distributed to the participant.

 

Q: How does Code Section 415 limit annual additions to a 401(k) plan? -TOP

A: Code Section 415 limits the annual additions that may be allocated to an individual's account in any limitation year. The limitation year is the calendar year unless another 12-month period is designated in the plan document. For 1998, the maximum annual addition is the lesser of 25 percent of compensation or $30,000.

 

 Q: Is the $30,000 limit indexed for inflation? -TOP

A: Yes, the $30,000 limit is indexed for inflation. However, under the General Agreement on Tariffs and Rade (GATT) pension provisions, the dollar limit must always be a multiple of $5,000 and will always be rounded to the next lowest multiple of $5,000.

 

 Q: Who is highly compensated employees? -TOP

A: An employee is a highly compensated employee (HCE) for a plan year only if the employee performs services for the employer during the determination year. In addition, the employee must be a member of at least one specified employee group 

 

 Q: What are the maximum contribution limits for 2001? -TOP

A: The IRS has released new limits that significantly impact Qualified Plans.

Type of
Limitation

2001

2000

401(k) Elective Deferrals

$10,500

$10,500

Max. Defined Benefit

$140,000

$135,000

Max. Defined Contribution

$35,000

$30,000

Annual Compensation Limit

$170,000

$170,000

Highly Compensated
($80,000 index)

$85,000

$85,000

Income Subject to
Social Security Tax

$80,400

$76,200

While the 401(k) Deferral limit remains at $10,500, increases in two other important limit increases offer significant opportunities.

The Defined Contribution limit has increased from $30,000 to $35,000. This limit has been virtually frozen for years, and the increase significantly improves the results of both Money Purchase Pension and Profit Sharing Plans.

The maximum Defined Benefit Limit increase from $135,000 to $140,000 is most helpful to established plans. The increase may afford the opportunity to make a "make up" contribution, or to absorb "overfunded" benefits.

 

 Q: Is there a law that requires employers to make participant contribution deposits into the plan with a certain timeframe? - TOP

A: Yes. Under the DOL Regulations, an elective deferral becomes an ERISA plan asset on the earliest date on which it can reasonably be segregated from the employer's general assets. However, in no event may the contributions be segregated later than the 15th business day of the month following the month in which the participant contribution would have been otherwise payable to the participant in cash. If this rule is not complied with, then the employer has committed a prohibited transaction. The PWBA takes the position that this is either a prohibited loan of plan assets to the employer or a prohibited taking of such assets.

 

ERISA Section 501(l) imposes a penalty of 20 percent of the amount recovered by the DOL from a fiduciary who breaches his fiduciary duty or commits another violation of ERISA, such as a prohibited transaction. The so-called "502(l) penalty" is to be assessed when the amount recovered is pursuant to a settlement with the DOL or a court order. The DOL construes its authority to assess the penalty very broadly and has taken the position that a civil action need not have been instituted and no written settlement agreement is necessary to subject the plan sponsor to the penalty.

 

 Q: Who is considered a key employee? -TOP

A: A "key employee" is an employee (or relation or former employee) who, during the plan year that ends on such determination date or the preceding plan year, is

(i) an officer earning compensation in excess of $130,000 (indexed for cost-of-living adjustments in $5,000 increments),
(ii) a five percent owner,
(iii) a one percent owner earning over $150,000

 

 Q: What special vesting requirements apply to to-heavy plans? -TOP

A: If a 401(k) plan becomes top-heavy, account balances attributable to employer contributions and matching contributions must vest at an accelerated rate, at least as rapidly as on of the following two schedules:

 

Year of Service 

Vesting Percentage

Fewer that 2 

0%

2 

20%

3 

40%

4 

60%

5 

80%

6 or more 

100%

 

Year of Service 

Vesting Percentage

Fewer than 3 0%

0%

3 or more 

100%

 

B-35 Q: What are the maximum contribution limits for all DC plans? -TOP

A: Maximum Benefit and Contribution Limits 2007-2012



Limitation 201220112010200920082007
IRAs $5000$5000$5000$5000$5000$4000
Catch-up Contributions for IRAs $1000$1000$1000$1000$1000$1000
401(k)/403(b)/SAR-SEP IRA Elective Deferrals $17000$16500$16500$16500$15500$15500
Catch-up Contributions for 401(k)/403(b)/ Government 457(b) Plans and SAR-SEP IRAs $5500$5500$5500$5500$5000$5000
Defined Benefit Plans $200000$$1 95,000 $195000$195000$185000$180000
Defined Contribution Plans and SEP IRAs $50000$49000$49000$49000$46000$45000
Annual Compensation Limits $250000$245000$245000$245000$230000$225000
457(b) Plans $17000$16500$16500$16500$15500$15500
Highly Compensated Employee* $115000$110000$110000$110000$105000$100000
SIMPLE IRA Elective Deferrals $11500$11500$11500$11500$10500$10500
Catch-up Contributions for SIMPLE IRAs $2500$2500$2500$2500$2500$2500
Key Employee Threshold $165000$160000$160000$160000$150000$145000
SEP Minimum Compensation $550$550$550$550$500$500
Income Subject to Social Security $110100$106800$106800$106800$102000$97500

Source: Internal Revenue Service, October 20, 2011. *Note: Maximum HCE compensation utilizes prior year limits. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Smith Barney Financial Advisors do not provide tax or legal advice and are not "fiduciaries" (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by Morgan Stanley Smith Barney. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their tax or legal advisors before establishing a retirement plan and to understand the tax, ERISA and related consequences of any investments made under such plan

 Key Employee: Dollar amount for officer is 50% of the DB limit.

 

 Q: Is there a new IRS ruling that states that employee salary reductions and employer matching contributions can be transferred to a 401(k) after the close of the plan year, and are treated as if made during the plan year?  -TOP

A: No. There is a private letter ruling that allows HCEs to contribute to a nonqualified plan, and then the have the contributions transferred to a 401(k) plan, up to the level where the plan can still pass the ADP test.

An employer maintained a qualified 401(k) plan and a nonqualified deferred compensation plan, both of which provided for salary deferrals. If, for a plan year, a participant elected to have salary deferrals under the nonqualified plan transferred to the qualified 401(k) plan, the lesser of the calculated ADP and ACP limits or the participant's salary deferrals under the nonqualified plan would be transferred to the 401(k) plan. (TAG)

 

 Q: What is the Actual Contribution Percentage or ACP Test? -TOP

A: The IRS requires that the Actual Contribution Percentage (ACP) Test, also known as the 401(m) Test, be completed each year. It ensures that the plan does not discriminate in favor of Highly Compensated Employees (HCEs) with respect to employer matching contributions, and/or employee after-tax contributions. The ACP Test must be performed within 12 months following the end of the plan year. If the plan fails the ACP test, a 10% penalty tax is assessed on the distribution required to correct the failed test. To avoid the penalty tax, the plan sponsor must have the test completed, and corrective actions taken, within 2 ½ months of the year end.

 

 Q: What are the basic rules of the Actual Deferral Percentage or ADP Test? -TOP

A: The IRS requires that the Actual Deferral Percentage Test [also known as the 401(k) Test], be completed each year. It compares the pre-tax deferral contributions made by Highly Compensated Employees (HCEs) with those made by non-highly compensated employees. The intent is to ensure that the HCE group does not benefit disproportionately from its company's 401(k) plan, as compared to the Non-Highly Compensated Employee group. To satisfy the ADP Test, a 401(k) plan must pass either of the tests below: 

1. Basic Test - The average Actual Deferral Percentage (ADP) of the HCE may not exceed 125% of that of the non-HCE. Here is an example of the Basic Test: Assume the average HCE pre-tax contribution in a company is 7% and the average non-HCE pre-tax contribution is 4%. Consider the calculations below: Test:

What is 125% of 4%?  Answer: 5%
Is 7% > 5%? Answer: Yes

Test Result:
Test Fails

2. Alternative Test - The average ADP of the Highly Compensated Employee may not exceed the lesser of either 2-percentage points above the average ADP of the non-HCE or 200% of the average ADP of the non-HCE. In other words, the sponsor must pass both Alternative Test sections. Here is an example of the Alternative Test: Assume again that the average HCE pretax contribution in a company is 7% and the average non-HCE pretax contribution is 4%. Now consider these calculations below:

Test:
What is 200% of 4%?  Answer: 8%
What is 4% plus 2%?  Answer: 6%

Take the lesser of the two answers above: Answer: 6%
Is 7% greater than 6%?  Answer: Yes

Test Result
Test Fails

The ADP Test must be performed within 12 months following the end of the plan year. If the plan fails the ACP test, a 10% penalty tax is assessed on the distribution required to correct the failed test. To avoid the penalty tax, the plan sponsor must have the test completed , and corrective actions taken, within 2 ½ months of the year end.

Q: We regularly use "temps." Must I include them in our 401(k) coverage testing? -TOP

A: Perhaps. Some temps may qualify as leased employees. People who meet the tax code's definition of a "leased employee" must be treated as employees of the organization for which they perform services, and must be included in Section 410(b) coverage testing. Generally, a leased employee: 

(1) provides services under an agreement between the recipient of those services and an employee leasing organization (such as a temporary help firm); and 
(2) has performed services for the recipient on a substantially full-time basis for at least one year. In addition, the services provided must be subject to the control of the recipient.

 

Q: Do sales commissions count as compensation? -TOP

A: Yes, the basic definition of compensation encompasses sales commissions. It also includes all of an employee's wages, salary, bonuses, incentive compensation, tips, taxable reimbursements (other than deductible moving expenses) and other taxable fringe benefits paid to an employee. The definition includes both cash and noncash income.

 

 Q: What is the ratio/percentage test? -TOP

A: Under the "percentage test" part of the ratio/percentage test, at least 70 percent of an employer's nonhighly compensated employees (NHCEs) must be eligible to participate in the plan. A plan that fails the percentage test, however, still may be nondiscriminatory if it can pass the "ratio test," under which the percentage of NHCEs who are eligible to participate in the plan (out of all NHCEs) must be at least 70 percent of the percentage of highly compensated employees (HCEs) who are eligible to participate in it (out of all HCEs). When counting NHCEs for both of these tests, collectively bargained employees; employees who do not meet minimum wage or service requirements of the plan; and certain nonresident aliens, airline pilots and terminated employees can be excluded.

 

 Q: What is the average benefit test? -TOP

A: The third minimum coverage test, the average benefit test, consists of a fair cross-section test and a numerical test. The fair cross-section test consists of two elements. Under the first, it must be demonstrated that the group of eligible employees reflects "reasonable business classifications," based for example on job categories or salaried versus hourly employees. Under the second part, the plan must use a classification that does not discriminate in favor of HCEs. A modified version of the "ratio test" (above) is used for this purpose. The modified version permits the ratio of NHCE to HCE eligibility percentages to be significantly less than 70 percent, depending on the relative number of NHCEs the plan sponsor employs. The numerical average benefit test requires that the average of all employer-provided contributions (the average benefit percentage) for NHCEs must be at least 70 percent of the average benefit percentage for HCEs.

 

 Q: Are corrective excess contributions tax-free? -TOP

A: No. If an employer corrects a failed plan by distributing excess contributions (in the case of the ADP test) or excess aggregate contributions (in the case of the ACP test), then the affected employees must include those amounts as taxable income (except to the extent they represent a return of after-tax contributions).

 

 Q: Our workforce is heavily unionized. How do I run the nondiscrimination tests?-TOP

A: A collectively bargained employer must test separately 401(k) plans that cover employees who are in a collective bargaining unit from 401(k) plans that cover employees who are not in a collective bargaining unit. In addition, the employer must test each collective bargaining unit separately even if the employees covered by the collective bargaining unit participate in a plan in which employees not covered by a collective bargaining unit (for example, salaried employees) participate. Employer and matching contributions as well as after-tax elective contributions made by employees in a collective bargaining unit are automatically deemed to pass the ACP test.

 

 Q: Is there any way to avoid ADP and ACP nondiscrimination testing?-TOP

A: Yes, but not until 1999 plan years. When new rules (enacted as part of  the Small Business Job Protection Act of 1996) take effect in 1999, a plan that provides either a specific level of matching contribution or a minimum nonelective contribution to all eligible NHCEs for a plan year may be exempt from ADP and ACP testing. The contributions must be immediately fully vested and subject to other restrictions on withdrawals and other features. Plans maintained by public employers do not need to perform nondiscrimination tests. 

 

 Q: -What are Annual Additions? -TOP

A: Refers to the total of all contributions allocated to the participant account(s) in all defined contribution plans and simplified employee pensions plan of the employer for the limitation year.

 

Q: What is a Annual Additions Limitation? -TOP

A: A limitation imposed on the participant's account by the IRS. It limits the amount of annual contributions a participant can make to their account to $35,000 or 25 percent of their compensation, whichever is less. The limitation year as defined in the 401(k) Pro plan document is the calendar year. This means that the participant can't exceed these contribution limits during the calendar year. Participant contributions to the cafeteria plan (IRS Section 125 plans) are not applied to the Annual Additions Limitation.

 

 Q: What is a Determination Year? -TOP

A: The determination year is used to determine income or loss with respect to either excess deferrals or excess contributions and excess aggregate contributions. In the case of excess deferrals, the determination year is the calendar year in which the excess deferrals were made. In the case of excess contributions and excess aggregate contributions, the determination year is the plan year in which such contributions were made.

 

 Q: What is Gross Annual Compensation -TOP

A: Generally refers to all wages paid to an eligible employee during the plan year. Compensation includes: salary, overtime, bonuses, commissions, taxable reimbursements and allowances, cash and non-cash fringe benefits, moving expenses and deferred compensation and welfare benefits.

For self-employed participants, Annual Compensation refers to Earned Income as defined in the 401(k) Pro Plan Document.

 

Q: What is a Key Employee? -TOP

A: As defined by the IRS, a Key Employee means any employee or former employee who at any time during the 5 year period ending on the Determination date was: 1. An Officer of the Employer with the compensation excess of 50 percent of the dollar limitation under Code Section 415(b)(1)(A) - The Officer Compensation Thresholds for the past seven years are:

• 2001...............$70,000
• 2000...............$67,500
• 1999...............$65,000
• 1998...............$65,000
• 1997...............$62,500
• 1996...............$60,000
• 1995...............$60,000
• 1994...............$59,400

2. a 5% owner or the Employer

3. a top ten owner (one of 10 employees who owns the largest interest in the Employer and had annual compensation from the Employer exceeding the dollar limitation under IRC Section 415(c)(1)(A) $35,000

4. A 1% owner, having compensation from the Employer of more than $150,000.

This definition applies when performing the compliance Top Heavy Test.

Q: What is the Look Back Year? -TOP

A: The look back year is the twelve month period immediately preceding the first day of the plan year.

 

Q: What is the Minimum Coverage Test? -TOP

A: The IRS requires the Minimum Coverage Test on an annual basis. This test ensures that an employer's plan does not discriminate in favor of Highly Compensated Employees (HCEs). This test must show that the percentage of non-HCEs who are benefiting by the plan is at least 70% of the percentage of HCEs benefiting by the plan. Here is an example of the Minimum Coverage Test:

Test: Assume 40% of the non-HCEs in the company benefit from the plan and 50% of the HCEs in the company benefit from the plan.
What is 70% of 50%?  Answer:35%
Is 40% >35%?  Answer: Yes

Test Result: Test Passes

If a plan fails the Minimum Coverage Test, the Employer must take corrective action within 9 ½ months after Plan Year end. This may require including additional employees in the plan who originally were not eligible and therefore were not benefiting employees, and proving them with an employer contribution.

 

Q: What is the Top -Paid Group or 20% HCE group? -TOP

A: The top-paid group is the highest paid 20% of the Employer's employees. If you choose the Top-Paid Group (or Top 20%) option, you may be able to minimize the number of employees who are considered Highly Compensated Employees (HCEs). When using this option, all employees are ranked by compensation, and only those who fall in the top 20% and who earn greater than $80,000 in the look-back year (the 12 month period preceding the current plan year) are considered Highly Compensated.

For example, assume that ten employees work for you. One is a 5% owner, and three others earned greater than $80,000 indexed in the look-back year. When you rank all ten employees by compensation and then apply the Top 20% option, there are only two employees --instead of four-- who must be defined as HCEs. This example assumes that the 5% owner is one of the employees who earned greater than $80,000. If the 5% owner was not one of the employees who earned greater than $80,000, then you would have three HCEs - the two in the Top 20%, as well as the 5% owner.

 

Q: What is the Top Heavy Test? -TOP

A: A compliance test required to determine if the plan is Top Heavy. A plan is considered Top-Heavy if more than 60% of the assets of the plan are for the benefit of Key Employees (see Key Employees in this Glossary). This calculation includes all withdrawals for the previous five years. If a plan is Top-Heavy, then the employer is required to make minimum contributions equal to the highest contribution percentage of any key employee up to maximum of 3% of compensation to all non-key employees. The plan would then require a special accelerated vesting schedule.

 

 Q: The employer matching contribution 401(k) plan safe harbor now satisfies the top-heavy rules". Does this mean that if a 401(k)plan is a safe harbor plan using the safe harbor matching contribution, they do not need to run the top heavy test? -TOP

A: Yes. Under EGTRRA a safe harbor 401(k) plan is deemed not to be top heavy.(TAG)

 

 Q: Can non-vested employer contributions be used towards passing the top-heavy test? -TOP

A: Yes. There is no requirement that the match be 100% vested to be used towards passing the top-heavy test minimums.

 

Q: What is the new EGTRRA definition of a "key employee" for purposes of the top-heavy test? -TOP

A: A "key employee" is an employee who, during the plan year that ends on such determination date or the preceding plan year, is

(i) an officer earning compensation in excess of $130,000 (indexed for cost-of-living adjustments in $5,000 increments),
(ii) a five percent owner,
(iii) a one percent owner earning over $150,000

 

 Q: What is the new EGTRRA definition of "officer" for top-heavy testing? -TOP

A: Officers with annual compensation greater than $130,000 for 2001 are key employees.

 

 Q: Can an excess contribution under a plan's ADP test be "reclassified" as a catch up contribution for persons 50+ instead of distributing the excess? -TOP

A: Yes. The new proposed regulations make it clear that, if the participant is 50+ an excess contribution can be reclassified as a catch up contribution for that participant.

 

 Q: Can top-heavy plans offer a corrective contribution that can be subject to a vesting schedule? Does our 401(k) Easy system allow for this employer contribution to be vested? -TOP

A: Yes and No--all top-heavy corrective contributions must be 100% vested immediately under 401(k) Easy. The alternative to a complex top-heavy situation is to change the plan to a Safe-Harbor 401(k).

 

 Q: If an existing company starts a 401(k) how are the HCEs determined? -TOP

A: HCEs are persons who are 5%+ owners and/or earned $80,000+in the look-back year and was in the top 20% of employees ranked by pay.

 

 Q: If a brand new company starts a 401(k) how are the HCEs determined? -TOP

A: HCEs are only the 5%+ owners

 




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