Providing a benefit like a 401(k) to your employees is an inexpensive and usually low maintenance benefit that is highly valued amongst employees. And yet, there are still some important things to know if you are the administrator of the plans- the biggest being compliance testing.
Compliance testing is required by the IRS at the end of the year to ensure a company’s 401(k) plan does not unfairly favor owners and highly compensated employees (HCEs) and that the plan stays within IRS-required limits. If your 401(k) plan fails any compliance testing, corrective actions must be taken within the timeline provided by your 401(k) provider.
In 2023 the IRS considers anyone earning more than $150,000/year a “highly compensated employee” (HCE) which is up from the previous threshold in 2022 of $135,000/year. In the event that specific IRS limits are exceeded, you or your 401(k) provider will need to process the excess contributions (depending on overage type.) Typically, excess employee deferrals will be processed as a refund to the employees and paid out to them by check or direct deposit by the end of the plan year or as soon as administratively feasible. We always suggest a clear communications plan for your team and the individuals impacted as there are usually a lot of questions as to how this happened in the first place and what the impact to them will be as this is processed. We have communication plans ready to tailor to your company, but also have a FAQ here as a starting point for your impacted team. Excess employer contributions are typically processed as a forfeiture to the plan and will be used to offset future employer contributions until depleted.
If your plan fails any of the below nondiscrimination tests, your 401(k) provider should contact you with details on how to correct the issue and the deadlines to do so as every provider has a bit of a different process. Note that if your 401(k) provider doesn’t receive compensation data in a timely manner, it can mean additional costs – particularly if your plan fails the ADP or ACP tests. Depending on your 401(k) participation rates within your company, we usually suggest either monthly or quarterly audits of the plan to make smaller adjustments as you go- if possible.
Actual Deferral Percentage Test (ADP): This test compares the average deferral percentage of HCEs against the average deferral percentage of non-highly compensated employees (NHCEs).
If not compliant in this ADP test, you will need to correct this by either refunding HCE their excess contributions or by making employer contributions to NHCEs to restore balance.
Actual Contribution Percentage Test (ACP): This test compares the average employer matching contribution percentage of HCEs against the average of NHCEs.
If not compliant in this ACP test, you will need to correct by either refunding HCE excess contributions or making employer contributions to NHCEs to restore balance.
Top-Heavy Test: A plan is considered “top-heavy” when the owners and most highly paid employees (“key employees”) own more than 60% of the value of the plan assets. This ratio is tested every year based on the account balances on the last day of the prior plan year. If your plan is determined to be “top-heavy” you will need to correct this by having the non-key employees receive a minimum contribution under the plan.
Minimum required contribution for each non-key employee is the lesser of:
Three percent, or
The highest contribution percent of any key employee (including deferrals that are not catch-up contributions)
Does all of this seem like a huge hassle? Yep, but necessary. Take a deep breath- we are here to help! Another idea/option that avoids the hassle of most nondiscrimination testing is to elect what is called a “safe harbor plan.” A safe harbor plan provides all eligible plan participants with an employer contribution. In exchange, safe harbor plans allow businesses to avoid these annual IRS nondiscrimination testing. If your company has the budget to sponsor an employee match this can be a huge win for employee morale, future recruiting efforts, avoidance of these compliance tests, and these employer contributions are deductible on the employer’s federal income tax return (to the extent that the contributions do not exceed the limitations described in section 404 of the Internal Revenue Code.) Email us at hello@retainhr.com if you want to chat about this more or need help- we are on deck.