401(k) Plan Testing 201

Transcription

1 401(k) Plan Testing 201 Kimberly B. Martin, APA, CPC, QPA NIPA, Education Director Bates & Company, Inc., Account Executive Kimberly B. Martin, APA, CPC, QPA NIPA, Education Director Bates & Company, Inc., Account Executive As the Education Director of NIPA, Kim Martin is responsible for the leadership and strategic management of the association s educational programs. Kim is also an account executive at Bates & Company, Inc., providing administration and consulting services to clients. 1

2 Agenda Whether the ADP/ACP test is performed correctly Alternative testing strategies that may improve test results Corrective action that must be taken to fix a failed ADP/ACP test Special 401(k) Tests Nondiscrimination Tests 401(k) arrangement = ADP Test 401(m) arrangement = ACP Test Automatic Pass Safe harbor 401(k) plans QACAs SIMPLE 401(k) plans Only HCEs (or only NHCEs) 2

3 Failed ADP Test Participant Compensation Deferrals ADP Amy (HCE) $250,000 $15, % Bill (HCE) $150,000 $10, % Carl (HCE) $130,000 $6, % HCE ADP 6.00% Dee (NHCE) $70,000 $4, % Elli (NHCE) $40,000 $0 0.00% Fred (NHCE) $10,000 $0 0.00% NHCE ADP 2.33% % Fail 2x or % Failed ADP Test Test performed correctly? Apply testing strategies Take corrective action 3

4 Performing the ADP Test Identify eligible employees Classify HCEs and NHCEs Calculate each participant's ADR Determine the HCE ADP and the NHCE ADP Perform the numerical ADP test ADP Test Performed Correctly? Correct employees included? Correct HCEs/NHCEs identified? Correct contributions tested? Correct testing calculations used? Correct testing method applied? Correct compensation used? 4

5 Correct Employees Included? Eligible employees An eligible employee is any employee who is eligible to make elective deferrals under the plan for all or a portion of the plan year Employees who make a one-time, irrevocable election not to participate in the plan, are not eligible employees Correct HCEs/NHCEs Identified? A highly compensated employee (HCE) is defined as an employee who Owns more than 5% of the employer at any time during the current or preceding plan year, or For the preceding ( look-back ) year, Received compensation greater than $120,000 (in 2017), and If elected by the employer in the document, was a member of the top-paid group (i.e., was among the top 20% of employees, ranked based on compensation) A non-highly compensated employee (NHCE) is any employee who is not considered to be an HCE 5

6 HCE Ownership Test Related employers Own more than 5% of a related employer? No aggregation of ownership Example: ABC Co. and DEF Co. are related Owner ABC Co. DEF Co. 5% Owner? G 4% 2% No H 1% 7% Yes Attribution under IRC 318 Family attribution Between spouses From parent to child (including adopted) From child to parent From grandchild to grandparent Not from grandparent to grandchild No double attribution No sibling attribution 6

7 Example Family Attribution 100% Owner s: Attribution Applies? Spouse Yes 20-year old daughter Yes 35-year old son Yes Son s wife No Son s 15-year old daughter No Mom Yes Grandpa Yes Brother No Attribution under IRC 318 Additional attribution from Partnerships, estates, trusts, and corporations In proportion to the interest or ownership Example: Individual owns 50% of Partnership P P owns 50% of Corporation C Individual is attributed to own 25% of C Corporations 5% or more ownership is required Stock option Treated as owning stock, even if option not yet exercised 7

8 HCE Compensation Test Related employers aggregation of compensation Example: ABC Co. and DEF Co. are related Employee J Compensation ABC Co. $ 50,000 DEF Co. $100,000 Aggregated Compensation $150,000 Correct Contributions Tested? Individual ADR = deferrals compensation Contributions included: Elective deferrals Designated Roth contributions Excess deferrals of HCEs QNECs/QMACs used to pass ADP test Contributions excluded: Catch-up contributions Excess deferrals of NHCEs EACA permissible withdrawals Corrective distributions of excess annual additions 8

9 Correct Compensation Used? Individual ADR = deferrals compensation Compensation IRC 414(s) compensation must be used for calculating ADRs The definition will be specified in the plan document Correct Testing Method Applied? The testing method is defined in the plan document Prior year testing method NHCE ADR calculated based on deferrals and compensation in the year prior to the year for which the testing is being performed HCE ADR calculated based on elective deferrals and compensation during the testing year Allows employers to proactively limit HCE deferrals to a level that will pass the ADP test Current year testing method Both NHCE ADR and HCE ADR calculated based on deferrals and compensation during the testing year 9

10 Example Which Year s Data is Used? 2017 Calendar Year 401(k) Plan Testing Method HCEs 2017 ADR NHCEs 2017 ADR NHCEs 2016 ADR Current Year Prior Year Correct Calculations? ADP of the NHCEs Average of the NHCE ADRs ADP of the HCEs Average of the HCE ADRs Include eligible employees who do not defer Example: NHCE #1 ADR = 0% NHCE #2 ADR = 6% Average = (0% + 6%) 2 NHCEs = 3% NHCE ADP = 3% 10

11 Correct Calculations? The ADP of the eligible HCEs cannot exceed the greater of: 1.25 times the ADP of the eligible NHCEs, or The lesser of: 2 times the ADP of the eligible NHCEs, or 2 plus the ADP of the eligible NHCEs ADP of NHCEs Up to 2% Applicable Test 2x 2% to 8% 2+ 8% or more 1.25 Failed ADP Test Participant Compensation Deferrals ADP Amy (HCE) $250,000 $15, % Bill (HCE) $150,000 $10, % Carl (HCE) $130,000 $6, % HCE ADP 6.00% Dee (NHCE) $70,000 $4, % Elli (NHCE) $40,000 $ % Fred (NHCE) $10,000 $0 0.00% NHCE ADP 3.00% % Fail 2x or % 11

12 Apply Testing Strategies Otherwise excludable employee testing Alternative definition of compensation Amendment Change in testing method Change in HCE definition Otherwise Excludable Employees Available to plans that allow employees to become participants sooner than the statutory one year of service/age 21 eligibility requirements Such plans may be treated as comprising separate plans for ADP testing ( permissive disaggregation ): Statutory YOS/Age Lesser YOS/Age 12

13 Otherwise Excludable Employees Eligible Employees Otherwise excludable employees plan Employees who have attained the plan s lower age/service requirements but not age 21 and one year of service Statutory employees plan Employees who have attained age 21 and one year of service 401(k) Plan ADP Test Statutory Employees ADP Test Otherwise Excludable Example Otherwise Excludable Employees KLM Company 401(k) Plan 3-month eligibility YOS? Compensation Deferral ADR HCE 1 Yes $225,000 $18, % HCE ADP 8.00% NHCE 1 Yes $ 75,000 $ 3, % NHCE 2 Yes $ 40,000 $ 2, % NHCE 3 No $ 25,000 $ % NHCE 4 No $ 20,000 $ % NHCE 5 No $ 15,000 $ % NHCE ADP 3.00% % FAIL 2x or % 13

14 Example Otherwise Excludable Employees Plan 1 Statutory Employees YOS? Compensation Deferral ADR HCE 1 Yes $225,000 $18, % HCE ADP 8.00% NHCE 1 Yes $ 75,000 $ 3, % NHCE 2 Yes $ 40,000 $ 2, % NHCE ADP 6.00% % PASS 2x or % Example Otherwise Excludable Employees Plan 2 Otherwise Excludable Employees YOS? Compensation Deferral ADR HCE ADP 0.00% NHCE 3 No $ 25,000 $ % NHCE 4 No $ 20,000 $ % NHCE 5 No $ 15,000 $ % NHCE ADP 1.00% NO HCEs AUTOMATIC PASS!! % 2x or % 14

15 Consequences of Disaggregation Relationship of the nondiscrimination rules to IRC 410(b) minimum coverage rules Requirements designed to work together Nondiscrimination rules use the definition of plan used for coverage and visa versa After application of disaggregation Coverage Plan Nondiscrimination Plan Otherwise Excludable Employees Each plan must pass the ADP test and the minimum coverage test 401(k) Plan Statutory Employees Otherwise Excludable Employees Coverage Test ADP Test Coverage Test ADP Test 15

16 Early Participation Rule Alternative permissive aggregation single ADP test Eligible Employees Employees who have attained age 21 and one year of service, and HCEs who have satisfied the plan s lower age/service requirements but not age 21 or one year of service Does not apply to the minimum coverage test 401(k) Plan ADP Test Statutory EEs + HCE Otherwise Excludable No ADP Test NHCE Otherwise Excludable Early Participation Rule: Single ADP Test Statutory Employees Coverage Test 401(k) Plan ADP Test (Statutory ADP test + HCE Otherwise Excl) Otherwise Excludable Employees Coverage Test 16

17 Example Early Participation Rule KLM Company 401(k) Plan 3-month eligibility YOS? Compensation Deferral ADR HCE 1 Yes $225,000 $18, % HCE 2 No $ 50,000 $ 3, % HCE ADP 7.00% NHCE 1 Yes $ 75,000 $ 3, % NHCE 2 Yes $ 40,000 $ 2, % NHCE 3 No $ 25,000 $ % NHCE 4 No $ 20,000 $ % NHCE 5 No $ 15,000 $ % NHCE ADP 3.00% % FAIL 2x or % Example Early Participation Rule NHCEs 3, 4 & 5 are otherwise excludable employees not tested YOS? Compensation Deferral ADR HCE 1 Yes $225,000 $18, % HCE 2 No $ 50,000 $ 3, % HCE ADP 7.00% NHCE 1 Yes $ 75,000 $ 3, % NHCE 2 Yes $ 40,000 $ 2, % NHCE ADP 6.00% % PASS 2x or % 17

18 Permissive Disaggregation Optional It s an elective disaggregation rule, not mandatory Operational Written election is not required Decision made on a year-by-year basis Permissive Disaggregation Impact of prior year testing method Year-to-year election could trigger a plan coverage change Special weighted-average calculation of prior year NHCE % 2016 Disaggregation 2015 None Disaggregation

19 Alternative Definition of Compensation Compensation used for ADP testing must satisfy the nondiscriminatory definition of compensation under IRC 414(s) Safe harbor definitions are deemed to satisfy 414(s) Other compensation definitions must be reasonable and satisfy the compensation ratio test The document may provide a specific definition or permit any definition allowed under 414(s) Different definitions of 414(s) compensation may be used each year Alternative Definition of Compensation 414(s) safe harbor definitions 415 compensation General definition Simplified definition W-2 compensation 3401 compensation 415 compensation excluding all elective deferrals 415 compensation excluding all fringe benefits 415 compensation excluding all elective deferrals and all fringe benefits Any modification to a safe harbor that affects only HCEs 19

20 Alternative Definition of Compensation 415 compensation excluding all elective deferrals Example: 415 compensation = $50, (k) plan deferrals = $4,000 Cafeteria plan deferrals = $1,000 ADR with total compensation = $4,000 $50,000 = 8.00% ADR with net compensation = $4,000 $45,000 = 8.89% Consistent definition must be used in prior year testing Example Alternative Definition of Compensation 2017 calendar year plan using W-2 wages W-2 Wages Deferral ADR HCE 1 $300,000* $18, % HCE ADP 6.67% NHCE 1 $ 50,000 $ 4, % NHCE 2 $ 30,000 $ % NHCE ADP 4.50% % FAIL 2x or % * Limited to $270,000 under IRC 401(a)(17) 20

21 Example Alternative Definition of Compensation ADP test using net compensation (assumes only 401(k) deferrals) Net Compensation Deferral ADR HCE 1 $300,000* $18, % HCE ADP 6.67% NHCE 1 $ 45,500 $ 4, % NHCE 2 $ 30,000 $ % NHCE ADP 4.95% % PASS 2x or % * $300,000 - $18,000 = $282,000, limited to $270,000 under IRC 401(a)(17) Alternative Definition of Compensation Measurement year Plan year or period of eligibility for new participants Example: Calendar year plan Participant s entry date = October 1st Elective deferrals = $250 Plan year compensation = $20,000 ADR = $250 $20,000 = 1.25% Compensation from entry date = $5,000 ADR = $250 $5,000 = 5.00% Net compensation from entry date = $4,750 ADR = $250 $4,750 = 5.26% 21

22 Switch Testing Methods Prior year testing current year testing Allowed without prior IRS approval Current year testing prior year testing Not allowed unless the plan has used the current year testing method for the lesser of: 5 years, or The number of years the plan has been in existence A plan amendment is required to switch testing methods Timing by the last day of the plan year in which the amendment is effective Change Definition of HCEs Optional HCE elections Lookback year Use calendar year beginning in the 12-month period preceding the current plan year Top paid group Employees with compensation greater than the dollar limit and part of top paid group Top 20% of employees ranked in order of descending compensation for the lookback year A plan amendment is required to change elections Timing by the end of the plan year; ideally before the beginning of the plan year 22

23 Correcting ADP Test Failures Options: Distribute excess contributions Recharacterize excess contributions as Catch-up contributions After-tax employee contributions Make QNECs/QMACs Timing within 12 months after the end of the plan year Corrective Distributions Excess contribution amount Calculated using the leveling method: Step 1 Determine the total dollar amount to be refunded Step 2 Allocate the total refund among HCEs 23

24 Failed ADP Test Participant Compensation Deferrals ADP Amy (HCE) $250,000 $15, % Bill (HCE) $150,000 $10, % Carl (HCE) $130,000 $6, % HCE ADP 6.00% Dee (NHCE) $70,000 $4, % Elli (NHCE) $40,000 $ % Fred (NHCE) $10,000 $0 0.00% NHCE ADP 3.00% % Fail 2x or % Corrective Distributions Step 1 Determine the total amount of excess contributions to correct the failed ADP test The ADR of the HCE with the highest ADR is reduced by the amount required to bring that HCE s ADR down to the next highest HCE s ADR This step is repeated until the total ADP of the HCEs is reduced to the highest permitted ADP under the plan This process determines the total amount of the excess contributions that must be distributed, but does not identify the HCEs who will receive the refund 24

25 Example Corrective Distributions Step 1 Determine the total amount of excess contributions to correct the failed ADP test Participant Comp Deferral ADR 1 st Adjust Adjust ADR Amy (HCE) $250,000 $15,000 6% 6% Bill (HCE) $150,000 $10,500 7% $150,000 x 1% = $1,500 6% 2 nd Adjust $250,000 x 1% = $2,500 $150,000 x 1% = $1,500 Adjust ADR Excess Amount 5% $2,500 5% $3,000 Carl (HCE) $130,000 $6,500 5% 5% 5% $0 Total 6% 5.67% 5% $5,500 Corrective Distributions Step 2: Allocate the total amount of excess contributions among the HCEs with the highest deferral amount The deferral of the HCE with the highest deferral amount is reduced to the amount required to bring that HCE s deferral amount down to the next highest HCE s deferral amount This step is repeated until the total amount of excess contributions that must be distributed (from step 1) has been allocated 25

26 Example Corrective Distributions Step 2: Allocate the total amount of excess contributions among the HCEs with the highest deferral amount Participant Comp Deferral Adjusted Deferral Amount Amy (HCE) $250,000 $15,000 Bill (HCE) $150,000 $10,500 Amount after 1 st adjustment = $10,500 Amount after 2 nd adjustment = $10,000 Amount after 1 st adjustment = $10,500 Amount after 2 nd adjustment = $10,000 Apportioned Excess $5,000 $500 Carl (HCE) $130,000 $6,500 No adjustments $0 Corrective Distributions Must include attributable earnings Any reasonable method can be used if it (i) does not violate IRC 401(a)(4), (ii) is used consistently for all participants and all corrective distributions under the plan, and (iii) is used to allocate income to participant s accounts The following alternative formula is specified in the regulations Earnings attributable to elective deferrals for the plan year Requirement applies to plan year earnings x Excess contributions for the plan year Balance attributable to elective deferrals 26

27 Corrective Distributions Taxation Taxed in year of distribution Not subject to 10% early distribution tax Voluntary 10% tax withholding Corrective Distributions Timing Plan Year Tested: 12/31/2016 Statutory correction period (12 months) If correction occurs by 3/15/2017* If correction occurs after 3/15/2017* but on or before 12/31/2017 If correction occurs after 12/31/2017 1/01/2017 to 12/31/2017 No further action required Employer is required to file a Form 5330 and pay a 10% excise tax on the excess May use EPCRS to correct * The 2½ month time frame is extended to 6 months for EACAs (6/30/2017 for 2016 calendar plan years) 27

28 Corrective Distributions Administrative matters Source/ordering of distributions Forfeit related match No spousal consent required Not eligible for rollover Report on Form 1099-R Fail ADP after total distribution Recharacterize Excess Contributions As catch-ups Must be 50 or older by the end of the calendar year Deferrals are classified as catch-up contribution when Plan limit is exceeded, or Statutory limit is exceeded ( 402(g), 415, ADP test) Optional provision; document will state if permitted 2017 catch-up limit = $6,000 Example: Amy (age 52): $5,000 excess contribution catch-up Bill (age 44): $500 excess contribution distributed 28

29 Recharacterize Excess Contributions As after-tax employee contributions Optional provision; document will state if permitted Must include in the ACP test Not commonly used as a correction method QNECs/QMACs Contributions to NHCEs to increase ADRs Must be 100% vested Subject to elective deferral withdrawal restrictions Contribution formula/allocation conditions specified in document Targeted or uniform percentage/dollar amount Minimum hours/last day requirement options Example: NHCE Comp Deferral 1% QNEC Total Contrib Adjusted ADR Dee $70,000 $4,900 $700 $5,600 8% Elli $40,000 $800 $400 $1,200 3% Fred $10,000 $0 $100 $100 1% Total $1,200 NHCE ADP 4% 29

30 QNECs/QMACs Must be made by the end of the 12-month period following the plan year Problematic with prior year testing May be funded by forfeitures, if allowed in document Cannot be used in both the ADP and ACP tests QMAC shifting option Portion of QMAC not needed to pass the ACP can be shifted to NHCEs ADR for ADP testing purposes Shifting QMAC to ADP Test Requirements Shifted QMAC cannot be included in the ACP test Cannot shift a QMAC if it would be excluded from ACP test because it is disproportionate QMAC must be deposited within 12 months of the end of the plan year Uniform testing method for ADP and ACP test 30

31 Example Shifting: QMAC to ADP Test HCE NHCE ADP fail 8.00% 5.00% ACP* pass 3.00% 2.50% Shift 1% of QMAC in ACP to ADP HCE NHCE ADP pass 8.00% 6.00% ACP* pass 3.00% 1.50% * Assume only match are QMACs EPCRS Correction After 12-Month Period Timing Plan Year Tested: 12/31/2016 Statutory correction period (12 months) If correction occurs between 1/01/2018 and 12/31/2019 If correction occurs after 12/31/2019 1/01/2017 to 12/31/2017 May use SCP or VCP to correct mistakes determined to be insignificant or significant May only use SCP to correct mistakes determined to be insignificant May use VCP to correct both insignificant and significant mistakes 31

32 EPCRS Correction Options Method 1 Increase ADP of NHCEs so test passes Requires a QNEC to all eligible NHCEs Same percentage for each NHCE Method 2 One-to-one method Corrective distribution of excess contributions (and earnings), and QNEC of that same dollar amount allocated to all eligible NHCEs Example: Method 1 Increase ADP of NHCEs 1% QNEC of $1,200 allocated to Dee, Elli and Fred or Method 2 One-to-One Method $500 (plus earnings) corrective distribution to Bill, and $500 (plus earnings) QNEC allocated to Dee, Elli and Fred Failed ACP Test Participant Compensation Match ACP Amy (HCE) $250,000 $3, % Bill (HCE) $150,000 $2, % Carl (HCE) $130,000 $1, % HCE ACP 1.50% Dee (NHCE) $70,000 $1, % Elli (NHCE) $40,000 $0 0.00% Fred (NHCE) $10,000 $0 0.00% NHCE ACP 0.50% % Fail 2x or % 32

33 Failed ACP Test Test performed correctly? Apply testing strategies Take corrective action Performing the ACP Test Identify eligible employees. Classify HCEs and NHCEs. Calculate each participant's ACR. Determine the HCE ACP and the NHCE ACP. Perform the numerical ACP test. 33

34 Correct Employees Included? Eligible employees Eligible to make after-tax employee contributions Eligible to receive matching contributions Satisfy allocation conditions (hours/last day) Example: Last day employment required for match Active participant who deferred/didn t defer = included in the ACP test Terminated participant who deferred/didn t defer = not included in the ACP test Correct HCEs/NHCEs Identified? See ADP test discussion 34

35 Correct Contributions Tested? Individual ACR = contributions compensation Contributions included: Matching contributions Forfeitures allocated as a match QNECs/QMACs not used to pass ADP test After-tax employee contributions Contributions excluded: Forfeited matching contributions attributed to excess contributions NHCE disproportionate matching contributions Rollover contributions Loan repayments Correct Compensation Used? See ADP test discussion 35

36 Correct Testing Method Applied? See ADP test discussion Note: The ACP testing method is not required to be the same as the ADP testing method Correct Calculations? ACP of the NHCEs Average of NHCE ACRs ACP of the HCEs Average of HCE ACRs Include employees eligible to receive the match but who don t Example: NHCE #1 ACR = 0% NHCE #2 ACR = 3% Average = (0% + 3%) 2 NHCEs = 1.50% NHCE ACP = 1.50% 36

37 Correct Calculations? The ACP of the eligible HCEs cannot exceed the greater of: 1.25 times the ACP of the eligible NHCEs, or The lesser of: 2 times the ACP of the eligible NHCEs, or 2 plus the ACP of the eligible NHCEs ACP of NHCEs Up to 2% Applicable Test 2x 2% to 8% 2+ 8% or more 1.25 Passing ACP Test Participant Compensation Match ACP Amy (HCE) $250,000 $3, % Bill (HCE) $150,000 $2, % Carl (HCE) $130,000 $1, % HCE ACP 1.50% Dee (NHCE) $70,000 $1, % Elli (NHCE) $40,000 $ % Fred (NHCE) $10,000 $0 0.00% NHCE ACP 0.83% % Pass 2x or % 37

38 Applying Testing Strategies Otherwise excludable employee testing Alternative definition of compensation Amendment Change in testing method Change in HCE definition Same methodology as for the ADP test Correcting ACP Test Failures Options Distribute excess aggregate contributions Make QNECs/QMACs Shift deferrals from ADP test to ACP test Timing within 12 months after the end of the plan year 38

39 Corrective Distributions Calculation of excess aggregate contribution Use 2-step leveling method (see ADP test correction) Partially vested match Distribute vested portion of excess Forfeit non-vested portion of excess Must include attributable earnings Timing 12-month period, 2½ month deadline Taxed in year distributed, report on Form 1099-R No spousal consent required, no rollovers QNECs/QMACs Contributions to NHCEs to increase ACRs Must be 100% vested Subject to elective deferral withdrawal restrictions Contribution formula/allocation conditions specified in document Targeted or uniform percentage/dollar amount Minimum hours/last day requirement options Timing 12-month period following the plan year May be funded by forfeitures, if allowed in the document Cannot be used in both the ADP and ACP tests 39

40 Shifting Elective Deferrals Elective deferrals may be shifted from the ADP test to the ACP test if: The ADP test is satisfied with all deferrals, including those shifted; The ADP test is satisfied with non-shifted deferrals only; and Both the ADP test and ACP test use the same testing method Example Shifting: Elective Deferrals to ACP Test HCE NHCE ADP pass* 8.00% 6.00% ACP fail 3.00% 1.00% Shift 4% of deferrals in ADP to ACP HCE NHCE ADP pass* 4.00% 2.00% ACP pass 7.00% 5.00% * ADP test passes before and after deferrals are shifted, as required 40

41 Check the Plan Document Eligible employees HCE definition 414(s) compensation definition Prior or current year testing method ADP/ACP testing procedures ADP/ACP correction options Source/ordering of distributions Attributable earnings Catch-up contributions permitted After-tax employee contributions permitted QNEC/QMAC formulas/conditions Matching contribution allocation conditions 2017 NAFE Session # 401(k) Plan Testing 201 For more information, please contact: Kimberly B. Martin, APA, CPC, QPA kmartin@nipa.org Phone (904)