I. Introduction-Historical Background

401k plans were created by the government to allow persons, especially middle- and lower-income persons, to save for retirement. The government is particularly concerned that 401k plans not favor highly compensatedemployees(HCEs) over non-highly compensated employees(NHCEs), and established nondiscrimination and plan compliance rules to promote fairness.

A highly compensated employee (HCE) is defined as an employee who is a member of either of two groups:

• A 5% (or more) owner (or spouse, parent, child, grandparent), or holder of vested options representing 5% or more of the business any time during the year or preceding year.
• An employee who earned more than $110,000 in gross W2 compensation (indexed) during the previous year. To reduce the number of HCEs the employer may elect to consider only the employees earning more than $110,000 in gross W2 compensation and are in the top 20% of all eligible employees ranked by gross W-2 compensation. A newly hired employee (who is not a 5% owner) who would otherwise be considered a HCE is de facto not an HCE in year of hire because no compensation was paid to this new hire in the preceding “look back” year. For compliance testing, gross W2 compensation must include all pre-tax contributions to qualified plans.

A non-highly compensated employee(NHCE) is any employee eligible to join the plan who does not meet the definition of a highly compensated employee (HCE)

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 2011 the limit is $245,000.

II. Minimum Coverage Requirement

The minimum coverage rules require the employer make the plan available to a cross-section of employees. A 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.

Example: 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 which originally were not eligible and therefore were not benefiting employees, and proving them with an employer contribution.

III. Non-discrimination 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.

A highly compensated employee (HCE) is defined as an employee who is a member of either of two groups:

• A 5% (or more) owner (or spouse, parent, child, grandparent), or holder of vested options representing 5% or more of the business any time during the year or preceding year.
• An employee who earned more than $110,000 in gross W2 compensation (indexed) during the previous year. To reduce the number of HCEs the employer may elect to consider only the employees earning more than $110,000 in gross W2 compensation and are in the top 20% of all eligible employees ranked by gross W-2 compensation. A newly hired employee (who is not a 5% owner) who would otherwise be considered a HCE is de facto not an HCE in year of hire because no compensation was paid to this new hire in the preceding “look back” year. For compliance testing, gross W2 compensation must include all pre-tax contributions to qualified plans.

An employer who maintains one or more plans on a fiscal year basis may use calendar year data in order to simplify determining who are a HCE and NHCE. At the employer’s election, employees excludable from compliance testing can include: employees with less than 6 months employment, employees who work less than 17.5 hours per week, employees who work fewer than 6 months per year, union members, employees not yet 21years old, and nonresident aliens.

Special catch-up contributions by employees over 50 years of age are excludable from the ADP Test. For purposes of determining the group of highly compensated employees, corporations that are members of a controlled group, or businesses under common control are treated as a single employer.

A non-highly compensated employee (NHCE) is any employee eligible to join the plan who does not meet the definition of a highly compensated employee (HCE). 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. The safe harbor option is described in Section VI.)

The amount of salary deferrals that the 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.

The User can run the ADP test and ACP test as often as required to see the results any time during the plan year. If a problematic trend develops, the User 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 the Users’ plan.

Actual Deferral Percentage (ADP) Test

Any eligible employee can contribute up to the maximum amount allowable by law per year ($16,500 in 2011), 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 ADP test passes if the ADP for the eligible 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 deferrals (including before-tax and Roth deferrals) contributions made during the plan year by his or her gross compensation for the plan year. An employee who is eligible to join the plan but chooses not to defer a portion of salary is included in the calculation with an ADR of zero.

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 NHCE pre-tax contribution is 4%. Consider the calculations below:

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

Test Result: Test fails because the average contribution percentage of the HCE exceeds 6%.

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 NHCE 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:

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 because the average contribution percentage of the HCE exceeds 6%.

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 2½ months of the year-end.

Actual Contribution Percentage (ACP) Test

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. 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.

Employer contributions (QNECs and QMACs) must be 100% fully vested to be included in the ACP Test calculations. The ACP Test can also be used to check compliance of 401(m) plans. 401(m) plans are combination employee contribution/employer matching contribution plans

Top Heavy Test

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%.

A "key employee" is a more than five (5%) percent owner (or spouse, parent, child, grandparent), an employee (or relation or former employee) who is an officer earning compensation in excess of $160,000 (indexed), or a one (1%) percent owner earning in excess of $160,000 (indexed).

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.
• 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 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.

IV. Using The Plan Administration Software to Run Compliance Tests

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

• ACP compliance test of employer contributions
• ADP compliance test of employee contributions
• Top-heavy test

Test results are based on employees’ actual wage data input by the User, combined with actual participant contribution data. Testing can be performed as frequently as User requires. The capability for frequent ad hoc compliance tests helps User anticipate the year-end results and head off problems.

• ACP Test Results shows the employer 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 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 lists separately for key employees and non-key employees the individual’s name, social security number, and plan assets for that individual and the group as a whole.

V. 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.

Correction BEFORE the End of the Plan Year

Failed ADP/ACP tests can be corrected in either of two ways: one, the sponsor can 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 frequently during the year. 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 the employer can make additional qualified nonelective or matching contributions to the accounts of non-highly compensated employees, or alternatively, 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. The employer can make Qualified Non-Elective Contributions (QNECs) or Qualified Matching Contributions (QMACs) to the NHCEs in any format such that at least one-half of all NHCEs receive the QNEC (or QMAC). In addition, the QNEC (or QMAC) should not exceed 5% of the receiving NHCE’s compensation or two times the plan’s “representative contribution rate.” In addition, the QNEC (or QMAC) cannot exceed twice the QNEC (or QMAC) that other NHCEs receive, when expressed as a percentage of compensation. Such corrective contributions are 100% vested and subject to the same distribution restrictions as salary deferrals.

METHOD 2: Distribution of the Excess
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.

This method of correction relies upon reduction of the contributions of highly compensated employees, starting with the highest dollar amount contributed, until the ADP or ACP reaches the permissible level (“leveling method”). The employee contribution of the HCE who deferred the greatest dollar amount is reduced to equal the next highest HCE contribution based upon dollar amount. This process is repeated until the test passes.

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.

IRS FORM 1099-R
Corrective distributions are reported on Form 1099-R. The gross distribution is reported in Box 1. If distribution is within 2 ½ months use Code P. After 2 ½ months use Distribution Code “8” in Box 7. Distributions within 2 ½ months are not subject to federal income tax or Social Security tax.

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

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.

VI. Option to Plan Testing: The SafeHarbor Method of Plan Administration

There is a safe harbor option that allows an employer to omit compliance 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 2011 to amend its 401k plan to provide the safe harbor contribution and to avoid ADP/ACP testing for 2011. However, the employer must have provided participants with a notice prior to January 1, 2011 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 worked 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 SafeHarbor 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.

VII. 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.