401K PLAN SAFE HARBOR PLAN RULES
In order to avoid having to perform cumbersome annual testing for your 401(k) qualified retirement plan, including the complicating and uncertain ADP and ACP testing rules, in order to determine eligible contributions for all plan participants, the 401(k) plan safe harbor rules were established.
1. Nondiscrimination Testing
401(k) Plan are subject to ERISA law in order to ensure that highly compensated employees (HCEs) or key employees do not receive or have available greater benefits than are available to lower paid workers. This is why ERISA has included certain compliance tests in order to compare benefits paid to lower paid employees to the HCEs or key employees.
The compliance test are the following:
- General Nondiscrimination Test (IRC 401(a)(4) (ADP & ACP)
- The Minimum Coverage Tests (IRC 401(b))
- Top Heavy Test (IRC 416)
- 402(g) limit test (i.e. employee deferral limit - $18,500 for 2018 - $24,500 if over 50)
- 415 limits (i.e. $55,000 for 2018 - $61,000 for those over 50)
2. The Minimum Coverage Tests (IRC 401(b))
I n any Plan Year, the plan must pass one of two coverage tests, either the ratio percentage test or the average benefit test. For the ratio percentage test, if 100% of the highly compensated employees are given a benefit, the plan is required to provide contributions for at least 70% of the non-highly compensated employees. If less than 100% of the highly compensated employees receive a contribution, the plan must give a contribution to at least as many non-highly compensated employees as 70% of the percentage of highly compensated employees who were given a contribution. In order to meet this requirement, contributions may have to be made for employees who do not meet the hours requirement or who terminated their employment during the plan year, even though the plan states an employee must work a certain number of hour or work for you on the last day of the plan year in order to receive a contribution. If the plan does not meet the ratio percentage test, it must be tested under the average benefit test. Under this test, the employer must meet two separate non-discrimination tests. The plan must benefit a class of employees the IRS finds not to be discriminatory in favor of highly compensated employees. Second, the average benefit percentage of the non-highly compensated employees must be at least 70% of the average benefit percentage of the highly compensated employees.
General Nondiscrimination Test (IRC 401(a)(4)
What is ADP and ACP Testing?
More commonly known as the non discriminatory tests associated with 401k plans -- the ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) tests compare the average of salary deferral and employer match percentages for highly compensated employees (HCE) to the average of salary deferral and employer match percentages for non-highly compensated employees (NHCE).
The ADP test counts elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of the HCEs and NHCEs. Dividing a participant’s elective deferrals by the participant’s compensation gives you that participant’s Actual Deferral Ratio. The average ADR for all NHCEs (even those who chose not to defer) is the ADP for the NHCE group. Do the same for the HCEs to determine their ADP. Calculate the ACP in the same manner, instead using the matching and after-tax contributions for each participant, divided by the participant's compensation.
In other words ADP looks at employee deferrals/compensation and the ACP looks at after-tax contributions & matching contributions/compensation.
Salary deferrals and matching contributions made on behalf of highly compensated employees may not exceed a specific ratio of the salary deferrals and matching contributions made on the behalf of non-highly compensated employees. The ADP and ACP tests are performed to ensure the highly compensated employees do not derive more of a benefit from a qualified plan than non-highly compensated employees.
The ratios are determined by first calculating the salary deferral % and the matching contribution % of each highly compensated employee and then totaling those calculated percentages for the entire highly compensated group (HC Group). This total is divided by the number of members of the group to obtain an average deferral percentage (ADP) or average contribution percentage (ACP). The same calculations are made for each non-highly compensated employee. The total of these calculated percentages is divided by the number of members in the non-highly compensated group (NHC Group).
The ADP test is met if the ADP for the eligible HCEs doesn't exceed the greater of:
- 125% of the ADP for the group of NHCEs, or
- the lesser of:
- 200% of the ADP for the group of NHCEs, or
- the ADP for the NHCEs plus 2%.
The ACP test is met if the ACP for the eligible HCEs doesn't exceed the greater of:
- 125% of the ACP for the group of NHCEs, or
- the lesser of:
- 200% of the ACP for the group of NHCEs, or
- the ACP for the NHCEs plus 2%.
Or said another way:
The deferral or matching contribution % for highly compensated employees may not exceed the following ratio:
If NHCE % is
Maximum HCE % is
2 Times NHCE ADP % / ACP %
2% to 8%
2% More Than NHCE ADP % / ACP %
1.25 Times NHCE ADP % / ACP %
NCHE for ABC Inc
Average Deferral Percentage - 13% Divided by # of NCHE -3 = 4.33
HCE ADP/ACP - 8.91%
NHCE ADP/ACP% - 7.67%
The Plan uses the current year testing method. Therefore the maximum ADP for the HCEs is determined as follows:
7.67% (NHCE ADP) x 2 = 15.34%
7.67% (NHCE ADP) + 2% = 9.67%
The maximum ADP for the HCEs is the lesser of the two percentages, or 9.67%
Since the HCE ADP was 8.91%, the Plan passes this required test
The calculations for the ACP test are done in the same manner as the ADP test
Therefore the maximum ACP for the HCEs is determined as follows:
2% (NHCE ADP) x 2 = 4%
2% (NHCE ADP) + 2% = 4%
The maximum ACP for the HCEs is the lesser of the two percentages, or 4%
Since the HCE ACP was 2%, the Plan passes this required test
3. Top Heavy Test
Under IRC 416 top heavy test, a plan is deemed to be top-heavy if more than 60% of plan assets are in the account of key employees.
-A Key employee is:
- An officer having annual compensation greater than $160,000 for 2010
- a greater than 5 percent owner
- a greater than one-percent owner of the company with compensation above $150,000.
The top heavy test is done annually as of the last day or the prior plan year.
ABC has 3 employees, all participate in the plan. On 12/31, ABC has gathered the following info:
Key employees: Eric - $68,000 account balance
Non-Key employees: Joe - $25,000 & Ben $7,000
To determine whether the plan is top heavy, ABC has to divide the value of the aggregate account balances of the key employees by the value of all the account balance. So, ABC has 68% of its assets in key employees accounts. Because Eric is a key employee and his account is over 60% of assets, the plan is top heavy.
What happens if plan is Top-Heavy?
If plan is top heavy, vesting may not exceed 6 years and the employer generally must make a 3% minimum contribution for non-key employees who contribute.
4. Get Around ADP and ACP Testing - The Safe Harbor Plan
If you want to avoid getting headaches and seasickness due to your 401(k) plan’s testing failures each year and subsequent corrections, consider adopting a safe-harbor design.
Starting in 1999 a new twist on the traditional 401(k) plan is available for plan sponsors, the "Safe Harbor 401(k) Plan". This twist on the traditional 401(k) plan promises to be a simpler plan to administer. If an employer adopted this type of 401(k) plan there would be no need to worry about the ADP/ACP testing at the end of each year, and; in some cases, no need to make Top Heavy contributions (since 2002 – safe harbor plans satisfy top heavy requirements). All this in exchange for a commitment to make a minimum level of contributions that many sponsors make anyway.
1. ADP Safe Harbor
Employers are not required to satisfy the ADP test if the plan meets of one of the following safe harbors:
ADP Safe Harbor #1
The employer must make a matching contribution for each non-HCE equal to:
- 100% of the employees elective deferrals that do not exceed 3% of the employee’s compensation, and
- 50% of the employee’s elective deferrals from 3-5 of compensation
Alternative to ADP Safe Harbor #1
There is an alternative to satisfying the ADP Safe Harbor #1, The meet the alternative test, one can use a different formula, but the outcome in total matching dollars must be the same of greater then under the ADP Safe Harbor #1 test. The most common formula that meets this safe harbor is a dollar-for-dollar match on an employee’s deferral that do not exceed 4% of compensation.
ADP Safe Harbor #2
An employer can satisfy this safe harbor by making a non-elective contribution of at least 3% of each eligible non HCE compensation, regardless of whether the employee elects to defer
2. ACP Safe Harbor
Employers are not required to conduct or satisfy ACP testing if they satisfy one of the ADP safe harbors described above, and if they meet all the following conditions:
-No employee contributions or elective deferrals in excess of 6% of compensation are matched
- The level of the employer’s matching contributions does not increase as an employee contribution or elective deferrals increase
- The match of any HCE does not exceed the match for a non-HCE at the same level of employee contribution
3. QACA ADP/ACP Safe Harbor
Beginning in 2008, employers have one more means to avoid the ADP and ACP testing through the QACA feature. If the plan meets the specific requirements for the QACA, the plan is exempt from ADP and ACP testing. Also, the plan would be exempt from top-heavy testing.
A QACA requires minimum levels of automatic deferrals, mandatory employer contributions, and additional notice requirements.
Automatic Contribution Arrangement
An automatic contribution arrangement is a retirement plan enrollment feature that allows an employer to automatically reduce an eligible employee’s pay by a default; percentage stated in the plan unless the employee affirmatively chooses not to contribute a different amount. Employers must notify employees of this option and must give employees the opportunity to make a deferral rate change or stop deferrals.
There are two types of automatic contribution arrangements: Eligible Automatic contribution arrangements (EACAs) and qualified automatic contribution arrangements (QACAs)
- An EACA, available for plan years beginning after 2007, is a type of automatic contribution arrangement that must uniformly apply the plan’s default percentage to all employees after providing them with a required notice. It may allow employees to withdraw automatic enrollment contributions (and earnings thereon) by making a withdrawal election as required by the terms of the plan (no earlier than 30 days or later than 90 days after the employee’s first automatic enrollment contribution was withheld from the employee’s wages). Employees are 100% vested in their automatic enrollment contributions.
- A QACA is available for 401(k) plans for years beginning after 2007. It is an automatic contribution arrangement with special “safe harbor” provisions” that exempt the 401(k) plan from annual ADP and ACP nondiscrimination testing requirements. A QACA must specify a schedule of uniform minimum default percentages starting at 3% and gradually increasing with each year that an employee participates. Under a QACA, an employer must make a minimum of either:
a) a matching contribution of 100% of an employee’s contribution up to 1% of compensation, and a 50% matching contribution for the employee’s contributions above 1% of compensation and up to 6% of compensation; or
b) a non-elective contribution of 3% of compensation to all participants, including those who choose not to contribute any amount to the plan.To learn more about the advantages of establishing a safe harbor 401(k) qualified retirement plan, please contact a tax specialist at 800-401-5762.