ePlan’s Guide to 401(k) Compliance Testing

Does your company’s 401(k) plan benefit all employees equally or have you noticed that Highly-Compensated Employees (HCEs) employees are ahead of the game? This is where compliance testing comes in.

Plan administrators must review and resolve annual compliance, or nondiscrimination, testing to ensure that the company is fairly administering its 401(k) plan under the Employment Retirement Income Security Act (ERISA) rules.

Most 401(k) plans are required to pass certain IRS-mandated nondiscrimination tests to confirm Highly-Compensated Employees (HCEs) do not disproportionately benefit and no IRS contribution limits are exceeded.

If your company’s 401(k) plan fails any of the necessary compliance tests, you, the plan administrator, is responsible for taking corrective action to bring the plan back into compliance before the required IRS deadlines to avoid potential plan disqualification.

What is Compliance Testing?

Each year, qualified employer 401(k) plans must undergo various compliance tests including an:

• Annual deferral limit (ADR) test
• Annual additions limit (ADL) test
• Actual deferral percentage (ADP) test
• Actual contribution percentage (ACP) test
• Top-heavy test
  Read on for further information regarding these tests.

Who qualifies as a highly compensated employee?

For the 2023 compliance testing plan year, the IRS defines a highly compensated employee (HCE) as an employee who earns more than $135,000 a year (2022) from the company, who owns more than 5% of the business’ interest during the testing period, or an employee of the company who is a family member of a greater than five percent stockholder/owner.

Note that the compensation limit will be $150,000 (2023) for the 2024 compliance testing plan year.

Types of Compliance Tests

Annual Deferral Limit (ADL) Test:

The Annual Deferral Limit Test reviews the total amount of plan deferrals for each employee during the calendar year; it also determines if any of the plan participants have exceeded the maximum deferral limit.

If the limit has not been exceeded, then no further action is required; however, if the employee has exceeded the limit, the employer must distribute the excess deferrals with earnings to the employee as taxable income. For the 2023 plan year, an eligible employee is permitted to defer up to $22,500 or 100% of their annual compensation, whichever is less. Any matching contributions associated with the excess deferrals will be forfeited to the plan.

Annual Additions Limit (AAL) Test:

There is a limit to the total contributions that a plan participant can accumulate in one plan year. The total amount is the sum of all contribution types including deferrals, employer matching, profit sharing and allocated forfeitures. For the 2023 plan year, the final amount must be no greater than $66,000 or 100% of the participant’s income, whichever is less.

Actual Deferral Percentage (ADP) Test:

The Actual Deferral Percentage Test compares the contributions of both highly compensated employees and non-highly compensated employees. This test seeks to ensure that HCEs do not contribute a larger amount to their plans than non-HCEs. In order for the test to pass, the ADP of the HCE group must not exceed the greater of:

• 1.25 times the ADP of the NHCE group or the lessor of
  • 2 plus ADP of NHCE group and
  • 2 times the ADP of the NHCE group.This compliance test takes average contributions from both groups and produces an actual deferral ratio (ADR). The employer plan passes the test if the amount for HCEs does not exceed that of non-highly compensated employees, (NHCEs).

Actual Contribution Percentage (ACP) Test

The Actual Contribution Percentage Test is like the ADP test, but it reviews the employer matching contributions rather than employee deferrals. In order for the test to pass, the ACP of the HCE group must not exceed the greater of:

• 1.25 times the ACP of the NHCE group or the lessor of
  • 2 plus ACP of NHCE group and
  • 2 times the ACP of the NHCE group.

Companies pass the ACP test if their matching contribution percentage to highly compensated employees does not exceed the matching contribution percentage to non-highly compensated employees. If they pass the test, no further action needs to be taken.

Top-Heavy Test

The Top-Heavy Test reviews the retirement accounts of key employees. For the 2023 compliance testing plan year, key employees are defined as officers earning over $200,000 (2022), greater than 5% owners of the business, or employees owning more than 1% of the company and making over $150,000 per year. For the 2024 compliance testing limit, employees must make over $215,000 (2023) to be considered key employees.

After compliance testing, the plan is said to be top-heavy when the total value of retirement plan accounts for key employees exceeds 60% of total plan assets. If the plan is determined to be top-heavy, employers must make a minimum contribution of up to 3% of compensation to all non-key employees in the interest of plan fairness.

What if I fail compliance testing?

If an employer-sponsored plan fails compliance testing, the IRS will provide an opportunity to correct the issues, whether it’s refunding highly compensated employees, making qualified non-elective employee contributions, or a combination of both.

How can I stay compliant?

If the compliance testing process seems like a challenge, there is one way that you can ensure your plan stays compliant. A Safe Harbor 401(k) lets you skip many of the compliance tests that are necessary for most 401(k) retirement plans. For more information on the compliance testing process visit the ePlan Help Center or email admin@eplanservices.com.

This content is for educational purposes only, is not intended to provide specific legal or financial advice, and should not be used as a substitute for the legal advice of a qualified attorney or financial professional. The information may not reflect the most current legal developments, may be changed without notice and is not guaranteed to be complete, correct, or up-to-date.