What Happens If You Fail 401(k) Compliance Testing?

The IRS wants 401(k) plans to benefit all employees fairly. To maintain that balance, they require all 401(k) plans to meet certain compliance standards. Therefore, the Employee Retirement Income Security Act of 1974, better known as ERISA, mandates a series of tests called non-discrimination tests in order for the plan to remain in tax-qualified status.

If your company-sponsored 401(k) plan fails non-discrimination testing, don’t worry, you’re not alone. It’s common for businesses to fail testing from time to time. Fortunately, you’ll have a chance to make corrections. The following information will help you understand how to get your plan corrected and keep it compliant.

How non-discrimination testing works

Non-discrimination testing aims to ensure that all employees are contributing a proportionate amount of funds into their accounts.

There are two primary non-discrimination tests:

• Actual Deferral Percentage (ADP): Compares the salary deferrals of HCEs and NHCEs.
• Actual Contribution Percentage (ACP): Compares the employer matching contributions made to HCEs and NHCEs

HCEs and NHCEs are defined as:

• Highly Compensated Employees (HCEs): Owns more than 5% of the business or earned more than a specified amount of compensation in the year preceding the testing year. Most recently, the HCE compensation limit for 2023 testing is based on the 2022 compensation limit of $135,000.
• Non-highly compensated employees (NHCEs): All of the other employees.

The top-heavy test is the third type of test used for plan compliance. This test compares the account balances of Key Employees as compared to Non-Key Employees.

• Key Employees: A key employee is an employee who:
  • Owns more than 5% of the business in the year just completed, or
  • Owns more than 1% of the business in the year just completed, and has annual compensation greater than $150,000, or
  • is an officer of the company and has annual compensation greater than $200,000.
• Non-Key Employees: All of the other employees

Family attribution rules apply to both HCEs and Key employees. If you employ a spouse, child, parent, or grandparent, they will also be considered owners.

What to do if you fail the ADP or ACP tests

Failing the ADP or ACP tests ultimately means that the plan deferral or contribution percentages are imbalanced between highly compensated employees (HCEs) and non-highly compensated employees (NHCEs).

To correct these imbalances, you have two options:

• You can decrease the HCEs’ contributions: This option would involve taking money out of the employee’s 401(k) and giving it back to them as taxable income which would require them to pay more in taxes.
• You can increase the NHCEs contributions: This option means you’ll have to create qualified non-elective contributions to their 401(k) accounts. It won’t create higher taxes for your employees, but it will cost your company money. On the bright side, these non-elective contributions are tax deductible.

What to do if you fail the top-heavy test

Your plan is top-heavy if your key employee balances are more than 60% of plan assets. You can correct this by contributing funds to non-key employees of 3% of their compensation according to IRS regulations.

The 3% top-heavy contribution can be offset by employer matching or profit-sharing contributions. To avoid top-heavy failures in subsequent years, you can limit the contributions (employee contributions, employer match, and profit sharing) of Key Employees, or consider a safe harbor plan design.

The penalty for failure

Fortunately, you do not face penalties for a failed non-discrimination test. However, you will face a penalty if you fail to make corrections to your plan in a timely manner. The deadline for correcting a failed ADP or ACP test is within 12 months of the close of the plan year, so if your plan failed this year, you’d have until December 31st of next year to make your corrections.

Though you technically have until December of the following year, you will be subject to an excise tax of 10% of the required contribution returns if the corrections aren’t made by March 15th of the following plan year.

If you fail to make these corrections, you’ll need to file a form 5330 with the IRS to advise of the failure and remit payment of the excise tax.

The IRS Employee Plans Compliance Resolution System (EPCRS) will provide you with the following options to bring your plan into compliance:

• Self-Correction Program: Allows plan sponsors to make certain corrections to their plan without notifying the IRS or paying a fee.
• Voluntary Correction Program: Allows the plan sponsor to propose a plan correction through written application to the IRS. This is available for many failures but does require a fee. The IRS provides a response regarding the proposed corrections you requested in your submission.

Possible reasons for failing non-discrimination testing

Failing non-discrimination testing could be the result of a few factors:

• Your plan is not accessible to enough of your employees: Ensure your plan enrollment requirements aren’t too strict.
• Not enough of your employees choose to participate: Encourage your employees to participate or sign employees up for auto-enrollment with an opt-out option.
• NHCEs are not benefiting from the plan as much as HCEs: Consider offering an employer match or increasing the match currently in place.

Eliminate the risk of failing compliance testing

Adopting a Safe Harbor plan design will typically exempt the plan from compliance testing. However, exemption from all compliance testing will depend on the plan features you choose. Normally, the Safe Harbor option must be in place more than 30 days prior to the start of a new year. A Safe Harbor plan requires an employer match or non-elective contribution.

However, the benefit is that the HCEs and Key Employees can contribute up to the allowed limit for the year without risk of failing compliance tests and having to either remove their money or fund more money into participant accounts.

If you fail top-heavy testing, there is another option. You are permitted to retroactively enroll in a Safe Harbor Non-Elective Contribution, (NEC) which will exempt you from needing to make corrections. ACP and ADP exemption is based on your plan’s design. A retroactive Safe Harbor plan enrollment will do a few things:

1. Your plan for 2023 will be amended into a Safe Harbor Plan with a 4% NEC.
2. Based on each eligible employee’s compensation, each employee will receive a 4% NEC for the plan year.
3. Your plan will be automatically amended for the 2024 plan year allowing for a 3% NEC

If you decide to retroactively enroll in a Safe Harbor plan, do not accept the results of your failed compliance tests. Once the amendment to your plan is complete, your compliance tests will be updated. It’s important to note that you may still be subject to top-heavy testing if you contribute more than the 3% required to an employee’s retirement Plan.

How to maintain plan compliance

Working with a third-party plan provider such as ePlan Services can help take the guesswork out of plan management. We provide you with the education you and your employees need to ensure that you understand the components of your plan.

You and your employees will also have access to our helpful tools, such as our employee dashboard and Retirement Outlook Calculator. We’ll work with you to help keep your plan compliant. For more information on how ePlan Services can help keep your plan compliant, reach out to our knowledgeable consultants today or visit our Help Center.

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.