Common Compliance Testing Questions
By Pa Nhia Lor, QKA
Qualified retirement plans must follow very specific rules for providing benefits to eligible employees. These rules are intended to limit unduly favorable benefits to owners and highly paid employees, at the expense of other employees. Administering these rules requires certain benefit tests for several categories of employees, and those tests are in turn accompanied by several technical terms. If you’re new to qualified retirement plans, or simply need a refresher on these common terms in the retirement plan industry, we’ve got you covered.
Key Employee Definition
An employee is considered a key employee if, at any time during the plan year, the employee is
a five percent owner* of the company during the testing period,
a one percent owner* of the company with annual compensation over $150,000 (not indexed) during the testing period, or
an officer of the company that earned more than the amount as indexed below during the testing period.
*To be considered either a five percent or a one percent owner, an employee must own (or be considered to own) more than five percent or more than one percent of the company, respectively.
NOTE: The family attribution rules apply to the determination of ownership for key employees, as well as highly compensated employees. This means that an employee may be defined as a key or highly compensated employee solely due to a family relationship to another key employee.
Who is an officer? An officer is an administrative executive (i.e., Chief Executive Officer, Vice President or higher level) who is in regular and continuous service with the employer, has binding authority, and makes decisions on behalf of the company. For an officer to be considered a Key Employee, the officer must earn the indexed amount within the testing period.
Highly Compensated Employee (HCE) Definition
A highly compensated employee (HCE) is someone who
was a five percent owner* at any time during the current plan year or preceding year, or
earned more than the amount indexed below for the prior plan year.
*To be considered a five percent owner, an employee must own (or be considered to own) more than five percent of the company.
What is the Average Deferral Percentage (ADP) Test?
The ADP test compares the average salary deferrals (amounts withheld from one’s pay) contributed by the HCEs to the average deferrals contributed by the non-HCEs. There is an allowable spread between the deferral percentages of the two groups. Exceeding that spread will require a correction.
What is the Average Contribution Percentage (ACP) Test?
The ACP test is like the ADP test except it compares the average matching contributions and nondeductible employee contributions made on behalf of HCEs compared to such contributions made on behalf of non-HCEs. Here, too, there is an allowable spread between the two groups before a correction would have to be made.
What if an Employer Fails the ADP or ACP Test?
To correct an ADP or ACP testing failure, the most common method is for the employer to return “excess contributions” of salary deferrals contributed by HCEs (for an ADP testing failure) or excess aggregate contributions of matching or nondeductible employee contributions of HCEs (for an ACP testing failure) to some or all of the HCEs. This is done to reduce their average contributions to the allowable level.
Employers can also make a qualified nonelective contribution (QNEC) or qualified matching contribution (QMAC) to the non-HCEs to help pass the test; however, this can be costly. A combination of these two methods is also acceptable.
If the employer returns excess contributions or excess aggregate contributions to HCEs, the contributions generally must be returned within 2½ months after the close of the plan year in which the excess occurred. If the employer returns contributions after this deadline, the employer must file Form 5330 and pay a 10 percent penalty tax on the excess amount.
Is There a Deadline by which ADP & ACP Testing Failures must be corrected to avoid plan disqualification?
If the excess is not corrected by the end of the plan year following the year in which the excess was made, the cash or deferred component of the plan risks disqualification.
What is the Top-Heavy Test?
The top-heavy test compares the percentage of total plan assets in the accounts of key employees to the percentage held in the accounts of non-key employees. If the key employees hold more than 60 percent of the total plan assets as of the determination date, the plan is deemed top-heavy for the following plan year, and corrective action may be required
What is the Determination Date Definition for the Top-Heavy Test?
The determination date is the last day of the preceding plan year, or, in the case of a first plan year, the last day of such plan year. Except for the first plan year, a top-heavy plan has a delayed effect. If a plan is determined to be top-heavy as of December 31, 2023, the plan will be top-heavy for the 2024 plan year.
My Client’s Plan is Top-Heavy. Now What?
If a plan is top heavy, the employer generally must make a minimum contribution on behalf of each non-key employee if any key employee receives a contribution or makes a deferral for the plan year. If any key employee receives or makes a contribution of three percent or more of compensation, the employer must make a contribution on behalf of non-key employees of three percent. But if no key employee receives a contribution (including employee deferrals and employer contributions) of three percent or more, the minimum contribution need only equal the same percent as that of the key employee with the highest contribution percentage. Other employer contributions, such as matching or profit sharing, may help offset the top-heavy contribution requirement.
An Employer Corrected a failing ADP/ACP Test with a QNEC/QMAC. Can the Employer Use this to Correct the Top-Heavy Test?
Yes. As long as the QNEC/QMAC was previously used to correct the ADP/ACP failure, the QNEC/QMAC can be used to offset or reduce a top-heavy contribution requirement as it is considered an employer contribution. Employers can use QNEC/QMAC contributions to offset the top-heavy test if they did not already make any top-heavy contributions for that same testing period.
