Understanding Plan Compliance Testing

As your third party administrator, we’ll conduct the necessary tests each year to evaluate your plan’s compliance with federal regulations. We’ll work with you to design your plan so that passing these tests is more likely and, in some cases, guaranteed. If your plan does fail any of the compliance tests, we’ll walk you through the necessary remedial actions to get your plan back on course. While failing any test is typically not a problem, failing to take the necessary corrective measures within the prescribed time frame can jeopardize the qualified status of your plan.

The first step towards compliance peace of mind is to understand the various tests and standards to which your plan is held.

Important Definitions:

Highly Compensated Employee (HCE): An individual can be categorized as an HCE by reasons of ownership or by compensation.
- Ownership Test: Any employee who owns, directly or indirectly, more than 5% of the business regardless of compensation. An employee can indirectly own more than 5% of outstanding company stock through attribution if the stock is directly held by a spouse, child, grandchild, or parent.
- Compensation Test: Any employee who earns more than a prescribed dollar amount in the preceding plan year. These limits are adjusted annually. For 2007, an individual is deemed to be an HCE if they earned more than $100,000 in 2006
Non-Highly Compensated Employee (NHCE): Any employee that is not a HCE.
Key Employee: An individual can be categorized as a Key Employee by reasons of ownership, status, and compensation.
- 5% Owner: All employees who own, directly or indirectly, more than 5% of the company regardless of compensation.
- 1% Owner: All employees who own, directly or indirectly, more than 1% of the company and whose annual compensation exceeds $150,000.
- Officer: An officer of the company whose annual compensation for the year exceeds a prescribed dollar amount. These limits can be adjusted annually. For 2006, the dollar limit is $140,000.
Non-Key Employee: Any employee that is not a key employee.

Compliance Tests:
Unfortunately, there is no way to reduce the entirety of the applicable Internal Revenue Code provisions to a few simple paragraphs! So please note that these descriptions are intended to provide a brief summary of each test and do not cover all possible conditions and permutations applicable to these tests. In general, these tests limit the maximum benefit participants can receive from the plan and ensure that NHCEs benefit “enough” from your Plan relative to the benefit received by your HCEs and Key employees.

Annual Additions (415) Limits: The annual additions limit determines the maximum amount that can be “added” or allocated to a participant each limitation period (typically the calendar year or Plan Year). The annual addition limit does not include investment earnings, loan repayments, catch-up contributions, and rollover contributions. The annual additions limit for a participant is the lesser of 100% of a Participant’s compensation, or a set dollar limit defined each year. For the 2006 plan year, this dollar limit is $44,000. This dollar limit is pro-rated if the Plan is subject to a short limitation period.
402(g) Annual Deferral Limit Tests: This test evaluates whether a participant has exceeded the annual deferral limit set by the federal government. Since the limit is an individual limit, not a plan limit, individual deferrals into multiple plans must be aggregated. The annual deferral limit typically changes year to year and has recently increased in $1,000 increments. For calendar year 2006, this dollar limit is $15,000, and will be $16,000 for calendar year 2007. Excess deferrals must be returned to the participant.
Top-Heavy Test: A plan is top-heavy if the account balances for Key Employees exceed 60% of the total account balances of all participants on the last day of the preceding plan year. Plans that are determined to be top-heavy must provide minimum contributions to all non-key employees who are participants equal to the lesser of 3% of compensation for the entire plan year, or the contribution percentage of the Key Employee with the largest contribution as a percent of compensation. Safe harbor plans meeting certain conditions are granted non-top-heavy status regardless of the Key Employees’ total account balance relative to the total plan account balance.
Minimum Coverage Requirements - 410(b): The minimum coverage rules require that qualified plans establish eligibility and participation criteria such that a nondiscriminatory cross-section of HCEs and NHCEs receive benefits from the plan. An employee is considered to be “benefiting” if s/he is eligible to make or receive contributions (even if s/he does not take advantage of this opportunity). Excluded employees do not benefit. Each type of contribution (salary deferrals, employer matching contributions, and employer non-elective contributions) into the plan must meet coverage requirements. To pass coverage, a plan must satisfy either the ratio percentage test or the average benefits test. Under the ratio percentage test, the percentage of NHCEs who benefit under the plan must be at least 70% of the percentage of HCEs who benefit under the plan. If a plan fails the ratio percentage test, the average benefits test, which considers additional factors including the percentage of employees that are NHCEs and the average benefits provided under the plan, may be used. If a plan fails coverage requirements, the plan must extend benefits to excluded employees until the tests are passed.
General Nondiscrimination Requirement – 401(a)(4): The general nondiscrimination test requires that the allocation of employer non-elective or profit sharing contributions benefit NHCEs “enough” relative to the benefit realized by HCEs. Detailed regulations spell out the calculations required for satisfying this provision. Design-based safe harbor contributions can eliminate the need for general nondiscrimination testing. If a safe harbor allocation formula is not utilized, we will design and calculate your employer contribution each year to maximize your contribution objectives subject to satisfaction of the general nondiscrimination requirements.
Contribution Tests - ADP/ACP Tests: Defined contribution plans are also subject to the Average Deferral Percentage (ADP) and the Average Contribution Percentage (ACP) tests. These tests measure the actual deferral ratio (ADR) and the actual contribution ratio (ACR) of the HCEs relative to the deferral and contribution ratios of the NHCEs, respectively. If the HCE’s average percentage is too high relative to the average percentage of the NHCEs, then corrective measures including a refund from the HCEs contributions or a qualified non-elective contribution to the NHCEs may be required. For example, if the average deferral ratio for the NHCEs is 4%, then corrective measures are required if the HCEs average deferral ratio exceeds 6%. Design-based safe harbor contributions can eliminate the need for plans to meet these testing requirements.
Maximum Deduction Limit: The government imposes a deduction limit on employer contributions. Currently, employer contributions to defined contribution plans are deductible up to a maximum amount equal to 25% of the employer’s total payroll.
Compensation Ratio Testing – 414(s): This test applies if the Plan’s definition of compensation is different from W-2 Compensation and evaluates whether the exclusion of a type of compensation adversely impacts a certain sector of employees.