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By Kelsey Mayo, Partner, Poyner Spruill
Qualified plans provide great tax benefits—a tax deferral for participants and an immediate deduction for plan sponsors. In exchange for these benefits, the plan must jump through a number of hoops, including annual testing. These annual tests will include some or all of the following:
These tests look at contributions made for both highly compensated employees1 (HCEs) and non-highly compensated employees (NHCEs) to determine whether the plan is impermissibly discriminating in favor of HCEs. The ADP (“Actual Deferral Percentage”) test compares average deferrals made by HCEs to those made by NHCEs. The ACP (“Actual Contribution Percentage”) tests compare matching contributions received and after-tax contributions made by HCEs to those received and made by NHCEs. And the 401(a)(4) test looks at whether other benefits (such as defined benefit plans or profit-sharing contributions) sufficiently benefit NHCEs. Safe harbor plans may automatically satisfy one or more of these tests.
This test looks at total benefits or assets in a plan, to determine whether key employees2 have a disproportionate amount of assets as compared to non-key employees. This generally looks to see whether key employees hold more than 60% of such benefits or assets.
This test looks to see whether the plan benefits the required amount of non-HCEs.
This test looks to see whether the total amount of benefits for a participant is within IRS statutory limits. The annual contribution limit for defined contribution plans in 2022 is $61,000 ($67,500 for those eligible for catch-up contributions). The annual benefit limit for defined benefits plans in 2022 is $245,000.
This test looks to see whether the total amount a participant has deferred during the plan year is within IRS statutory limits. The annual deferral limit in 2022 is $20,500 ($27,000 for those eligible for catch-up contributions).
This test looks at total employer contributions in a plan year to determine whether the employer has contributed more than 25% of the total of all participants’ compensation for the plan year to the plan.
Being a safe harbor plan, however, does not exempt a plan from all testing. Safe harbor plans do generally automatically satisfy the ADP and/or ACP tests. Some safe harbor plans may also be exempt from top-heavy testing. However, the other tests noted above do apply. Therefore, it is equally important for safe harbor plans to be tested.
The most important thing a plan sponsor can do is to provide complete and accurate census data (and as soon as possible after year-end). Testing errors often occur because incomplete data is provided. Common errors include not providing data for the entire employee population, providing incomplete compensation information, and not identifying companies that are related (particularly if ownership has changed or the owner or the owner’s spouse has sold/acquired an interest in another business).
1A highly compensated employee is generally one who either: (1) owns more than 5% of the company sponsoring the plan at any time during the current or previous year or (2) satisfied an income threshold in the prior year. This income threshold is indexed annually. In 2022, you would look to see whether the employee made more than $130,000 in 2021. Employers can also make top-paid group elections. See Code Section 414(q).
2A key employee is generally one who: (1) owns more than 5% of the company sponsoring the plan, (2) owns more than 1% of the company sponsoring the plan and makes more than $150,000 annually, or (3) is an officer of the company sponsoring the plan and makes more than $200,000 in 2022 (indexed annually).
Reach out to your TPA and advisor now to begin coordinating on census data preparation. Does your TPA need information presented differently than last year? Do you have the information required, and is it complete? Start working now to get census data ready on time.
After testing is complete, reflect: How did plan administration go this past year? Did we uncover any errors during testing? What practices can we put in place now to avoid these errors in the future?
Testing season can be stressful, but careful planning can help ensure that it runs as smoothly as possible. Your TPA and advisor partners are here to provide support along the way!
While no one likes to hear they failed, take heart, it is common to discover a testing failure (and sometimes to discover other errors as well)! Now is the best time to find and correct these things.
For example, if ADP and ACP testing reveal excess contributions to HCEs, you can refund those excess contributions without excise taxes so long as the correction is made within two and a half months after the end of the plan year (March 15th for calendar year plans).
Errors caught quickly are also often eligible for self-correction under the IRS’s self-correction program (SCP) part of its Employee Plans Compliance Resolution System (EPCRS).
Thus, it is vital to get that accurate and complete census data early to preserve your best options. Talk to your TPA now about any changes that have occurred and any questions you have. Working together you will have a successful season!