What are the common tests that your retirement may be subject to?
Retirement plans allow participants and plan sponsors to save funds for retirement in a tax-deferred method. If you are delaying paying taxes, there are of course many rules that you must follow to keep your plan’s tax-qualified status. Most plans will be subject to several tests, although there are plan design features that may allow your plan to receive an automatic pass on certain ones.
Testing the money going into the plan and how the contributions are calculated:
Testing participant contributions: If your plan allows for participants to defer compensation from their paychecks into the retirement plan, the plan will be subject to ADP or actual deferral percentage testing. The test analyzes the deferrals made by participants from their paychecks to determine if the participation level and contribution levels are discriminatory in favor of the owners and highly paid participants. If there is too much discrepancy, the test would fail, and corrections must be made. Testing is not needed if the plan is making safe harbor contributions.
Testing matching contributions: If the plan is providing a matching contribution, then the same exact test is performed except this time, you are comparing the average matching or contribution rate for each group. It is called an ACP or actual contribution percentage test. If there is too much discrepancy, the test would fail, and corrections must be made. Testing is not needed if the plan is making safe harbor matching contributions.
Testing how the plan benefits participants: This test looks at the ratio of each type of contribution made to the plan to determine if the number of benefitting participants is discriminatory in favor of the owners and highly paid participants. Testing is not necessary if everyone is able to participate regardless of job classification, hours of service during the plan year, or employment on the last day of the plan year. This test is referred to as a 410(b) or coverage test. If the plan doesn’t benefit enough people an amendment may be required.
Testing compensation: This test looks at the amount of compensation used for each type of contribution to ensure that the compensation used is not discriminatory in favor of the owners and highly paid participants. Typically, you would need this test if you are excluding certain forms of compensation like bonuses or overtime pay. The code section tested here is called a 414(s) test. If the compensation is found to be discriminatory, an amendment may be required.
Testing the balances in the plan:
This test, referred to as the top-heavy test, looks at the balances attributable to key members in the plan who are owners and officers of a certain level. If the balances of key members of the plan comprise more than 60% of the total balance in the plan, minimum contributions must be made to the plan in the following year – or those key members won’t be able to participate. This test is based on Section 416 of the internal revenue code. The safe harbor plan design can help plans that are top-heavy meet those minimum contribution levels.
Individual participant tests:
Employee deferrals: There is an individual deferral limit that participants cannot exceed for each calendar year. This is called the participant’s 402(g) limit. The limit for 2021 is $19,500 for those under age 50 and $26,000 for those age 50 and over. Most payroll software will track this and help avoid a violation of this limit. However, this is a limit across all plans that participants have participated in during that calendar year. Employers are only responsible for tracking the plan they sponsor. It is up to the individual participant to track their personal limit if they have participated in more than one plan during that year. Keep in mind that if a participant exceeds the limit for the year, they may have to take a refund from the plan that you sponsor if that is when the overage occurred. If your plan has a shorter period of service before participants become eligible, such as 30 days or even 6 months, you may wish to have participants report to you the deferrals they have contributed to any other plan so you can help track that in the payroll software and avoid excess.
Total additions to the plan: The combined limit on contributions across all types – deferrals, matching, other employer contributions, and catch up – for each plan year cannot exceed certain IRS limits. This individual participant limit called the 415 limit, is for each plan that they are a member of, not a combined limit across all the plans that they participated in during the plan year. The limit for 2021 is the lessor of a) 100% of compensation or b) $57,500 for those under age 50 and $63,500 for those age 50 and over.
ERISA or the Employee Retirement Income Security Act, put these rules in place to protect the participants in the plan, and to ensure that the plan is doing what it was designed to do – benefit participants. These tests can get complicated and correction methods and plan amendments can be difficult to navigate. Having a reliable, knowledgeable, innovative third-party administrator (TPA), can be a valuable asset to your retirement plan team. ML&R Wealth Management serves as the TPA for our clients and is happy to perform all tests and help work through corrections as needed. Please contact us for more information.