ADP/ACP Testing - Back To Basics & Then Some

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ADP/ACP Testing - Back To Basics & Then Some

  1. 1. ADP/ACP Testing Back To Basics & Then Some Pension Pundits, LLC info@pensionpundits.com Ilene H. Ferenczy 404.320.1100 x102  Adam C. Pozek 651.204.2600 x107
  2. 2. Nondiscrimination Testing   Designed to ensure that the salary deferral feature is being used by both highly compensated employees (HCEs) and nonhighly compensated employees (NHCEs) Can meet safe harbor or can test each year for nondiscrimination (ADP and ACP tests) 2
  3. 3. Actual Deferral Percentage (ADP) Test   For each participant: Calculate the percentage of compensation contributed (i.e., the actual deferral ratio or ADR) Average the percentages separately for HCEs and NHCEs (i.e., the actual deferral percentages or ADPs) 3
  4. 4. Actual Deferral Percentage (ADP) Test  The ADP for the HCEs must be equal to or less than one of the following:   125% of ADP for NHCEs The lesser of:   200% of ADP for NHCEs ADP for NHCEs plus 2 percentage points 4
  5. 5. Actual Deferral Percentage (ADP) Test  Special rules:  Must count all participants eligible to defer (not just those contributing)  Must combine HCE deferrals to all 401(k) plans of the employer in each plan’s ADP Test 5
  6. 6. Compensation Used  The law permits testing to be performed using any nondiscriminatory compensation definition under IRC §414(s).   Safe harbor (basically 415 comp with or without deferrals, with or without reimbursements, full year or only during participation) Nondiscrimination tested (compensation ratio test) 6
  7. 7. Compensation Used   What does the plan permit? Does the recordkeeper get the correct compensation information from the client? 7
  8. 8. Compensation  Other Definitions that Pass IRC §414(s) Nondiscrimination Testing   Must exclude specific type of compensation, not percentage of compensation Compensation ratio nondiscrimination test Average % of Total Compensation Included for HCEs DOES NOT EXCEED by more than a de minimis amount Average % of Total Compensation Included for NHCEs 8
  9. 9. Average NHCE Ratio = 88.10% Average HCE Ratio = 89.74% Total Comp Bonus Plan Comp Ratio Harry $190,000 $20,000 $170,000 89.47% Ron $150,000 $15,000 $135,000 90.00% Hermione $ 85,000 $10,000 $ 75,000 88.24% Fred $ 75,000 $10,000 $ 65,000 86.67% George $ 50,000 $ 5,000 $ 45,000 90.00% Ginny $ 40,000 $ 5,000 $ 35,000 87.50%  Definition of compensation passes compensation ratio test 9
  10. 10. Average NHCE Ratio = 88.10% Average HCE Ratio = 95.00% Harry Ron Hermione Fred George Ginny  Total Comp $190,000 $150,000 $ 85,000 $ 75,000 $ 50,000 $ 40,000 Bonus Plan Comp Ratio $0 $190,000 100.00% $15,000 $135,000 90.00% $10,000 $10,000 $ 5,000 $ 5,000 $ $ $ $ 75,000 65,000 45,000 35,000 88.24% 86.67% 90.00% 87.50% Definition of compensation fails compensation ratio test. HCE ratio exceeds NHCE ratio by more than de minimis amount. 10
  11. 11. Compensation  Since this is a testing alternative, do not need to apply consistently from year to year   Although, if you change arbitrarily, more likely to have compensation determination errors On the other hand, it can make a failed test pass. 11
  12. 12. Early Entrant Rule (Disaggregation of Otherwise Excludable Employees)  Consider this alternative if have eligibility requirements that are more lenient than statutory requirements   age 21 1 year of service and early entrants defer at a lower rate than others 12
  13. 13. Early Entrant Rule  Two “flavors”  Test people with less than 1 year, age 21 separately   410(b) coverage test must also be done this way if this method is used Carve NHCEs who are early entrants out of the testing altogether and do one test 13
  14. 14. Early Entrant Rule  Appears to be dictated by testing and not by document    But what does the document say? Watch entry date issue Does not have to be done consistently on a year-to-year basis  But what does the document say? 14
  15. 15. Example   401(k) Plan allows employees to participate once they have reached age 18 and work for 3 months Demographics show average deferral rates:      Under age 21: 3-6 months of service 6-9 months of service 9-12 months of service 12 months of service 0% 2% 2.5% 4% 6% 15
  16. 16. Example   If ADP testing excluded people with less than 1 year of service and under age 21, would have a better chance of passing testing Under the alternate testing method, that is exactly what can be done 16
  17. 17. Prior Year Testing Alternative  May use prior year’s ADP for NHCEs   Can take into account QNECs and QMACs only if they are allocated during the prior year and paid to trust within 12 months of the end of the prior year For the first plan year with a 401(k) plan, may use ADP of 3% for NHCEs or actual current year ADP of NHCEs, but plan must specify which method is to be used 17
  18. 18. Prior Year Testing  Prior year's ADP is determined without regard to changes in the identity of NHCEs    Means that a given participant could be included in both prior year ADP for NHCE and current year ADP for HCEs Exception: plan coverage changes through plan mergers or changes in the eligibility criteria of the plan Use weighted average of subgroups, unless change is minor (less than 10%) 18
  19. 19. Adjustment to Prior Year ADPs for Coverage Changes  Example: Plan N and Plan P are merged  Plan N had 300 NHCEs with prior year ADP of 6%  Plan P had 100 NHCEs with prior year ADP of 4%  The prior year ADP for the NHCEs is the weighted average of the two groups: (300/400 x 6%) + (100/400 x 4%) = 5.5% 19
  20. 20. Changes from Current Year to Prior Year Testing  Permitted only if:    Current year method was used for 5 years (or less if used for the plan’s entire existence); or Mergers and acquisitions if change is necessary to conform plan to acquiring company's plan's testing method and is made in the 410(b) transition period Amendment to change must be in place by end of the plan year for which testing is being performed 20
  21. 21. Prior Year vs. Current Year Practical Considerations   Advantage to prior year: can act earlier to limit HCE deferrals and to enable passage Problems:   What is good in one year is not necessarily good in the next Prior year testing eliminates QNEC as an alternative 21
  22. 22. Prior Year vs. Current Year Practical Considerations  Changing testing methods generally has no effect in the year you need it unless you anticipate it before year end … and can only be done every 5 years 22
  23. 23. Actual Contribution Percentage (ACP) Test   Applies to matching contributions and after-tax employee contributions Test is structured the same as the ADP 23
  24. 24. Borrowing or Shifting  Useful if ADP test is passed but ACP test is failed Before: HCE NHCE ADP 4.0% 4.0% ACP 4.75% 2.00% Fail HCE NHCE 4.0% 3.25% 4.75% 2.75% Pass After: 24
  25. 25. Borrowing or Shifting  Rules for use   Plan must not prohibit ADP test must meet nondiscrimination testing both before and after the shift 25
  26. 26. Correcting ADP Failures  Methods    Refund excesses to HCEs Reclassify as after-tax contributions (if plan permits) QNECs or QMACs Proportionate to compensation  Proportionate to deferrals  Flat dollar amount  “Bottom Up” Note: Limitations apply on flat dollar or bottom up QNECs or QMACs  26
  27. 27. Correcting ACP Failures  Methods   Distribute vested excesses to HCEs; forfeit nonvested excess QNECs or QMACs Proportionate to compensation  Proportionate to deferrals  Flat dollar amount  “Bottom Up” Note: Limitations apply on flat dollar or bottom up QNECs or QMACs  27
  28. 28. 401(k) Plan Excesses  Note: Code and regulations call:    402(g) excess: excess deferrals 401(k) ADP testing excess: excess contributions 401(m) ACP testing excess: excess aggregate contributions 28
  29. 29. Determining ADP Excesses to Refund  Leveling method used  Calculate amount of excess contributions to be refunded   Determine what the ADP for the HCEs must be, and adjust the deferrals of the HCEs whose rates of deferral are high. Figure out what they could have deferred. The rest is excess. Total the excesses to get the amount to be refunded. 29
  30. 30. Determining ADP Excesses to Refund  Allocate total to be refunded   Allocate the total to be refunded among HCEs based on the total dollar amount of deferral, not the percentage of deferral Effect: lower paid high deferring HCEs are not disproportionately affected by corrective refund 30
  31. 31. I Love Rock N Roll, Inc. # HCEs 12 # NHCEs 33 NHCE ADP 3.32% Max HCE ADP 5.32% Actual HCE ADP 7.57% Refunds $40,578
  32. 32. I Love Rock N Roll, Inc. Refunds - Step #1 Name Comp Elective Deferrals Deferral Percent Adj. Def. Percent Difference (%) Difference ($) 1. Roger Daltrey $135,000 $11,500 8.52% 5.39% 3.13% $ 4,224 2. David Gilmour $145,000 $12,000 8.28% 5.39% 2.89% $ 4,184 3. Jimi Hendrix $ 84,000 $ 4,500 5.36% 5.36% 0.00% $ 4. Paul “Bono” Hewson $230,000 $15,500 6.74% 5.39% 1.35% $ 3,103 5. Janice Joplin $230,000 $15,500 6.74% 5.39% 1.35% $ 3,103 6. Jim Morrison $230,000 $10,500 4.57% 4.57% 0.00% $ 7. James “Iggy Pop” Osterberg $230,000 $15,500 6.74% 5.39% 1.35% $ 3,103 8. Robert Plant $230,000 $15,500 6.74% 5.39% 1.35% $ 3,103 9. Henry Rollins $230,000 $15,500 6.74% 5.39% 1.35% $ 3,103 10. Frank Sinatra $230,000 $15,500 6.74% 5.39% 1.35% $ 3,103 11. Grace Slick $ 90,000 $15,300 17.00% 5.39% 11.61% $10,449 12. Britney Spears $230,000 $15,500 6.74% 5.39% 1.35% $ 3,103 $2,294,000 $162,300 7.57% 5.32% 0 0 $40,578
  33. 33. I Love Rock N Roll, Inc. Refunds - Step #2 Name Elective Deferrals Excess Contribs Net Deferrals 1. Paul “Bono” Hewson $15,500 $4,827.80 $10,672.20 2. Janice Joplin $15,500 $4,827.80 $10,672.20 3. James “Iggy Pop” Osterberg $15,500 $4,827.80 $10,672.20 4. Robert Plant $15,500 $4,827.80 $10,672.20 5. Henry Rollins $15,500 $4,827.80 $10,672.20 6. Frank Sinatra $15,500 $4,827.80 $10,672.20 7. Britney Spears $15,500 $4,827.80 $10,672.20 8. Grace Slick $15,300 $4,627.80 $10,672.20 9. David Gilmour $12,000 $1,327.80 $10,672.20 10. Roger Daltrey $11,500 $ 827.80 $10,672.20 11. Jim Morrison $10,500 $ 0.00 $10,500.00 12. Jimi Hendrix $ 4,500 $ 0.00 $ 4,500.00 $40,578.00 $121,722.00 $162,300
  34. 34. I Love Rock N Roll, Inc. Refunds - Step #3 Name Excess Contribs Age Catch-Up Contribs 1. Paul “Bono” Hewson $4,827.80 49 2. Janice Joplin $4,827.80 66 3. James “Iggy Pop” Osterberg $4,827.80 62 4. Robert Plant $4,827.80 60 5. Henry Rollins $4,827.80 48 6. Frank Sinatra $4,827.80 93 7. Britney Spears $4,827.80 27 8. Grace Slick $4,627.80 69 $4,627.80 9. David Gilmour $1,327.80 63 $1,327.80 10. Roger Daltrey $ 827.80 65 $ 827.80 11. Jim Morrison $ 0.00 65 12. Jimi Hendrix $ 0.00 Refunds 66 $40,578.00 $4,827.80 $4,827.80 $4,827.80 $4,827.80 $4,827.80 $4,827.80 $26,094.60 $14,483.40
  35. 35. Plans with Designated Roth Contributions  Refunds for participants who make only Roth deferrals are of Roth amounts    Only earnings are taxable on refund Never a qualified distribution If mixed deferrals:   Plan can designate which deferral is refunded first Plan may permit participant to designate what should be refunded 35
  36. 36. Refunding Excess Contributions   Must reclassify excess contribution as catch-up contribution when affected participant is catch-up eligible Refund excess to other participants  Must be done by not later than 2½ months after plan year end or else 10% excise tax under IRC §4979 owed   If EACA under IRC §414(w), have 6 months after plan year end If not done within 12 months of plan year end, plan is subject to disqualification 36
  37. 37. Refunding Excess Contributions  Year of income:  For plan years 2007 and before:   If refunded within 2½ months of the end of the plan year being tested: the year that includes the earliest dates during the plan year on which any elective contributions were made by the employee that would have been paid as compensation had the employee not elected to defer such amounts to the plan (always prior year for calendar year plans) If refunded after 2½ months after the end of the plan year being tested: taxable in year distributed 37
  38. 38. Refunding Excess Contributions  Year of income:   For plan years 2008 and after: reported on Form 1099R in the year of refund (PPA change) Reported on Form 1099-R 38
  39. 39. Refunding Excess Contributions  Must forfeit associated matching contribution if:   401(k) deferral is refunded; or 401(k) deferral is reclassified as a catch-up contribution and the plan does not match catch-up contributions 39
  40. 40. Gap Period Income  Gap period defined   Period between end of year and date of refund No longer required  Pre 2006: Optional  2006: Required for excess contributions/aggregate contributions per final 401(k) regs  2007: Required for excess deferrals per Roth distribution regs  2008: Repealed for excess contributions/aggregate contributions per PPA  2008: Repealed for excess deferrals per WRERA
  41. 41. Correcting ACP Excesses through Distribution    Can distribute vested matching contributions to participant Must forfeit nonvested matching contributions Rules regarding timing, excise taxes, and taxation of distribution are the same as for ADP excesses 41
  42. 42. QNECs and QMACs  Always permissible    Limitations apply     Pro rata to compensation (QNEC) Pro rata to deferral (QMAC) Bottom-up Per capita Other methods that produce uneven QNECs and QMACs used in testing What does the document permit? 42
  43. 43. Example Facts     Strongman Sports Equipment, Inc., owned by former wrestler, Joustin’ Jake, has a 401(k) plan for its employees. There are 5 HCEs who defer, on average, at the rate of 8%. Deferrals for the 50 NHCEs average 5% NHCE Deferral rate needed to pass ADP is 6% 43
  44. 44. Initial Testing Group/Participant Deferral Rate ADP 5 HCEs 8% apiece 8% 50 NHCEs 5% apiece 5% 44
  45. 45. QNECs/QMACs  Could do a 1% QNEC to all eligible NHCEs. If average NHCE pay is $20,000, this is a $10,000 QNEC (1% x $20,000 x 50 employees) 45
  46. 46. 1% QNEC to all Group/Participant Deferral Rate ADP 5 HCEs 8% apiece 8% 50 NHCEs 5% +1% QNEC apiece ($10,000) 6% 46
  47. 47. QNECs/QMACs  Targeting has been made more difficult.  In pre-2006 years, could do bottom-up QNECs. If, for example, SSEI had one employee who terminated early in the year after earning $1,000, it could pay that person a $500 QNEC, raising the deferral percentage for him to 55%. When average additional 50% over the total 50 employees, it increases the average for the NHCE group by the needed 1%. 47
  48. 48. Targeted QNECs before Final 401(k) Regs Group/Participant 5 HCEs 49 NHCEs 1 NHCE with $1,000 compensation Total for NHCEs Deferral Rate ADP 8% apiece 8% 5% apiece (245% total) 5% + 50% QNEC (55% total) 300% 300%/50 = 6% 48
  49. 49. Targeted QNECs under Final 401(k) Regs  Rule:  Cannot include QNEC in ADP test if it exceeds greater of:    5%; or 2 x the highest QNEC given to at least 50% of the NHCEs (or all NHCEs who participate at year end) Example: have 50 NHCEs and need 50 more percentage points to pass testing   Give nothing to 25 Either:   Give 10 lowest paid NHCEs a 5% QNEC Give 25 lowest paid NHCEs a 2% QNEC 49
  50. 50. Listing of QNECs to Determine Median              NHCE 1 = 0% NHCE 2 = 0% NHCE 3 = 0% NHCE 4 = 0% NHCE 5 = 0% NHCE 6 = 0% NHCE 7 = 0% NHCE 8 = 0% NHCE 9 = 0% NHCE 10= 0% NHCE 11 = 0% NHCE 12 = 0% NHCE 13 = 0% NHCE 14 = 0% NHCE 15 = 0% NHCE 16 = 0% NHCE 17 = 0% NHCE 18 = 0% NHCE 19 = 0% NHCE 20 = 0% NHCE 21 = 0% NHCE 22 = 0% NHCE 23 = 0% NHCE 24 = 0% NHCE 25 = 0%    NHCE 26 (median guy) = ½ x = lowest QNEC in this group NHCE 27-50 get a QNEC not greater than x (or, if more, 5%) and not less than ½ x Result: the QNECs of any member of a group of one-half of the NHCEs is not greater than (a) 5% or (b) 2 times the lowest QNEC in the group 50
  51. 51. Example of Possible Proportionate QNECs   50 NHCEs averaged 3% deferrals and they need to be 6% Under the new rules, the median guy cannot get less than ½ what anyone else in the “bottom” 25 gets or 5%   Top 25 paid NHCEs get no QNEC If all of bottom paid 25 NHCEs get equal QNEC, each gets 6% QNEC in addition to 3% deferral (9% total)   NHCE ADP = ((25x9%)+(25x3%))/50= (225+75)/50 = 300/50 = 6% If bottom paid 10 guys get 2x QNEC of top 15 of the bottom paid guys:    Bottom 10 get 8.59% QNEC (total ADR is 11.59% including 3% deferral) Median 15 get 4.29% QNEC (total ADR is 7.29%) NHCE ADP = ((10x11.59%)+(15x7.29%)+(25x3%))/50 = (115.90+109.35+75)/50 = 300.25/50 ≈ 6% 51
  52. 52. Anyone Else Got a Headache??? 52
  53. 53. Results – Are They Worth It?   Targeting is much more difficult and fine tuning may not have that significant an effect Remember:   Can give 5% QNEC to all or any NHCE without worrying about the effects of targeting Can give any QNEC to ½ of the NHCEs without worrying about the effects of targeting 53
  54. 54. Results – Are They Worth It?  Remember:  The wider the spread of compensations among the NHCEs, the greater the impact of targeting 54
  55. 55. Limiting HCE Deferrals During the Year  Does the plan permit this?    Is contribution in excess of deferral limit a catch-up contribution? Communication What if limit is too low at year end? 55
  56. 56. Automatic Enrollment  Pros   Helps pass the ADP test by raising the average level of salary deferrals by NHCEs Congress loves it     New(er) safe harbor If safe harbor not used, can still qualify for later correction timing without 10% excise tax Congress confirmed preemption of state payroll laws Helps employees save for their retirement 56
  57. 57. Automatic Enrollment  Cons     Small accounts (although new “mistaken deferral” refunds (i.e., permissive withdrawals) may help) More accounts without participant direction (although new default fund rules will help) Administrative hassle (more than ADP testing failures?) Employee resentment 57
  58. 58. Safe Harbor Plans  “Classic” Safe Harbor designs     If plan is top-heavy, would need to make 3% contribution anyway Under PPA, vesting converts to top-heavy schedule for all contributions, so full vesting may not be so painful 3% nonelective contribution can be basis for cross-testing, with advantages that outweigh the additional cost of vesting Matching contribution may encourage more deferrals (but is that a good thing if we have a SH plan?) 58
  59. 59. PPA Safe Harbor Plans  Automatic enrollment safe harbor     Encourages savings more than regular safe harbor Full vesting not required 6% rate may be higher than is acceptable to participants and escalating rates of deferral may be difficult to administer Increasing rates of deferral may lead to increasing matching contributions which may make cost prohibitive 59
  60. 60. Education and Information    Better enrollment meetings help increase participation Effect of investment advisory services? Cost issues? 60
  61. 61. Whoops! We screwed up!   If do not correct ADP/ACP testing failure within 12 months of year end, plan is potentially disqualified Options    Do nothing and pray Self-correct using EPCRS rules Correct with IRS approval under VCP 61
  62. 62. Do Nothing and Pray (Religious or Ostrich Approach)    Cheapest option Most vulnerable on audit (IRS likes people who at least try to stay in compliance and fix errors when found) Liability protection: make sure that, if this option is elected, it’s the client’s choice 62
  63. 63. Self-Correction Using EPCRS  Approved correction method: one-to-one     Determine excess Refund excess to HCEs (including earnings) Make a QNEC on behalf of NHCEs equal to the refunded amount and allocate proportionate to compensation (plus earnings from end of plan year) Problem: if only contributions are deferrals and matches, this will create very small accounts for individuals who have never deferred 63
  64. 64. Self-Correction  If use other method of correction, risk disqualification on audit    Incomplete correction of original error Possible disqualifying contribution allocation in attempted correction Timing for permissible correction:   Not later than the last day of the third plan year following the year of testing Anytime if de minimis (and it probably isn’t) 64
  65. 65. Correction with IRS Approval under VCP  When to Use:   Self-correction period has passed Want to use correction method other than one-to-one method described above    E.g., want to allocate QNEC in proportion to deferrals, rather than compensation Note: it is unlikely that the IRS will approve refund-only correction after 401(k) correction period has passed M&A situation and buyer is nervous 65
  66. 66. Questions? 66
  67. 67. More Information • Be aware of helpful websites • www.irs.gov • www.dol.gov/ebsa • www.benefitslink.com • www.ihflaw.com* • www.dwcconsultants.com* * Just a little shameless promotion!  67
  68. 68. Contact Information Pension Pundits, LLC Ilene H. Ferenczy Adam C. Pozek Law Offices of DWC Consultants, Inc. Ilene H. Ferenczy, LLC 5 Brook Pasture Lane, Suite A 2200 Century Parkway, Suite 560 Essex, MA 01929 Atlanta, GA 30345 (651) 204-2600 x107 (V) 404.320.1100 x102 (V) (651) 204-2700 (F) 404.320.1105 (F) adam.pozek@dwcconsultants.com ilene@ihflaw.com 68

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