Testing 101:
Understanding Compliance Testing
Susan M. Wright, CPA, APM, Director of Compliance & Consulting
Jason Frey, QPA, Consultant
Topics of Discussion
♦ The Annual Information Form
♦ The importance of complete and accurate census data
♦ Overview of required plan testing
♦ Plan design considerations
♦ Important dates to remember for 2012
♦ Questions and answers
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What is the Annual Information Form?
♦ The Annual Information Form (AIF) includes important
plan information necessary to complete annual testing
and the Form 5500
♦ We will not commence annual testing for your plan (or
contribution calculations) until after we have received
your completed AIF
3
When is the AIF due to DailyAccess?
♦ The AIF is due to DailyAccess no later than the 15th day
of the month following your plan year end
♦ AIFs for calendar year plans were due by Monday,
January 17th
What happens if the AIF is returned to DailyAccess
after the due date?
We cannot guarantee to provide your testing results or
government filings by their respective deadlines.
If you have a calendar year plan and have not submitted your
AIF , it is crucial to do so immediately!
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Testing Data – Your Plan’s Census
♦ Complete and accurate census data is a fundamental
requirement for year-end testing
♦ Review the plan census report via the Plan Sponsor
Website to ensure that:
• Termination dates and rehire dates for each participant are
properly reflected in our system
• Annual hours worked are accurate for each participant
• All compensation and deferral amounts for each participant
have been properly included
Report any necessary corrections to your Account Executive
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Compensation/Payrolls
♦ Does your plan exclude any types of compensation?
– Were the excluded amounts included in your payroll uploads?
– Gross compensation is still needed for testing purposes
♦ Check your payroll system and payroll upload file
format for the upcoming year
– Check to make sure new compensation types are included
– Check to make sure the appropriate plan limits are in place
– If the definition of compensation in your plan has changed,
make sure the payroll file format has been updated
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Compliance Testing – Basic Definitions
♦ What is a Highly Compensated Employee (HCE)?
– More than 5% owners (and direct relatives)
– An employee with compensation greater than $110,000 in the
prior year
♦ What is a Key Employee?
– More than 5% owners (and direct relatives)
– Officers with compensation greater than $160,000
– 1% owners earning greater than $150,000
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Required Annual Compliance Testing
The Plan must pass certain annual testing to prove that
the plan does not discriminate in favor of HCEs or exceed
certain limitations. Some of the most common tests
include:
•
•
•
•
•
ADP/ACP Test
402(g) Limit Test
415 Annual Additions Test
Coverage Test
Top Heavy Test
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What is the ADP/ACP Test?
♦ The Average Deferral Percentage (ADP) test is performed to
determine whether the plan is discriminating in favor of HCEs with
respect to employee deferrals (pre-tax/Roth)
♦ The Average Contribution Percentage (ACP) test is performed to
determine whether the plan is discriminating in favor of HCEs with
respect to employer matching contributions
♦ The ADP Test compares the ADP of the HCEs against the ADP of
the Non-Highly Compensated Employees (NHCEs) to determine
whether the plan is discriminating in favor of the HCEs
Note: This test is not required for Safe Harbor 401(k) Plans
9
How are the ADP/ACP percentages calculated?
♦ The ADP/ACP is determined separately for the HCE group
and the NHCE group
♦ The ADP is calculated by taking each participant’s elective
deferrals, net of catch-up contributions, and dividing the
deferrals by his/her compensation
♦ The percentages are then added up and divided by the
number of eligible participants within that group
♦ The calculation is performed in the same manner for ACP
testing
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How are the ADP/ACP percentages calculated?
Employee
Compensation
401(k) Amount
ADP %
NHCE 1
25,000.00
2,500.00
10.00%
NHCE 2
50,000.00
1,500.00
3.00%
NHCE 3
50,000.00
0.00
0.00%
Average Deferral Percentage (13% divided by 3)
4.33%
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ADP /ACP Test Case Study
Employee
Status
Comp
401(k)
ADP %
Match
ACP %
Joe Smith
Owner
245,000.00
16,500.00
6.74%
7,350.00
3.00%
Mary Smith
Wife
50,000.00
10,000.00
20.00%
1,500.00
3.00%
Bill Smith
Son
50,000.00
0.00
0.00%
0.00
0.00%
HCE ADP/ACP
8.91%
2.00%
Jane Brown
NHCE
50,000.00
10,000.00
20.00%
1,500.00
3.00%
Steve Orr
NHCE
30,000.00
2,000.00
6.67%
900.00
3.00%
Susan Deen
NHCE
25,000.00
1,000.00
4.00%
500.00
2.00%
Billy Jones
NHCE
35,000.00
0.00
0.00%
0.00
0.00%
NHCE ADP/ACP %
7.67%
2.00%
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ADP/ACP Testing Results
The Plan uses the current year testing method. Therefore the
maximum ADP for the HCEs is determined as follows:
7.67% (NHCE ADP) x 2 = 15.34%
7.67% (NHCE ADP) + 2% = 9.67%
♦ The maximum ADP for the HCEs is the lesser of the two percentages,
or 9.67%
♦ Since the HCE ADP was 8.91%, the Plan passes this required test
♦ The calculations for the ACP test are done in the same manner as the
ADP test
Note: If the Plan used the prior year method, the maximum percentage would be
calculated using the prior year NHCE ADP %
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ADP /ACP Test Case Study – Different Facts
Employee
Status
Comp
401(k)
ADP %
Match
ACP %
Joe Smith
Owner
245,000.00
16,500.00
6.74%
7,350.00
3.00%
Mary Smith
Wife
50,000.00
10,000.00
20.00%
1,500.00
3.00%
Bill Smith
Son
50,000.00
5,000.00
10.00%
1,500.00
3.00%
HCE ADP/ACP
12.25%
3.00%
Jane Brown
NHCE
50,000.00
10,000.00
20.00%
1,500.00
3.00%
Steve Orr
NHCE
30,000.00
2,000.00
6.67%
900.00
3.00%
Susan Deen
NHCE
25,000.00
1,000.00
4.00%
500.00
2.00%
Billy Jones
NHCE
35,000.00
0.00
0.00%
0.00
0.00%
NHCE ADP/ACP %
7.67%
2.00%
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What happens if the Plan fails the ADP/ACP test?
Corrective measures will be required to comply with
the law
♦ Reclassify corrective distributions as catch-up contributions
♦ Issue corrective distributions to HCEs (“refunds”)
♦ Make an additional contribution to the plan, known as a
Qualified Non-Elective Contribution (QNEC)
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How are corrective distributions determined?
Corrective distributions are calculated based on the participants with the highest
deferral rates. However, the amounts are distributed to those participants
with the largest dollar amount of deferrals.
Step 1
Excess
Amt
Step 2
Refund
Amt
Reclassify
to
Catch-up
Deferrals
Remaining
in Plan
Employee
Comp
401(k)
ADP %
Max
ADP %
Joe Smith
245,000
16,500
6.74%
6.74%
0
3,865
3,865
16,500
Mary Smith
50,000
10,000
20.00%
12.27%
3,865
0
0
10,000
Bill Smith
50,000
5,000
10.00%
10.00%
0
0
0
5,000
12.25%
9.67%
3,865
3,865
3,865
31,500
Note: In this example, Joe was catch-up eligible so the amount that he would have
otherwise been distributed was reclassified as a “catch-up” contribution. Had he been
under age 50, this amount (adjusted for earnings) would have to be distributed to him.
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Is there a deadline for making corrective
distributions?
Generally, corrective distributions must be issued within
2½ months after the close of a plan year to avoid a
federally imposed 10% excise tax on the excess amounts.
♦ The deadline is March 15, 2012 for plans with year ending
12/31/11
♦ Additionally, corrective distributions must be made within 12
months following the close of the plan year
17
What if corrective distributions are not made
by the deadline?
Corrective actions must be taken to maintain the
qualified status of the plan.
♦ Most plans may use the IRS’s self-correction program to
correct this operational error. However, this can be costly.
• Corrective distributions must still be issued
• IRS 10% excise tax must be paid
• The employer must make an additional QNEC contribution to
the NHCEs equal to the amount of corrective distributions
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What is the 402(g) limit?
The 402(g) limit is an annual limit on the amount that an individual
may defer into the plan through pre-tax or Roth deferrals.
♦ This is a calendar year, individual limit - it is determined on a
calendar year basis, covering all plans in which the employee
participates
♦ Pre-tax and Roth contributions are combined to determine whether the
limit has been exceeded
♦ Catch-up contributions are not included in the limit
• The 2011 402(g) limit is $16,500
• The 2011 catch-up limit is $5,500
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What if the 402(g) limit is exceeded?
♦ The excess deferrals must be refunded before April 15th of the
year following the year in which the deferrals were made
♦ A participant who exceeds the limit for 2011 must be refunded
the excess amount (adjusted for earnings) by April 15, 2012
♦ If pre-tax deferrals are refunded after this date, the participant
is taxed in both the year of deferral and the year of
distribution
♦ If a participant participates in more than one plan, she/he must
notify the plan sponsor regarding which plan should make the
corrective distribution
20
What is the 415 limit?
Individual participants are subject to an overall annual contribution
limit, known as the 415 limit. This limit includes all contributions
made to the plan for a particular year on behalf of a participant,
including:
•
•
•
•
Pre-tax and Roth deferrals
Employer match and employer base contributions
Safe harbor contributions
Forfeiture allocations
Note: Rollover contributions and catch-up contributions are not included
as contributions for this purpose.
The 415 limit for the 2011 plan year is the lesser of 100% of gross
compensation or $49,000.
21
What if the 415 limit is exceeded?
It depends on the plan document provisions. However,
typically the following actions are required:
♦ Excess deferrals are refunded
♦ Excess employer contributions are forfeited
Note: Forfeited contributions generally must be used to reduce future
employer contributions
22
What is the Coverage Test?
♦ The Coverage Test is required to prove that the plan meets
certain minimum coverage standards set forth under the
Internal Revenue Code
♦ Generally, this test must be run separately for each distinct
component of the plan ― 401(k), employer match, and profit
sharing components ― independently of one another
♦ Generally, the plan must cover 70% of employees who have
met the minimum age and service requirements set forth
under the Internal Revenue Code (even if they are
otherwise excluded from the plan or a portion of the plan)
23
What is the Coverage Test?
♦ There are several different tests that can be applied to
determine whether the plan satisfies the coverage
requirements
Note: The plan is required to pass the Coverage Test ―
corrective measures must be taken should the plan fail this
required testing
♦ A plan may satisfy coverage requirements using either
the Ratio Percentage Test or the Average Benefits Test
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What is the Coverage Test?
♦ If the plan fails the Ratio Percentage Test (the 70%
test), the Average Benefits Test is applied
♦ If the plan continues to fail, typically an additional
employer contribution is required to satisfy this test
♦ Cross-tested plans are subject to additional coverage
testing requirements
25
What is the Top Heavy Test?
A defined contribution plan is generally considered top
heavy if, as of the last day of the prior plan year, the
account values of key employees represent more than
60% of the account values of all employees.
For example, a calendar year plan with a top heavy ratio
of 75% as of 12/31/10 would be top heavy for the 2011
plan year.
26
What happens if the plan is Top Heavy?
♦ The employer is required to make a 3% top heavy
contribution to all non-key employees that are actively
employed on the last day of the plan year
♦ All match and profit sharing contributions count toward the
top heavy minimum contribution
♦ Safe harbor plans are not required to make a top heavy
minimum if the only employer contribution is the safe harbor
contribution (this is true whether the plan provides for a safe
harbor match or safe harbor nonelective contribution)
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What happens if the plan is Top Heavy?
If no Key Employees benefit under the plan for a particular
plan year, then the top heavy minimum contributions are
not required for that plan year.
Note: A Key Employee is considered to be “benefitting” for this
purpose if he makes 401(k) or Roth deferrals into the plan,
even if the employer does not make any other contributions
to the plan.
28
Are there any other required tests?
♦ A number of additional tests may be required for your
plan. Common examples include:
• If your plan provides for a cross-tested profit sharing
allocation, additional coverage testing must be
performed
• If your plan uses a definition of compensation other than
a 414(s) safe harbor definition, additional testing must be
performed to prove that the definition of compensation is
nondiscriminatory (typically applies where a plan
excludes such items as bonuses or overtime pay)
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Are there any other required tests?
If your plan provides for different rates of matching
contributions or profit sharing contributions for different
groups of employees, additional testing will apply.
This is a broad overview of basic testing
requirements - additional testing may be required
for your plan based on your plan design.
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Achieving the design goals for your plan
♦ Retirement plan law is constantly changing
♦ Economic conditions have impacted businesses
• Plans that have stopped making employer contributions
are considering resuming this benefit
• Plan Sponsors may have changes in their workforce
demographics
31
Achieving the design goals for your plan
♦ Options to consider
• Increase your matching contribution
• Allow for more liberal eligibility requirements
• Amend your plan to include a safe harbor formula
• Utilize a cross-tested profit sharing formula
• Consider implementing a cash balance plan
32
Achieving the design goals for your plan
The Bottom Line: It is a good time to review your
current plan design to determine if changes would be
beneficial to achieve the overall goals of your Company.
Please contact your Account Executive if you would like to
schedule a call with one of our Compliance Consultants to
discuss your plan design:
• Design options
• Prepare a design study to demonstrate the cost associated
with various alternatives
33
Important Deadlines for 2012
For plan years ending December 31, 2011:
♦
March 15 – Corrective distributions must be made for ADP/ACP failures
to avoid the 10% Excise Tax
♦
April 15 – Deadline for corrective distribution of 402(g) excess deferrals
(all plans)
♦
July 31 – Request for Automatic Extension-5500 Series & 8955-SSA (2½
months)
♦
August 30 – Initial annual participant disclosure regarding plan
investments and expenses
♦
October 15 – Extended deadline for filing Form 5500 & 8955-SSA
♦
December 1 – For 2013 Plan Year: Due date for distributing Safe Harbor
notices and QDIA notices to participants
34
New Limits for the 2012 Plan Year
♦ Annual Deferral Limit (402(g))
$ 17,000
♦ Catch-up Contribution Limit
$ 5,500
♦ Annual DC Contribution Limit (415)
$ 50,000
♦ Annual Compensation Limit
$250,000
♦ Social Security Taxable Wage Base
$110,100
♦ Highly Compensated Income Threshold
$115,000
♦ Key Employee Income Threshold
$165,000
♦ Maximum DB - annual benefit
$200,000
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Questions & Answers
Please contact your DailyAccess Account Executive
at 888-535-4322 with questions or
to request a plan design study.
A recorded version of this presentation will be available at
www.dailyaccess.com.
We appreciate this opportunity to be of service
to you and your plan participants.
Thank You.
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