Pass Those Tests : Are you putting the correct amount in your 401(k)

Pass Those Tests : Are you putting the correct amount in your 401(k)

Pass Those Tests

Unless your 401(k) plan has adopted a “safe harbor” design, is a SIMPLE 401(k), or contains a qualified automatic contribution arrangement (QACA), you must perform the actual deferral percentage (ADP) nondiscrimination test each year. The ADP test compares the average rate at which highly compensated employees defer salary with the average deferral rate for nonhighly compensated employees. The difference between the highly paid and the lower paid employees must be within certain defined limits. If it isn’t, you must correct the excess contributions made by the highly compensated employees. Correcting Excess Contributions You have three basic correction options. The first is to refund the excess contributions. While refunds can be made anytime within 12 months of the close of the plan year, a 10% excise tax applies to excess contributions not returned within 2 and a half months after plan year-end. With either option, the amounts will be taxable to the employees. If allowed by the plan, an excess contribution made by an employee who is age 50 or older may be treated as a catch-up contribution, to the extent the employee hasn’t already made the maximum allowable catch-up contribution for the year. This treatment avoids the need to recharacterize or refund the excess amount. The third option is to make additional qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs) to nonhighly compensated employees. Such contributions will be treated as elective contributions for ADP testing purposes until the plan satisfies the nondiscrimination test. Ways To Avoid Failure If your plan has failed the ADP in the past or is likely to this year, you might want to look at adding automatic enrollment and automatic contribution escalation features to your plan (see “Automate Your Plan”). Both of these features are proven to increase plan participation by lower paid employees. Alternatively, or in addition to adding these plan features, you may want to ramp up your employee education efforts to reach lower paid and nonparticipating employees. Some approaches to consider: a targeted, personalized campaign of e-mails and/or paycheck stuffers stressing the benefits of participating in your plan, mandatory enrollment/education seminars on company time, posters in areas/departments with high concentrations of lower paid employees, and small prize incentives for attending retirement education/enrollment seminars or enrolling. Studies show that offering matching contributions usually increases plan participation. If you don’t currently offer a match or you discontinued your match during the recent economic downturn, consider offering one or bringing your company match back. Lower paid employees are often the ones most influenced by matching dollars. Those who participate frequently contribute up to the employer matching percentage. Consequently, changing your match structure from 50% on the first 4% of pay to 25% on the first 8% of pay could increase participant contributions without increasing your monetary outlay. If you think your plan is in danger of failing the nondiscrimination tests, talk with Jerry Smith. He will help you analyze your options, including adopting a safe harbor plan design.