The tax code governing 401(k) plans was written to prevent qualified retirement plans from overly favoring highly compensated employees (HCEs).  A series of non-discrimination tests were devised to measure whether a plan’s design or operation tends to favoring the HCEs over the nonhighly compensated employees (NHCEs).  In our last installment we discussed how the Average Deferral Percentage (ADP) test is calculated.  In this article we dive into the different methods of correcting for an ADP test failure.

Correcting ADP Failures:   Refunds to HCEs

There are generally two ways to correct a failed ADP/ACP test.  The most-popular correction method is to refund “excess” deferrals to HCEs.  The refund calculation is a two-step process.  First, the total refund amount is determined by calculating the total percentage points that must be refunded to satisfy the ADP test.

The next step calculates the dollars which would be refunded if the excess percentages were refunded first to the HCE with the highest deferral percentage until either the total excess percentages are refunded or until the resulting deferral percentage of that HCE equals that of the HCE with the next-highest deferral percentage.  If the test is still not satisfied, both HCEs are reduced together until the test is satisfied, and so forth.

The final step determines how much each HCE is to be refunded.  This is calculated by first allocating the total refund to the HCE with the highest deferral, in terms of dollars, until the total refund is applied or until the deferral of such HCE is reduced to that of the HCE with the next highest deferral, and so forth.

The amount refunded is considered a taxable distribution from the plan, and is reported as taxable income to the participant in the year it is distributed from the plan.  The corrective distribution is required to be completed by March 15th of the year following the year the excess contribution occurred.  If completed after March 15th of the following plan year, it is still considered to be taxable income in the year paid, however in addition, the Internal Revenue Code imposes a 10% excise tax on the employer.

Correcting ADP Failures:   QNECs

While a refund is the most-popular method of correcting an ADP failure, it is not always the most beneficial.  The primary reason is that the HCEs, often the owners of the company or its most-valuable employees, lose-out on the tax deferral aspects of contributions to a 401(k) plan.  An alternate method of satisfying the test is for the employer to make a Qualified Non-elective Contribution (“QNEC”).  A QNEC is an employer contribution that is fully-vested when made and subject to the same distribution limitations otherwise applicable to section 401(k) contributions.  A QNEC counts as a deferral in the ADP test.  Thus, a QNEC can be used to correct a failed ADP test.  A pro-rata QNEC would be allocated among NHCEs on the basis of compensation.

A QNEC must be provided for in the plan document.  In addition, the allocation formula must be set forth in the document prior to the end of the plan year being tested.  Many plans which contain QNECs will contain the “pro-rata” allocation formula set forth above.    Keep in mind that the existence of QNEC language in a plan does not obligate the employer to make a QNEC in the event the ADP test is not satisfied.  The employer retains the option of distributing amounts to HCEs.

The tax code governing 401(k) plans was written to prevent qualified retirement plans from overly favoring Highly Compensated Employees (HCEs).  A series of non-discrimination tests were devised to measure whether a plan’s design or operation lends to favoring the HCEs over the Non-Highly Compensated Employees (NHCEs).  All year end testing begins with the coverage test in accordance with IRS Code section 410(b).  Once the coverage test is passed or, if not passed, once steps have been taken to pass coverage, then the average deferral percentage (ADP) test must be performed.  The ADP test uses mathematical equations to compare the participation and contribution rates of the HCEs to the NHCEs in order to determine whether the plan is discriminating in favor of the HCEs.

Who is considered a Highly Compensated Employee?
Generally, a highly compensated employee is an employee who is either a more than 5% owner of the business (also known as a 5% owner) in the year of testing or the prior year, or someone who makes more than a specific  dollar threshold determined by the IRS and adjusted annually for cost-of-living increases ( for 2018 testing purposes, someone who earns $120,000 or more in 2017).  It is possible to further restrict the number of HCEs associated with a particular employer by limiting HCE designation based on a compensation threshold  to only  the highest paid 20% of employees.  This election may be particularly effective for small plans maintained by professional groups such as law firms and physicians.  However, this election must be written into the plan document provisions in order to be effective.

The 5% owner rule also requires careful review of the ownership attribution rules for families and trusts.  Family attribution rules dictate that the spouse, parent, legal child and grandchild of a more than 5% owner of the company are also considered 5% owners themselves.  For example, if John Smith owns 100% of a business that also employs his wife Jane; the family attribution rules dictate that, as his wife, Jane would also be considered to own 100% of the business.  Therefore, both John and Jane would  be considered to be HCEs due to either direct or attributed ownership.

How does the ADP Test work mathematically?

To perform the ADP test, first determine every employee who is eligible to make an elective deferral regardless of whether they actually contribute.  Then you divide this list into groups: HCEs and NHCEs.  Starting with the HCEs, each employee’s Actual Deferral Ratio (ADR) is determined by dividing the employee’s compensation into the amount the employee deferred into the plan.  Once each employee’s ADR is determined, the ADRs are averaged to arrive at the HCEs’ ADP.

Below is an example to illustrate this process:

The same process is followed for the NHCE group.

Once both the HCE and the NHCE and ADP figures have been determined, they are compared against each other.  The HCEs’ ADP may only exceed the NHCEs’ ADP by specific limits.  The limits may be summarized as follows:

Using our example in which the NHCEs’ ADP is 2.53%, the HCEs’ ADP is limited to 2.53% plus 2% for a maximum of 4.53%.  This test passes as the HCE average is 4.22%

Timing of the test

In general, the ADP testing should be completed within 2½ months after the end of the plan year.  The typical correction for a failing test involves the distribution of excess contributions to the HCEs until the point at which the test is satisfied.  In order to avoid an excise tax penalty, the plan sponsor is required to process these refund distributions by no later than 2 ½ months after the plan year end date.  If the plan document allows for it, a failing test may also be remedied by the plan sponsor contributing a Qualified Non-Elective Contribution (QNEC) to the NHCEs to raise their average to a passing result.

Download PDF

Almost every sponsor of every tax-qualified retirement plan must obtain a fidelity bond in accordance with section 412 of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  Despite the broad application of this requirement, a surprising number of plan sponsors are unaware of this requirement and, in fact, do not have a bond at all or do not have a bond in the proper amount.  Consequently, this article is written in order to help explain the requirement in order to attempt to ensure that those who are subject to this requirement satisfy it.

Obviously, in order to reasonably expect to satisfy this “ERISA bond” (“ERISA Bond”) requirement, it is necessary to understand exactly what it is.  In this regard, an ERISA Bond is a type of insurance that protects a plan against losses caused by acts of fraud or dishonesty. Fraud or dishonesty includes, but is not limited to, larceny, theft, embezzlement, forgery, misappropriation, wrongful abstraction, wrongful conversion, willful misapplication, and other acts.

It is important to understand that the ERISA Bond is different from fiduciary insurance.  The ERISA Bond protects plan participants from the acts of fraud or dishonesty described above.  However, fiduciary insurance protects a plan fiduciary from claims relating to a fiduciary breach under ERISA.  Thus, the ERISA Bond protects plan participants while fiduciary insurance protects plan fiduciaries.  In addition, the ERISA Bond is a mandatory requirement under ERISA for most retirement plans while fiduciary insurance is not required.

As mentioned above, most retirement plans are required to have an ERISA Bond.  This raises the question of exactly which plans must obtain the ERISA Bond. Although the bonding requirements generally apply to most ERISA retirement plans (and many funded welfare benefit plans), the ERISA bonding requirements do not apply to plans that are not subject to Title I of ERISA; the most notable of which are owner only, “solo k”, plans or to employee benefit plans that are completely unfunded (i.e., the benefits are paid directly out of an employer’s or union’s general assets).

Now that we understand which plans must have ERISA Bond coverage, we also need to understand exactly which persons must be covered by the ERISA Bond.  Under ERISA, every person who “handles funds or other property” of an employee benefit plan is required to be bonded unless covered by an ERISA exemption. ERISA makes it an unlawful act for any person to “receive, handle, disburse, or otherwise exercise custody or control of plan funds or property” without being properly bonded.

In application, the “handles funds or other property” qualification generally encompasses the ERISA plan administrator and those officers and employees of the plan or plan sponsor (employer, joint board, or employee organization) who handle plan funds by virtue of their duties relating to the receipt, safekeeping and disbursement of funds.

“Funds or other property” generally refers to all funds or property that the plan uses or may use to pay benefits to plan participants or beneficiaries. Plan “funds or other property” includes all plan investments such as land and buildings, mortgages, and securities in closely-held corporations. It also includes contributions from any source (such as employers, employees, and employee organizations) that are received by the plan, and cash, checks and other property held for the purpose of making distributions to plan participants or beneficiaries.

A person is deemed to be “handling” funds or other property of a plan whenever his or her duties or activities could cause a loss of plan funds or property due to fraud or dishonesty, whether acting alone or in collusion with others. The general criteria for “handling” includes but is not limited to: 1) physical contact with cash, checks or similar property; 2) power to transfer funds from the plan to oneself or to a third party; 3) power to negotiate plan property (e.g., mortgages, title to land and buildings or securities); 4) disbursement authority or authority to direct disbursement; 5) authority to sign checks or other negotiable instruments; or 6) supervisory or decision-making responsibility over activities that require bonding.

Generally, the amount of the ERISA Bond must be equal to at least 10% of the amount of funds “handled” in the preceding year. The bond amount cannot, however, be less than $1,000, and the Department cannot require a plan official to be bonded for more than $500,000, or $1,000,000 for plans that hold employer securities. These amounts apply for each plan named on a bond.

For example, assume a company’s plan has total assets of $1,000,000. The plan trustee, named fiduciary and administrator are three different company employees that each have access to the full $1 million, and each has the power to transfer plan funds, approve distributions, and sign checks. Under ERISA, each person must be bonded for at least 10% of the $1 million or $100,000.  (Note: Bonds covering more than one plan may be required to be over $500,000 to meet the ERISA requirement because persons covered by the bond may handle funds or other property for more than one plan.)

Finally, it is permissible under ERISA to pay for the ERISA Bond with plan assets. The purpose of the ERISA Bond requirements is to protect the plan. The ERISA Bond does not protect the person handling plan funds or other property or relieve them from their obligations to the plan.  As a result, there is no conflict created if the plan pays for the ERISA Bond.

As much as we hope this article helped you to better understand this topic, it is not to be construed as financial, tax or legal advice.  Therefore, if you believe that the issues discussed herein may apply to your (or your client’s) company, be sure to further discuss it with a qualified retirement plan professional.  For more information about this topic, please contact our marketing department at 484-483-1044 or your administrator at Legacy.