ADP/ACP Prior Year Testing

[Archimage]

I am curious as how others of you have handled the situation of notifying HCEs they can only defer x% on average but if you want to take advantage of the catchup contribution you need to contribute x% plus the catchup limit for the given year.

[No Name]

Hey,

No one jumped in, so I'll give it a shot. I've only got one 401(k) where there are consistant uncertainties re: pass/fail.

There is one participant who flip-flops between HCE and NHCE ( via 20% rule). He's quite content to max out, then get his refund post year-end. His deferrals sometimes affect the other HCEs (leveling), but no one understands this stuff but us (if WE do!).

Why only one problem plan? Its amazing, actually. At small companies that I service, there have been a welcome few "ringers"; working spouses that want to save for retirement, while the other spouse is affluent enough that they defer 70-90% (thanks, EGTRRA). Really helps that ADP test.

A few other plans have HCEs that couldn't be bothered. Lots of 0%s in the HCE group. (Cap Gains vs. Ordinary Income debate?)

[Guest texasactuary]

This is one of those difficulties in life.

The most recent long discussion about this was with a client who has a lot of low paid HCEs that like to max out. I told them the percentage for next year (6.76 + 2) and then tried to explain that the over-50 crowd could add $4000 or so on to that (remember that, assuming the 402(g) limit is not reached, these are not catch-ups until the testing is failed).

My recommendation in the end was to max out and wait for the refunds!

Fortunately the client is a pretty smart guy and he was able to follow at least enough to understand why i could not be more definitive.

[Guest Midas]

Texasactuary - I agree a deferral is not a catchup unitl it exceeds a statutory limit, but the IRS has also commented that a plan imposed limit is considered a limit for catch-up purposes. So in your example, you would not have to have the ADP test fail to create a catch-up. You could work into the plan document a "plan imposed" limit on HCEs. If using prior year method, it can be worded as...."HCEs are limited to 2 percentage points more than the NHCE average from the preceding year". Therefore, in your example, if an HCE deffered 9% and has not exceeded the 402g limit, .24% (9% - 8.76%) would be considered catch-up and not included in the test.

Archimage - to answer your question, if you have a plan imposed limit that is in the document (important to note that if the limit is not in the plan, it can not be used for catch-up purposes), using Texasactuary's example I would suggest to a catch-up eligible HCE to calculate their deferral % as follows:

HCE Compensation = $100,000

Prior year NHCE ADP% = 6.76%

Plan imposed limit = prior NHCE ADP% plus 2%

Current year catch-up = $4,000

Deferral % Calculation = (100,000 x 8.76%) + 4,000 / 100,000

= 8760 + 4000 / 100,000

= 12760 / 100,000

= 12.76%

In this example I would suggest to the HCE to defer 12% (round down if the plan requires whole %s for deferral) for the year. If the limit is in the plan, anything over $8,760 would be removed as catch-up prior to running ADP.

[Archimage]

There is one problem with your example. You never know what the other HCEs will defer. Some defer nothing and some do not decide until the last minute. That will change the amount of your catchup.

[Guest Midas]

Why would that change your catch-up? Catch-up is only assessed if the plan imposed limit is exceeded. In the example we used, the plan imposed cap is 8.76%. This is true, regardless what other HCEs defer. The plan imposed limit applies to all HCEs. If other HCEs do not wish to contribute up to the max, then that will not effect any one indivudual HCE. The limit is still 8.76% and will need to be exceeded for purposes of catch-up. The only result of other HCEs not contributing will be a better ADP pass.

[WDIK]

But obviously the "Midas approach" does not allow an HCE that wants to maximize deferrals the opportunity to take advantage of other HCE's not participating.

[Guest Midas]

The "Midas approach" is the IRS acceptable approach to allowing catch-up when a plan imposed cap exists on HCEs deferrals. The cap has to be hard coded in the document and apply to all HCEs. If not in the document, you can not allow catch-ups. Hard to put a cap in the document when the cap is variable. Obviously, if you are constantly trying to determing what the other HCEs are deferring, or going to defer (which is very difficult) then your cap is a moving target and will not be a definitely determinable limit for the purposes of allowing catch-ups.

I thought the original question was how to consult with client regarding how to get catch-up in the plan whan a plan imposed limit is being applied to the HCEs.

If you want advise on how to max out each HCE (which is totally different question), then Texasactuary has the right idea. Fail ADP and do refunds.

[WDIK]

I thought the original question was how to consult with client regarding how to get catch-up in the plan whan a plan imposed limit is being applied to the HCEs.

I did not get the impression from the original post that there was a plan imposed limit. I also did not mean to leave the impression that I was attacking your methodology. On the contrary, I quite enjoyed it. I was merely trying to add to the conversation and clarify other aspects of the scenario.

[Guest Midas]

WDIK - Thanks. Sorry if the tone sounded defenisive.

If the question is not referencing some sort of adminstrative cap for the HCE, then I do not understand the question. If the "x%" that Archimage eludes to is the Plan limit (i.e. plan document deferral limit = 75%), then what is the question regarding catch-up? Most plan's deferral limits are high enough for any HCE to reach 402g and catch-up limits. If the intent is to limit the HCE below the 75% to pass ADP, then we are talking about an Administrative cap of some sort. And unless that cap is oulined in the document the question about catch-up is a moot point.

[WDIK]

I will give you my interpretation of the original post. Since the thread title referred to prior year testing, I assumed x% referred to the maximum ADP for the HCE's. Archimage's use of the verbage "on average" seemed to support that assumption. Based on that, I thought that Archimage was trying to find a way to communicate to the HCE's that they could contribute catch-up contributions based on deferring more than the maximum ADP. As has been pointed out, this becomes a moving target for an individual HCE based on all the other HCE's deferral rates which definitely makes the communication process more difficult.

[Guest Midas]

WDIK- Your interpretation is exactly the same as mine.

Let me ask you this....do you not consider managing an HCE to the prior year's ADP% an adminstrative cap, meaning you are imposing a deferral limit less than what the plan allows? I would hope that you would agree that is an administartive cap. My point all along is when consulting with a client about his opportunity to put in catch-up over and above an administrative cap, that cap should be in the document and being applied to all HCEs. Therefore all this worry about what other HCEs are deferring is irrelavent.

Maybe you will understand Sal's presentation on this better than mine......

Chapter 11

Part B

3.b.2)a) Plan-imposed limits must be set forth in plan document. In order to be taken into account for catch-up contribution purposes, a plan-imposed limit is any limit on the elective deferrals that an employee can make which is “contained in the terms of the plan, but which is not required under the Internal Revenue Code.” See Treas. Reg. §1.414(v)-1(b)(1)(ii). An example of a plan-imposed limit would be a provision in a section 401(k) plan that limits elective deferrals to 10% of compensation for the plan year. An employee’s elective deferrals will be characterized as catch-up contributions (up to the annual catch-up limit)

to the extent that the elective deferrals for the plan year exceed that plan-imposed limit is reached, unless one of the statutory limits described in 3.b.1) above is reached first. In other words, the first statutory or plan-imposed limit reached is the level above which elective deferrals can be treated as catch-up contributions.

3.b.2)a)iv) Comments by IRS and Treasury on the plan-provided limit issue. At the

ASPA Summer Conference held in Irvine, CA, July 27 through 30, 2003, representatives from the IRS and Treasury were asked to comment on this issue. They agreed that, if an approved plan document (i.e., favorable opinion, advisory or determination letter) expressly authorizes the plan administrator to set a deferral limit, and the administrator follows the procedures authorized by the terms of the plan, that the limit so set would be a plan-imposed limit for catch-up purposes.

Plan practice tip. Given these comments, certainly the preferred practice would be to set forth the limit in the plan document, or at least a formula for determining such limit (e.g., HCEs are individually limited to three percentage points more than the NHC average for the preceding year).

[WDIK]

Let me ask you this....do you not consider managing an HCE to the prior year's ADP% an adminstrative cap, meaning you are imposing a deferral limit less than what the plan allows?

While I agree that a plan could use language as you described to tie an administrative cap to the ADP test, I do not think that such plan language is a requirement in order to take advantage of catch-up contributions based on the ADP limit. In fact, where a plan has more than one HCE, it appears to me that the HCE's lose flexibility by implementing the administrative cap. Such an approach may or may not be preferrable for a given scenario.

Sal's cite does not mention anything about the ADP test.

[Archimage]

Yes, that is my question and my point. An administrative cap would give a definite determinable amount. However, if another HCE decides to defer nothing then the the HCE I am dealing with has not put the most he can do to the cap. While a cap may make communication easier and amounts determinable, it does not reach the goal of maximizing deferrals for the HCE. (In my case anyway).