Compliance Testing

[Guest AlanB]

I'm so glad I found this message board. Sorry for the long post.

First, I own a small company with 5 employees. I administer the 401k plan using software which contains compliance testing. I have basic questions on compliance testing (ADP, Top Heavy etc) and other general questions.

First some background on the 401k. It's open to employees from day 1 of hire and no matching. The plan doesn't specify a max percentage contribution.

1) What is the max percentage allowed by law to contribute in a single year? 100% of salary? (I know there's a max amount of 15K for 2006).

2) Can I exclude someone who started this year from compliance testing? I have been told two different things. One is that I can if the employee is BOTH under 21 and less than one year service and the other is under 21 OR less than one year of service.

3) if every employee is highly compensated can we fail the non-discrimination testing?

4) let's say I'm testing for 2006, I look at the salaries from 2005? Please explain this.

Thanks in advance!

AlanB

[WDIK]

1) Although the technical answer is 100%, in practice you have to take into account tax withholding (FICA, etc.)

2) OR

3) You will not fail under the scenario you describe.

4) Prior year salary is used in determining who is a highly compensated employee, and current year salary is used for the testing (ADP, etc.)

[Tom Poje]

#4. you need to check the document in regards to testing. if prior year testing is specified, then you would use prior years comp and deferrals for the NHCEs. you always use current years comp and deferrals for the HCEs

[WDIK]

Tom's answer is certainly more complete. Although mine is technically correct for the scenario posed (i.e., all highly compensated employees), it was unintentionally so.

[Guest AlanB]

Wow! Thanks for the quick responses.

Just to confirm something since this is an important point for me to understand.

I just hired a new employee in May 2006 who is 40 years old (older than 21). I do not currently have his salary from last year since he didn't work for me.

Based on the answer to #2, I don't need to worry about him for compliance testing in 2006 anyway since he will only work 6 months or so in 2006 (less than a year). In 2007 I will have his 2006 salary (which is half a years salary - let's say $60K) but for a full year he would be getting $120K (Highly Compensated). In 2007 when I run all of the testing, he would be classified as non-highly compensated because of the 60K salary in 2006?

AlanB

[Tom Poje]

go to the head of the class. you are correct on all points.

it does not matter how much comp someone has with a previous employer.

you never annualize comp, so the fact a new employee made 60,000 for only part of the year still means he made only 60,000 for testing and for determination of HCE status, so ee is not treated as an HCE in 2007.

[Sully]

Make sure you run the top heavy test. You may be required to give a top heavy minimum contribution to all of the eligible non-key employees.

[austin3515]

You're doing okay on your own, but I would hire a TPA to do all this for you. There's thousands of things to know, and only someone who does it day in and day out can have a shot at even knowing most of them.

It will be worth the extra cost if you get audited by the IRS. Also, the fact that you didn't mention top-heavy in your original post means that you missed the single most important issue your Plan faces (in terms of how sorry you'll be if you get it wrong!). Small plans are almost guaranteed to become top-heavy at some point.

[GBurns]

AlanB

I always advise my clients to use qualified competent help whenever possible. I advise you to do the same for a few reasons.

There are things that you might miss and the consequences will cost more than if you had used a TPA. Plus you can blame etc the TPA for errors.

It is more profitable to work on building your business than working in your business. For example if you are currently making $84,000 per year ($1,600 per week) that equates with an hourly rate of about $40 per hour. It makes no sense to answer your own telephone, type your own letters, do your own payroll, take deposits to the bank, go to the Post Office, do filing etc etc or any other clerical function if you can easily hire competent clerical help for $20 per hour. And it is possible that you might only need this clerical help on a part time basis. Why do $20 oer hour work when you can do work worth $40 per hour?

How much more valuable would your time be if it was instead spent on getting more business, or getting the jobs done faster or better?

Let someone else sweat the little stuff for you.

[Guest AlanB]

I really do appreciate everyone's input and I would have to agree with the comments about me hiring a TPA. It probably will come to that.

I started a few years ago and found this 401k software to use called 401k - easy. It seemed like what I needed -something I could run, basic, fairly inexpensive (although I don't know what a TPA would cost). Keeping track of contributions is easy, but the compliance part stinks. They do run all of the tests - top heavy included but I have found that I really need to understand the details of the tests in order to plan. For example, if it looks like I may fail in the future maybe I'll switch to safe harbor.

Here's more details.

Essentially my company deals with very senior people so they all would be Highly compensated (maybe not the first year as discussed before). I own the company and everyone including me pretty much contributes either the full amount to the 401k or pretty close to it. I wasn't really focusing on the compliance aspect because I assumed I would always pass, but I (obviously) didn't understand the details.

Currently we pay something like $900 year for me to run it myself with Vanguard as the "holding"? company.

Any and all input in appreciated. Thank you in advance.

[Belgarath]

I'll just toss out a guess that a TPA "normal" range for a basic 5 person 401(K) plan will be somewhere between $1,000 and $2,000. Undoubtedly there will be amounts that are both higher and lower, depending upon a myriad of factors. A word to the wise on "lowball" fees - you know the old saying that you can't get something for nothing - usually the lowball fee either requires a specific funding arrangement that may have high costs, or may not cover essential services.

You sound pretty sharp on this stuff, but the compliance and plan document end is so detailed, and worse yet, changes so rapidly, that it is easy to get hung. I'm probably not the most objective source on this subject, but I'd second the motion to look into hiring a reputable TPA.

[Guest Pensions in Paradise]

Another advantage to hiring a TPA is that they might be able to design a "better" plan for you. One thing you should look into is cross testing, which might allow you to receive a larger percentage of company contributions. Heck, you could even post the data and I could run some numbers for you. Only need age, date of hire, estimated comp for 2007, and whether the person will be HCE for 2007.

[BG5150]

Based on the answer to #2, I don't need to worry about him for compliance testing in 2006 anyway since he will only work 6 months or so in 2006 (less than a year). In 2007 I will have his 2006 salary (which is half a years salary - let's say $60K) but for a full year he would be getting $120K (Highly Compensated). In 2007 when I run all of the testing, he would be classified as non-highly compensated because of the 60K salary in 2006?

This may be semantics, but you don't have to worry about him when doing the testing IN 2006 for the 2005 plan year. However, testing FOR 2006 (done in 2007, most likely) he will count if, in fact, he is eligible for the plan. He will NOT be an HCE because he has no compensation in the lookback year. Ne c'est pas? (Am I not correct?)

[Guest AlanB]

Boy, no wonder why so many small businesses don't have 401k plans!

Can someone "simply" state the rules for the three tests (ADP, ACP, Top Heavy).

Do I need to pass all three? I don't think I would ever fail the top heavy since I'm the only owner and my first employee has about the same amount in the 401k as I do (and there are other employees as well).

[Guest Pensions in Paradise]

Can someone "simply" state the rules for the three tests (ADP, ACP, Top Heavy).

That's the problem, there is no "simple" way to answer your questions. This area is very complex. If you really want to do it yourself there are quite a few books on the subject. IMHO, two of the better publications are The ERISA Outline Book and the Pension Answer book.

[Guest Boilerburm1]

And remember, once your NHCE is in the plan and establishes a deferral percentage for the NHCE class, the allowable HCE deferral is TOTALLY dependent on what that one NHCE does! So if he only defers 2%, your entire HCE group can only defer an average of 4% of pay.

This will be the case each time you bring in a new employee, so "allowable" HCE deferrals could be all over the board from year to year.

[Mike Preston]

Boy, no wonder why so many small businesses don't have 401k plans!

Agreed. The rules are complex.

If a small business wants a plan that is easy and safe to operate, they need to put in a plan that requires a certain minimum contribution, such as a Safe-Harbor plan. The hallmark of a Safe-Harbor plan is that the plan sponsor must be willing to make some sort of contribution to NHCE participants, if the circumstances arise where a contribution is required. That is, the employer doesn't get to choose whether an NHCE gets a contribution or not; the terms of the plan control whether the employer has to make a contribution. The problem with retirement plans in general is that there are so many options available at just about every turn that it is impossible to state that anything is absolute. Are you aware of what the Safe Harbor rules are? If so, you will know that a small business can easily sponsor a 401(k) plan if they want to. For those that choose not to it is because they see all these options and none of the "simple" ones are completely free of employer contributions.

Can someone "simply" state the rules for the three tests (ADP, ACP, Top Heavy).

Probably not. Simply because the rules are not simple. But I've been known to tackle the impossible before, so how's this:

1) ADP - "Average Deferral Percentage" test. The HCE's may only contribute a "given" percentage, on average, based on the average that the NHCE's actually contribute. Example: NHCE's contribute, on average, 2.5% of their pay. The HCE's are limited to, on average, 4.5% of their pay. If the ADP of the HCE's exceeds the allowable average, the plan must correct the problem by spitting back some deferrals to HCE's or by having the employer put in some money and giving it to the NHCE's. The rules on how you determine what to give back or how you add money to NHCE's are quite complex, so there is no way I can specify those within the context of a simple description. But one thing is for sure: if you don't fail the test you don't have to either give monies back or make additional contributions. With that said, the HCE ADP is a function of what the NHCE ADP is. If the NHCE ADP is between 0 and 2%, the HCE's are allowed twice that amount (Example: NHCE ADP is 2%, HCE ADP is allowed to be 4%). If the NHCE ADP is between 2% and 8%, the HCE's are allowed that percentage plus 2% (See above example). If the NHCE ADP is over 8%, the HCE's are allowed 125% of the NHCE ADP. The way I remember it is: "times 2 up to 2, plus 2 over 2, until you get to ..... 2 times 2 times 2 (that is 8), in which case you must use 5 times 5 times 5 (that is 125)." Yeah, I know.... cheesey at best.

One final complication that can't be ignored, even if it is a simple explanation. The NHCE ADP can be based on the current year or the prior year, at the option of the plan sponsor (must be in the plan document).

2) ACP - "Average Contributions Percentage" test. This is a test that tests the employer's matching contributions. For simplicity, you run through the exact same test as the ADP test.

There are very complicated rules which describe how the two tests interact when one of them is failing. However, the same rule applies here as above: if you don't fail the test, things are simple.

3) TH test: In concept, this one is simple. In practice, not quite so simple. The simple equation is that if as of the last day of the prior year more than 60% of the plan is held by participants who are defined as "KEY Employees" (this is not the same definition as HCE), then the plan is top heavy for the next year. For purposes of this calculation you sometimes have to add back in distributions that have taken place in either the last year or the five prior years, but that really isn't all that difficult once the rules for doing this are analyzed, but detailing them is beyond the scope of a simple answer. Also, discussion as to who is a KEY employee is a bit beyond the scope of this answer. But the general rule is: less than 60% in the accounts of KEY employees and the plan isn't top heavy.

Do I need to pass all three?

Not at all. There are just consequences associated with failing. In the case of ADP and ACP you "merely" have to give back monies to the HCEs or put monies into the plan for the NHCE's. In the case of a plan being top-heavy you merely have to make an employer contribution of at least 3% of pay to all participants who are not KEY employees.

The above is a very scaled down, imperfect, and incomplete answer. For details, consult a TPA in your neck of the woods.

Good luck.

[Guest AlanB]

Thank you! Great information!

For my company we have no matching so ACP is not applicable. As for top heavy, I'm the only owner (and the only one classified as a "KEY employee") and since I don't have more than 60% of the total, I think I will always be ok here.

As for ADP, that's the one place I believe I need to be concerned about. As Boilerburm1 stated, every new employee can be a problem.

My ADP for NHCE is based on the preceding year. So let's say I have this situation:

Example: Let's say this year 2006 I have 5 employees - 4 of which started in 2002 just for this example and always contribute the max (15K) and each have a salary of $150. The new employee in 2006 makes $150k, but in 2006 worked half a year for $75K and contributed nothing in 2006.

Are the following statements correct?

1) In 2006 we pass the ADP test (and no money is returned to the HCE) because the new employee is not counted anywhere in any calculation.

2) In 2007 (even though the new employee is really an HCE he wasn't classified that way in 2006) we fail the ADP test because the ADP for 2007 for HCE (let's say in 2007 they make the same and 15k was the max) is 10% and the ADP for the NHCE (based on 2006 numbers) is 0%.

If both statements are true, then the bottom line is that the company must really try and "push" the 401k for new employees in order not to have to return money to HCE's.

3) also, what is the max salary that you can put down for an employee or owner. i.e., I think I read somewhere that even if an employee makes 1 million the max is something like $210,000?

[Jim Norman]

Are the following statements correct?

1) In 2006 we pass the ADP test (and no money is returned to the HCE) because the new employee is not counted anywhere in any calculation.

Yes.

2) In 2007 (even though the new employee is really an HCE he wasn't classified that way in 2006) we fail the ADP test because the ADP for 2007 for HCE (let's say in 2007 they make the same and 15k was the max) is 10% and the ADP for the NHCE (based on 2006 numbers) is 0%.

Right - to a point. The HCEs would have their $15K contributions refunded and taxed. But it is not so simple. If your 4 employees hired in 2002 are all HCEs, this is true. But they don't necessarily have to be HCEs. An often overlooked aspect of the HCE determination is the "top paid group" election. In your example for 2007, the HCEs are generally those who earned over $100K in 2006. However you are permitted to limit the number of HCEs to just the top 20% when ranked on total pay. Given your small company, 20% would be 1. If you are the highest paid, that is you. If you are not the highest paid, you are still an HCE by ownership and the highest paid employee would also be an HCE. But, this top paid group election must be specified in the plan document. The others, even though over $100K, would be NHCEs, they could defer the max, the HCEs could probably defer the max or close to it even if the new employee does nothing.

If both statements are true, then the bottom line is that the company must really try and "push" the 401k for new employees in order not to have to return money to HCE's.

You can lead the horse to water but can't make him drink. This is where a "simple" plan done without good advice gets real expensive. Without the top paid group election or a safe harbor plan, if your new employee doesn't defer, all 4 HCEs are limited to zero. So, 4 * $15K = $60K lost contribution = $20K - $25K of additional income tax liability.

Other plan design considerations. You are in a unique situation in years where all your employees are HCE and you are not top heavy. With a tiered plan you could add additional profit sharing contributions for yourself as owner without having to make contributions to other employees, throw in another $29K for yourself, plus the 401(k) to total $44K. Has to be monitored year by year for the new hire NHCE and to watch top heavy. Again, the plan document has to allow for this. This approach would not use the top paid group election. Complicated? Yes. Worth a couple grand a year in fees? That's up to you to make that judgement, but you can't make the decision without the information.

"easy" or "simple" 401(k)s are often the most expensive plans because of the lost opportunities to do something better. You can't roll the clock back and get those prior years missed opportunities back.

[Archimage]

I assume your new HCE was hired in 2006. If so, this person would not be considered an HCE until 2008. In 2006 he didn't reach the HCE comp limit in determining HCE status for 2007. 2007 is the first year his comp would be above the limit in determining HCE status for 2008 plan year.

[Jim Norman]

Of course I should also point out that with a one year eligibility, the employee hired in 2006 isn't eligible to defer in 06. So the 07 ADP would pass with no NHCEs eligible and prior year testing.

This just furthers Mike Preston's comment that any simplified explanation will be incomplete.

[wsp]

Boy, no wonder why so many small businesses don't have 401k plans!

Actually this is why so many small businesses hire TPA's to administer their plans. Many times it's the smaller businesses that can reap the biggest dividends from doing so. And in your case, they can ensure that the maximum benefit is available for you, the business owner.

On a side note, a key employee is not determined by title or who the owner feels is key to their business. So, what you consider a key employee may be entirely different than what that the IRS says it is. Your plan very well may be top heavy and you don't know it. Especially given that you said that you have senior level, Highly Compensated individuals employed by you.

[Guest Boilerburm1]

Also, you can do a QNEC for NHCEs only. This may be a relatively inexpensive way to get the plan to pass without having to return deferrals to HCEs. And you also might consider safe-harbor to deem passing of the ADP test.

These are just a couple of things to consider as you contemplate why you don't have a TPA considering these things for you!!!!

[BG5150]

Also, you can do a QNEC for NHCEs only. This may be a relatively inexpensive way to get the plan to pass without having to return deferrals to HCEs. And you also might consider safe-harbor to deem passing of the ADP test.

Check the docs first to see if you can do this, first. You may have to amend them if a QNEC is not allowed (or, rather, not chosen as an option by the employer).

[John Feldt ERPA CPC QPA]

Another reason to have a TPA is to keep the form of the plan qualified. Most TPAs provide a plan document service to keep the plan up-to-date with all laws and regulations.

Has your plan been amended for the automatic rollover rules? This was required under 401(a)(31)(B) and is due no later than the filing deadline for your corporate tax return that contains March 28, 2005, or if later 12/31/2005. This includes any extension, if your filed an extension for your coprorate return. Perhaps you have a standardized or nonstandardized plan and the amendments are done by your document provider automatically. If it has been done, then a Summary of Material Modifications should be prepared and provided to your employees - that will be due no later than 210 days after the plan year in which the amendment was adopted.

Was the plan amended for 401(a)(9) by the end of 2003 (or thereabouts depending on your plan year)?

The next amendment will be for the Final 401(k)/401(m) regulations - this will generally be due no later than the filing deadline for your 2006 corporate tax return plus any extension, if you file an extension for your coprorate return.

[Guest AlanB]

From my plan documentation:

a "key employee" is defined as an employee meeting any of the following criteria:

• An officer of the company earning compensation of more than $130,000

• A 5% owner of the company

• A 1% or more owner of the company projected to earn more than $150,000

My employees are all employees and not "officers".

Here is a link to the info from their site:

www (dot) 401k-management (dot) com/pc/index.html

I've been reviewing the compliance section.

"Has your plan been amended for the automatic rollover rules". Don't know but I intend to ask.

Bottom line - I am moving to a TPA. I have been sufficiently scared!

[Mike Preston]

And now we know why you are a successful small business owner.

Best of luck!