TAX AND LEGAL ADVICE NOTE: Information provided here is for general and illustrative purposes only, and should not be relied upon by any person for tax or legal purposes, or construed as advice for such. 

ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) Tests

These nondiscrimination tests are to ensure that Highly Compensated Employees (HCEs) don’t receive excess benefits under the 401(k) salary deferral or employer matching options of a plan, in comparison to non-HCEs. Safe Harbor plans are generally exempt from these tests. The HCEs and non-HCEs are divided into separate groups, and average contribution rates are compared. If the HCEs exceed IRS limits, corrections are required by either refunding excess amounts to HCEs, or making special contributions to NHCEs.

Controlled Groups, Affiliated Service Groups, and Management Groups

When two or more companies have certain levels of common ownership, control, or association/involvement with each other, the IRS treats them together as a single employer for many tax-related and retirement plan purposes. When determining ownership, attribution to and from family members, trusts, and estates sometimes applies.

“Cross-Tested” or “New Comparability” Plans

“Cross-testing” is an advanced nondiscrimination testing method for 401(k)/profit sharing plans that often allows a significantly higher rate of the profit sharing contributions to be allocated to the owners and other targeted employees, than to the other employees. This works when the targeted employees are older. Prior to performing the general nondiscrimination test, contributions are converted to their projected value at retirement age. As the younger employees’ contributions accumulate compounded interest for a longer time, the disparity between their benefits and the older targeted employees’ benefits is narrowed, making the test easier to pass. To prevent excess disparity, the IRS requires a minimum “gateway” contribution to the non-Highly Compensated Employees of the lesser of 1/3 the highest Highly Compensated Employee's contribution rate, or 5% of compensation.

General Test

This nondiscrimination test prevents Highly Compensated Employees (HCEs) from receiving excess employer-funded contributions or benefits, when compared to non-HCEs. In “cross-tested” plans, the current contributions are converted to their projected value at the employees’ retirement ages, to improve test results. Certain plan designs are considered automatically non-discriminatory and are exempt from this test.

An employer sponsoring a retirement plan for the benefit of its employees is responsible for ensuring that the funds are safe and secure. The Employee Retirement Income Security Act of 1974 (ERISA) requires that qualified retirement plans subject to its disclosure and reporting requirements (generally, those with non-owner employees) be insured by an ERISA fidelity bond. The bond protects the plan against losses due to acts of fraud or dishonesty on the part of persons who handle plan assets.

ERISA requires that the value of the bond must be at least 10% of the plan's assets (minimum $1,000), up to a maximum of $500,000 (some providers offer an automatic-increase "inflation guard" option, so you don't have to monitor the 10% requirement). However, more coverage may be necessary if a plan has “nonqualifying” assets (assets whose values are not readily determinable on the open market): for a “small plan” (generally, under 100 participants), if the nonqualifying assets exceed 5% of the plan’s assets, then the bond must be at least equal to the value of the nonqualifying assets in order to exempt the plan from ERISA’s requirement for an annual independent accountant’s report.

ERISA bonds are readily available and easy to purchase. Your business insurance agent is a good person to contact for ERISA bond coverage. Colonial Surety offers online price quotes and order forms for reasonably-priced ERISA fidelity bonds for 401(k) plans. Colonial's fidelity bonds comply with U.S. Department of Labor guidelines and requirements, and can be delivered to the purchaser the next business day. Please go to www.colonialsurety.com for more information or to https://quote.colonialsurety.com/login/register_plan_sponsor?ref=CA0636 for a custom quote.

Highly Compensated Employees

“Highly Compensated Employees” (HCEs) are determined for purposes of various nondiscrimination tests (to ensure that plans provide sufficient benefits to non-HCES when compared to HCEs). The following are generally considered HCEs:

1) More-than 5% owners (and immediate family members of)

2) Employees with compensation over the annual limit in the prior plan year (the number of employees in this category may be limited to the “top-paid group” if the plan so elects)

Key Employees

“Key Employees” are determined for purposes of the Top Heavy test and minimum contributions. The following are generally considered Key Employees:

1) More-than 5% owners (and immediate family members of)

2) More-than 1% owners (and immediate family members of) with compensation over $150,000

3) Officers with compensation over the annual limit

Minimum Coverage Test

In general, a plan must benefit at least 70% of the non-Highly Compensated Employees (non-HCEs) of the Employer. If not all of the HCEs benefit, the 70% can be reduced. Employees with less than one Year of Service or under age 21 may be separately tested (or ignored, if none of them are HCEs).

A plan that requires that an eligible employee complete at least 1,000 hours and/or be employed on the last day of the year, or that excludes employees by job classification (e.g. part-time employees), may not pass this test and may require employer-funded contributions to certain non-HCEs originally not entitled to them.

“Safe Harbor” 401(k) Plans

401(k) Plans may be exempted from the ADP/ACP tests and Top Heavy requirements (with exceptions) by making certain minimum 100%-vested employer-funded contributions to non-Highly Compensated Employees as either Matching contributions that are generally 100% of the first 4% of compensation employees contribute, or 3% of compensation for all eligible employees. Annual advance notices to employees are required for Safe Harbor Matching contributions.

Top Heavy

A plan is considered to be “Top Heavy” if more than 60% of the plan’s assets (with some adjustments) are allocated to “Key Employees” in the prior plan year. If a plan is Safe Harbor and no non-Safe Harbor employer-funded contributions or forfeiture allocations are made, it is exempt from “Top Heavy” requirements (usually, a minimum contribution equal to 3% of compensation to all eligible non-Key Employees).