Compliance Tests-An Explanation

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1 Compliance Tests-An Explanation This document details the various compliance tests performed on your plan. Specifically, this document details a plan s compliance with Internal Revenue Code (IRC) Section 402(g), 401(k) and 401(m), 415(c), 410(b), and 416. IRC Section 402(g)-Excess Deferrals An excess deferral is the amount a participant defers to a 401(k) plan for a calendar year that is in excess of the limit on elective deferrals for that taxable year which is defined by IRC Section 402(g). In 2001, the limit on elective deferrals is $10,500. This number is indexed each year for cost-of-living increases. In 2002, the limit is $11,000. The amount a participant defers to the plan for 2001 that is in excess of the $10,500 is an excess deferral. Excess deferrals and any income should be returned to the participant by April 15 following the calendar year of the excess deferral. The excess deferrals are taxable to the participant in the tax year in which they were made. IRC Section 401(k) and 401(m)-Actual Deferral Percentage and Actual Contribution Percentage (ADP and ACP) Tests Elective deferrals, after-tax contributions, and matching contributions to a 401(k) plan are subject to certain nondiscrimination requirements that must be met if a plan is to maintain its qualified status (IRC Section 401(k) and 401(m)). Elective deferrals and the total after-tax and matching contributions satisfy these requirements if they pass the actual deferral percentage (ADP) tests and actual contribution percentage (ACP) test respectively. The ADP test provides that the average percentage of pay deferred by highly compensated employees (HCE) cannot exceed the average percentage of pay deferred by non-highly compensated employees (NHCE) by more than a prescribed amount. For plan years beginning after 12/31/96, an individual will be considered an HCE if: 1. the individual was a more than 5% owner of the Employer during the current plan year or 12 months immediately prior to the beginning of the plan year; or 2. the individual had compensation in excess of $85,000 during the 12 months immediately prior to the beginning of the plan year and, if elected by the employer, was in the top 20% of employees by compensation for the 12 months immediately prior to the beginning of the plan year. As of 1/1/2002, the compensation limit will be $85,000. To determine the average percentage of pay deferred, a ratio called the actual deferral percentage (ADR) for each eligible employee must first be calculated. The ADR is the ratio of the employee s elective contributions to the employee s compensation (In 2001, compensation is limited to $170,000; in 2002, the compensation limit is $200,000). Eligible employees are then divided into two groups for testing purposes: eligible HCE s and eligible NHCE s. To determine the ADR for each group, add together the ADR for each eligible employee in the group and divide the sum by the number of eligible employees in the group (including those with an ADR of zero-eligibles but not participating). The Small Business Job Protection Act of 1996 made several changes to the discrimination test process for 401(k) plan years beginning in A new testing method, called the prior year testing method, bases the ADP and ACP tests on the Non-Highly Compensated Employees (NHCEs) prior year s ADP and ACP results. The prior year testing method is optional for the Plan Year tests, so the old method (the current year testing method ) can still be used during these years without restriction. However, for the Plan Year beginning after December 31,

2 2001, either the current year testing method or the prior year testing method must be chosen and, as a general rule, that method must continue to be used unless a change is approved by the IRS. The IRS has approved a change in testing method under limited circumstances. A plan that is using the prior year testing method may switch to the current year testing method for any subsequent year. However, for plan years beginning after December 31, 2001, the plan may only switch from the current year testing method to the prior year testing method if, as a general rule, the current year method has been used for each of the preceding five plan years (or, if less, the number of years the plan has been in existence). Please note that a decision to use the prior year testing method, though it may provide the best test results at this time, may restrict the plans ability to change testing methods in the future. Under the prior year testing method, one is able to predict, in advance, the maximum elective deferrals that can be made by HCEs in a particular plan year. The prior year testing method requires that the HCEs ADP for any plan year be limited to the greater of: 1. the ADP for NHCEs in the prior plan year multiplied by 1.25; or 2. the lesser of: a) the ADP for NHCEs in the prior plan year x 2; or b) the ADP for the NHCEs in the prior plan year +2. Using the current year testing method, the ADP test is satisfied with respect to the elective deferrals if the HCE s ADP for the plan year is limited to the greater of: 1. the ADP for NHCEs in the current plan year multiplied by 1.25; or 2. the lesser of: a) the ADP for NHCEs in the current plan year x 2; or b) the ADP for the NHCEs in the current plan year +2. The ACP test is identical to the ADP test except that an actual contribution percentage (ACP) replaces the ADP. The ACP is simply the ratio of the employee s total after-tax and matching contributions to the employee s total compensation. Plans that do not have these contributions are not subject to the ACP test. If the alternate test (#2 above in both methods) must be relied upon to pass both the ADP and ACP, then a special aggregate limit applies. In these situations, an additional nondiscrimination test must be performed to determine if the multiple use of the alternate limit exceeds the permissible aggregate limit. IRC Section 415(c)-Annual Additions Limitation Defined contribution plans, including 401(k) plans, are generally subject to certain limitations on total annual additions. In particular, annual additions to defined contribution plans may not exceed the lesser of $35,000 or 25 percent of the participant s gross compensation (IRC Section 415(c)). The $35,000 limit will be adjusted for cost-ofliving increases according to the provisions included in the General Agreement on Tariffs and Trade (GATT). The limit on. Annual Additions in 2002 will be the lesser of $40,000 or 100 percent of the participant s gross compensation (IRC Section 415(c)). Annual additions include employer contributions, employee contributions (after-tax contributions), elective deferrals and forfeitures that are reallocated to employees.

3 IRC Section 410(b)- Participation IRC Section 410(b) deals with preventing discrimination regarding which groups of employees are covered by the plan. This regulation only applies if a plan is excluding a certain group of employees from participating in the plan or a feature in the plan is not provided to all employees (i.e., last day requirement to receive a contribution) Each component of the plan (elective deferrals, matching contributions, and profit sharing contributions) must pass the 410(b) ratio percentage test. The ratio test requires that a plan benefit a percentage of nonhighly compensated employees equal to 70% or more of the highly compensated employees who benefit under the plan. Those employees not yet eligible for the plan because of the plan s age and service requirements or employees who are covered by a collective bargaining agreement are not required to be counted for purposes of this test. If the plan fails the ratio/percentage test, it may still pass under a more complicated testing procedure called the Average Benefits Test. The Average Benefits Test is beyond the scope of this discussion. IRC Section 416-Top Heavy Test A plan is top-heavy if more than 60% of the account values are attributed to Key Employees. A Key Employee means an employee who at any time during the plan year or any of the four preceding plan years (subject to dollar limitations for those years), is: 1. An officer earning more than $70,000 (increases to $130,000 in 2002); 2. More than 5% owner; 3. 5% or less owner but more than 1% owner and earns more than $150,000 in one year from the employer; or 4. Among the ten highest percentage owners in the plan (Owning at least.5%) and earns more than 100% of the defined contribution limit ($30,000). The effects of a plan being top-heavy are as follows: 1. In general, a minimum contribution equal to 3% of total compensation must be allocated to all eligible employees who are employed on the last day of the plan year. To determine if the top-heavy minimum has been satisfied, salary deferral contributions and matching contributions are not recognized. 3. Account values attributable to employer contributions must vest according to the Top-Heavy vesting schedule if it is more rapid than the standard vesting schedule as shown in the plan document. Match Verification The match verification that may have been provided is based on an annual computation period with the formula specified in your plan document, or the formula that was supplied on your 5500 Questionnaire. The following possible reasons may account for discrepancies: 1. The computation period used for calculating the match was more frequent than the computation period in the Plan Document. If this is the case you may consider one of the following options for future plan years: a. Change the frequency of the match calculation to coincide with the document. b. Change your Plan Document computation period to coincide with the frequency of the match calculation. Please notify us in writing if you wish to change the computation period on your Plan Document.

4 However, if your document specifies an annual computation period for the tested plan year, then the appropriate adjustments should be made as indicated on the match verification report. Please send a payroll adjustment file for this purpose to your case manager or contact me with any questions. 2. Eligible compensation (compensation from an employee s date of entry through the last day of the plan year, or date of termination) was not provided and the assumption was used to prorate compensation. For example: John Doe earns $40,000 for the entire plan year and is eligible to enter the plan on July 1. His prorated eligible compensation would be $20,000. However, if John actually made $10,000 in the first six months of the year and $30,000 in the last six months, his eligible compensation would be $30, Compensation for plan purposes was not limited under Section 401(a)(17). The limit for 2001 is $170,000. For example: John Doe earns $500,000 for the entire plan year, the compensation would be limited to $170,000 for plan purposes. (i.e. deferral, and match calculation). 4. The calculation period in the document which was also used in practice was more frequent than annual. Please review to ensure that the match formula was applied correctly for each computation period. Employee Data Errors The following is a summary of the assumptions made for the errors listed on the data errors file. Any changes to the indicated assumptions may require re-testing and additional testing fees. Employee With Contribution and Zero Compensation: (Not included in testing) The employee is assumed to have been terminated in the prior plan year. All contributions are considered ineligible and are not included in all applicable testing. See Ineligible Contributions. Eligible Employee With Zero Compensation: (Not included in testing) The employee is assumed ineligible during the plan year and is not included in applicable testing. Contributions Greater then Compensation: (Included in testing) See Excess Annual Additions for contributions above the described limit. Ineligible Employee with Contributions: (Not included in testing) The employee and all contributions are assumed ineligible during the plan year and are not included in all applicable testing. See Ineligible Contributions. Match Contribution and Zero Deferral: (Included in testing) All contribution amounts are assumed eligible during the plan year and are included in all applicable testing. Also see Match Verification. Deferrals and No Match but Eligible: (Included in testing) All contribution amounts are assumed eligible during the plan year and are included in all applicable testing. Also see Match Verification. Current Term with Zero Compensation: (Not included in testing) The employee is assumed ineligible during the plan year and is not included in applicable testing. Employee Pre-tax contrib. Exceeds Plan Limit: (Included in testing) Our tests indicate that one or more of your employees has exceeded the deferral limit specified in your plan document. It is your responsibility to limit each participant s deferral percentage to the plan maximum.

5 Annual Discrimination Testing 401(k) and (m) Test Failure: Options to Pursue Option Evaluation of Option Who Takes the Lead 1. Target the "0's" (unenrolled) and 1. Improvement will result, but 1. We can look at the test and "lows" (low contribution rates) this option does not Design a mailer if you are with mail to their homes and guarantee testing success. Interested. special meetings. The "0's" are likely to be low wage workers in small, "remote" locations. 2. Amend the plan to incorporate 2. This amendment could be 2. We will prepare the plan a "bottom-up QNEC." This completed this year. Operation Amendment if requested. would permit small contributions of the amendment is permissive Use of the amendment will to low income participants in not mandatory. Use of the Subsequently be determined by order to make the test pass. amendment will cause the test Reviewing each year's test to pass and is usually low cost Results. to use but it requires 100% vested contributions to be given to a few low paid, possibly terminated or part- time participants. 3. Incorporate an automatic enroll- 3. This feature would automatically 3. You should decide whether ment or "negative" election procedure into the plan. enroll every eligible employee for 2 or 3% of his or her pay. Or not to use automatic enrollment. We will call you in (Employees can subsequently opt out.) Order to review the alternatives. 4. A "safe harbor" match of $1 for 4. No 401(k) or (m) tests would 4. You should decide. $1 on the first 3% of pay and 50 have to be run. cents on the dollar for the next 2% of pay could be written into the plan. (Must be fully vested when made.) 5. Limit the Highly Compensated 5. Would solve the testing problem 5. You should decide. contributions but severely restrict the plan's usefulness to HC's. 6. Use the match as a "Qualified 6. Helps the test incrementally. 6. You should decide. Matching Contribution" or QMAC Not really a solution but definitely of some help. 7. Reduce the match for HC's 7. May help the test but is sure 7. You should decide. to offend HC's.

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