bulletin Discrimination Testing: A Closer Look THE PA CHALLENGE: WINNER! In this issue

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1 Administer Your Plan Wisely is an educational campaign designed to help Plan Administrators manage their plans effectively. bulletin In this issue The PA Challenge Discrimination Testing: A Closer Look February 2008 THE PA CHALLENGE: WINNER! Congratulations to Barbara Williams of Conner & Winters, LLP! In the December AYPW Bulletin, we asked How many days do you have to distribute an SPD to a participant when he or she first becomes eligible for a plan? You have 90 days from the day a participant first becomes eligible for a plan to provide him or her with an SPD. Of all the respondents who answered the question correctly, Barbara was randomly selected as our winner and will receive an ipod Nano. Many thanks to the Plan Administrators who participated. Take the PA Challenge to showcase what you ve learned from reading this issue of the AYPW Bulletin and become eligible to win a prize. Here s how it works: STEP 1: STEP 2: STEP 3: STEP 4: Read this issue of the AYPW Bulletin. Find the box that contains the PA Question (see the box below for this issue s question) and answer it. Submit your response to the Program ( PAChallenge@mercer.com) by the deadline, and if you answer correctly, you ll be entered into a drawing. At the end of each quarter, we ll draw a name. The winner for this quarter will receive the newly-designed ipod Nano! PA Question: If your firm s 401(k) plan fails the annual discrimination test, what do you need to do? your answer along with your name and contact information to PAChallenge@mercer.com no later than March 15, Discrimination Testing: A Closer Look A 401(k) plan is subject to annual testing to ensure it does not discriminate in favor of highly compensated employees. State Street conducts this testing at no additional cost at midyear and year-end. By having State Street perform the tests, you streamline your administrative duties and add overall efficiency to the process, all while avoiding the fees third party administrators may charge you for this service. While State Street or another administrator is responsible for conducting the test, you, as Plan Administrator, play a crucial role in the testing process. At this time each year, as you review and complete the annual census materials (discussed in more detail in the December 2007 AYPW Bulletin), you provide the administrator with the information needed to complete the various discrimination tests for your firm. This issue describes the discrimination tests and how they are conducted. As you review this information, keep in mind the Plan Administrator's Guide contains additional information. Also, if you have questions or can't find the information you need, call the Plan Administrator Line at (800)

2 ADP Testing The test for actual deferral percentage, also known as the ADP test, measures the average of the ratios of pre-tax 401(k) elective deferrals and Roth 401(k) contributions to compensation. The ADP for highly compensated employees (HCEs) may exceed the ADP for non-highly compensated employees (NHCEs) only within certain limits. How the ADP Test Is Performed To help you better understand the outcome of this test, let s review how it is performed. Step One: First, the administrator lists all employees who are eligible to make elective deferrals whether or not the employees actually made deferrals. The list includes each employee s eligible compensation and deferral amount ($0, if no deferral is made). Step Two: The administrator next divides the list into HCEs and NHCEs. Starting with the NHCEs, each employee s actual deferral percentage (ADP) is determined by dividing the employee s compensation into the amount the employee deferred into the plan (again, $0 if no deferral is made). Once each employee s ADP is determined, the ADPs are averaged to arrive at the NHCEs ADP as a group. Consider the following table as an example: Actual Deferral Ratios Averaged to Determine the Non-Highly Compensated Employees' Average Deferral Percentage Non-Highly Compensated Employees (NHCEs) Compensation Deferral Actual Deferral Percentage (ADP)* Rebecca $70,000 $4, % Joseph $28,000 $0 0% Jessica $30,000 $ % Karen $10,000 $0 0% Victor $47,000 $2, % Total ADR: Divide by Number of NHCEs to Determine the NHCEs ADP: 2.53% *ADP is based on total deferral divided by compensation. Step Three: Perform the same process above for HCEs. Once both the NHCE and the HCE ADP figures have been determined, the administrator compares them. The HCEs ADP may exceed the NHCEs ADP only within the following limits: ADP Test Limits NHCEs ADP Maximum HCE limit 0 to 2% 2 times the NHCE limit 2% to 8% Add 2 to the NHCE limit > 8% 1.25 times the NHCE limit Using the example above in which the NHCEs ADP is 2.53%, the HCEs ADP is limited to 2.53% plus 2%, for a maximum of 4.53%. 2

3 ACP Testing The next test, known as the actual contribution percentage or ACP, averages the ratios of aggregate contributions (employer matching contributions and after-tax employee contributions) to compensation. Again, the ACP for HCEs may exceed the ACP for non-highly compensated employees (NHCEs) only within certain limits. How the ACP Test Is Performed This test is performed exactly like the ADP test. Step One: The administrator first lists all eligible employees, including their matching employer contributions and after-tax employee contributions. Then, the employees are classified as HCEs or NHCEs. Step Two: Next, the administrator determines the ACP ratio for each eligible employee by dividing the sum of the matching employer contributions and after-tax employee contributions by the employee s eligible annual compensation. The average ACP percentage for HCEs and NHCEs is then calculated. The average percentage of the HCEs may only exceed the average percentage of the NHCEs by specified limits to satisfy the ACP test. These limits are identical to those of the ADP test (see the chart on page 2). ADP or ACP Test Failure If your firm s 401(k) plan fails either or both of the aforementioned annual discrimination tests, you will need to complete a Corrective Measures for Contributions Form (Form 14) to notify State Street about any refunds you must make to HCEs to pass the discrimination test. If required, your firm must refund excess pre-tax, after-tax and matching contribution amounts, as well as investment earnings, to highly compensated employees by two and a half months after the plan year end. If this refund isn t made by the deadline, the firm will owe an excise tax equal to 10% of the refund amount. (The 10% excise tax only applies to the refunded contributions; interest is not included.) Note: To avoid violating the terms of the plan and applicable tax law, the refunds must be completed by the end of the plan year following the plan year being tested. Other corrective actions might also be available. Examples include making a qualified nonelective contribution (QNEC) or a qualified matching contribution (QMAC). These techniques are often employed to help produce better testing results. Please contact State Street to learn more about these additional corrective measures. Terms to Know Highly Compensated Employee (HCE): An HCE is any employee to whom at least one of the following applies: The employee was a more than 5% owner at any time during the current or preceding plan year. The employee had compensation in excess of the limit for the preceding year ($100,000 in 2007). The employee is a direct lineal ascendant or descendant of a more than 5% owner. Compensation: The Program s definition of eligible compensation affects the calculation of the ADP and ACP ratios. Per the ABA Retirement Funds Plan Document, please note: Compensation includes pre-tax contributions, and The ADP and ACP tests apply to compensation earned after the participant becomes eligible to enter the plan. Key Employee: A key employee is any employee who, during the current year or last four years, has been: A more than a 5% owner of the company at any time during the current or preceding plan year; An officer of the company receiving annual pay in excess of $145,000 (in 2007, as indexed); or A more than 1% owner of the company with annual pay in excess of $150,000; or who is A direct lineal ascendant or descendant of a more than 5% owner. Top-Paid Group: The top-paid group is the group of employees in the top 20% of the prior plan year ranked by compensation. These employees are also called highly compensated employees. See the sidebar on page 4 for more information about who makes up this group and how it is determined. 3

4 How does the 20% top-paid group work? Assume a law firm has 30 eligible employees whose compensation, listed in descending order, is as follows: Employee Compensation HCE 1 $155,000 Yes Yes 2 $140,000 Yes Yes 3 $125,000 Yes Yes 4 $118,000 Yes Yes 5 $116,000 Yes Yes 6 $115,000 Yes Yes 7 $113,000 Yes No 8 $109,000 Yes No 9 $108,000 Yes No 10 $106,000 Yes No $20,000 to $104,000 No No HCE under top 20% option Timing of the Tests Generally, the ADP and ACP tests must be completed within 2 1 /2 months after the end of the plan year to avoid paying a tax penalty. If failed, the tests must use the entire year s eligible compensation (beginning with entry date) and deferrals, and thus cannot be completed before year-end. Timely submission of the census data enables State Street (or your third party administrator) to complete the test in time for your firm to make any required refunds without having to pay a tax penalty. Keep in mind that the ADP and ACP discrimination testing can be completed for your firm s plan by the Program at your request for no additional cost. Need Help with Testing? State Street can conduct all required testing for your plan at no additional charge. Additionally, the Program s Legal and Compliance Teams will monitor or perform the following compliance services as described below, where applicable: IRC 401(k) Average Deferral Percentage (ADP) Mid-year and annually IRC 401(m) Actual Contribution Percentage (ACP) Mid-year and annually IRC 402(g) Limitations on amount of Elective Deferrals Monitored on a calendar year basis ($15,500 for 2008) IRC 415 Annual Additions Limitations Monitored ($46,000 for 2008) IRC 416 Top Heavy Testing Annually Without the top 20% option, all 10 employees making more than $105,000 (the limit for 2008) would be considered HCEs. However, if the top 20% election were made, only the top 20% would be considered HCEs; and therefore, in this example, instead of 10 HCEs, only the top 20%, or the top six individuals, would be considered HCEs. This eliminates four of the HCEs from the HCE group and adds them to the NHCE group for testing purposes. As those with higher incomes generally contribute to retirement plans at a higher rate, this may result in an increase of the average deferral percentage of the NHCE group while lowering the HCE group percentage. This would make it easier for your plan to pass the ADP and ACP tests. Note: More than 5% owners are always HCEs even if they are not part of the top 20%. Prepare Form 5500 and applicable schedules. Assist with determination of Highly Compensated Employees. Forfeiture allocations upon written direction from the Plan Sponsor Calculate employer Profit Sharing contribution upon written request from the Plan Sponsor. At the sponsor s direction we will prepare calculations within IRC 404 deduction limits (25% in 2008). Maintain the Program Plan Documents in compliance with applicable regulations. Prepare a conversion year Form This service requires that the conversion of assets is completed prior to year-end, and the participating law firm is able to provide the Program with accurate financial activity for the period prior to asset conversion. Contact State Street for these services by calling the Plan Administrator Line at (800)

5 Top Heavy Testing Top heavy testing determines whether more than 60% of the aggregate value of the plan accounts belongs to key employees the owners and officers of the business as of the last day of the prior plan year. Top heavy status is determined on a yearly basis. If a plan is top heavy, certain additional contributions may be required for non-key employees. Annual Additions Testing Annual additions testing is required each year to ensure that each participant's total account contributions (made by the employer and employee) and allocated forfeitures do not exceed the lesser of 100% of compensation or $45,000 (in 2007, as indexed) per plan year. After the close of each plan year, State Street reviews all contributions made to the plan on behalf of participants and allocated forfeitures to ensure that the $45,000 contribution limit has not been exceeded. If State Street calculates your employer contributions and, therefore, has received compensation figures for each participant, we can also monitor the annual additions limit to ensure the percentage limit has not been exceeded. NEW! Nondiscrimination Safe Harbor Plan Design Available Effective for plan years beginning on January 1, 2008, a new safe harbor design for 401(k) plans with automatic enrollment became available. It exempts the plan from ADP/ACP testing, and in some cases, top heavy minimum requirements. To qualify for this safe harbor, a plan design must: Provide for automatic employee contributions that start at a minimum of 3% of pay and increase automatically each year to reach at least 6% (but not more than 10%), and Offer employer matching contributions for non-highly compensated employees that equal at least 100% of the first 1% contributed, plus at least 50% of the next 5% contributed (yielding a match of at least 3.5% of pay on 6% contributed). Alternatively, the plan may offer employer non-elective contributions of 3% of pay for all eligible employees. As with other automatic enrollment plan designs, the new safe harbor automatic enrollment design must: Allow for participants to opt out at any time, Provide for certain participants to be included whether or not they have elected to participate, Furnish an annual notice to eligible participants within a reasonable amount of time before each plan year explaining the right to opt out and how contributions will be invested, and Provide a reasonable period of time after the notice is received to make contribution and investment elections before the first automatic contribution is made. Note that if your firm does not distribute the notice in a timely manner, your plan will not qualify as a safe harbor plan and it will be subject to the normal testing requirements. A firm s safe harbor matching contributions or non-elective contributions must be based on a nondiscriminatory definition of compensation and are subject to two-year cliff vesting and distribution restrictions. The Program can help you satisfy these requirements. If you are interested in learning more about automatic enrollment, please call the Plan Administrator Line at (800)

6 What Is a Cross-tested Plan? A cross-tested plan is an employer-sponsored, defined contribution retirement plan which favors older, long-term employees. Unlike traditional profit sharing plans, the eligible employees age, service and compensation are taken into account when determining the allocation of these contributions. So, the percentage of the plan contribution going to the investment accounts of owners and other HCEs can be much higher than under a traditional profit sharing plan if they are older on average than the other employees, and have longer records of service. This is permitted because IRS regulations provide a method, based on an actuarial analysis of projected benefits at retirement age (rather than the amount of the contribution currently allocated to an employee), of showing that the benefits provided to HCEs and NHCEs are comparable. State Street can provide you with a proposal and sample contribution calculation to demonstrate the benefits of this plan design to your firm. If you are interested, us at abaretirement@citistreetonline.com, and we will send you the census and plan questionnaires to complete. In the Next Issue... The next AYPW Bulletin will cover distributions taken upon termination of employment or death, including direct rollovers and taxation. Look for this issue in the spring. AYPW: Your Feedback Is Important Please let us know how this and future communications can help you better understand your firm s plan and your responsibilities. You can send us your comments, questions and ideas by: ING us at abaretirement@citistreetonline.com CALLING the Plan Administrator Line at (800) Plan Services Representatives are available Monday through Friday, 8:00 a.m. - 8:00 p.m. ET WRITING us at P.O. Box 5142, Boston, MA You also can visit our Web site at click on Contact Us, and complete and submit the form. The AYPW Bulletin is intended for information purposes only. Your firm s plan is governed by specific plan documents. If there is any discrepancy between this Bulletin and your plan document, the plan document will govern in all cases. The information in the AYPW Bulletin is believed to be reliable. However, it is distributed with the understanding that the publisher and contributors are not engaged herein in rendering legal, tax, accounting, investment management or other professional advice. 6