The MC Academy The Employee Benefits and Executive Compensation Series. Qualified Plans Part 2

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1 The MC Academy The Employee Benefits and Executive Compensation Series Qualified Plans Part 2 June 4, 2013

2 Nondiscrimination

3 Nondiscrimination in General Qualified Retirement Plans may not Impermissibly Discriminate in Favor of Highly Compensated Employees ( HCEs ) 3

4 Who is an HCE? An HCE is an employee who either: Received more than $115,000 in compensation from the employer in the prior year; or Was a 5% owner in either the current year or the prior year The $115,000 threshold is indexed annually 4

5 HCE Example 2012 Compensation = $105, Compensation = $120,000 Not an HCE for 2013 Note: Unless an individual is a 5% owner, he will never be an HCE in his first year of hire (because no compensation from the employer in the prior year) 5

6 Top-Paid Group Election Can limit HCEs under the first prong (i.e., by compensation instead of ownership) to top 20% of all employees by compensation Cannot expand the group of HCEs (i.e., will not pick up an individual with less than $115,000 in compensation in the prior year) 6

7 How Does a Plan Show That It is Nondiscriminatory? Various Numerical Tests Safe Harbors 7

8 Plan Features Subject to Nondiscrimination Requirements Contributions to a Defined Contribution Plan Benefits under a Defined Benefit Plan Coverage Benefits, Rights and Features 8

9 Examples of Benefits, Rights and Features Optional Forms of Payment Death Benefits Investment Options Deferral Limits Rates of Match Vesting Schedules 9

10 Coverage

11 Minimum Coverage in General The number of an employer s HCEs who benefit under a plan cannot be too disproportionate to the employer s other employees who benefit under that plan 11

12 Minimum Coverage in General Five basic questions: Who is an HCE? Who is the employer? Which employees are counted? What is the plan? What is too disproportionate? 12

13 Who is the Employer? To prevent employers from avoiding the coverage rules by moving all non-hces to a related company, certain related companies are treated as a single company for coverage purposes 13

14 Which Employees Are Counted? Subject to 4 specific exceptions, all employees of the employer are taken into account for coverage purposes 14

15 Employees Not Taken Into Account in the Coverage Test Employees who do not satisfy the plan s age and service requirements Union employees (but subject to separate testing) Nonresident aliens with no U.S. source income 15

16 Employees Not Taken Into Account in the Coverage Test For a plan with a last-day or minimum service accrual requirement, employees who: Are eligible but do not benefit under the plan Are not employed on the last day of the plan year and Complete less than 500 hours of service during the plan year 16

17 What is the Plan? Multiple plans may be combined for coverage testing purposes ( aggregation ) A single plan may be treated as separate plans for coverage testing purposes ( disaggregation ) 17

18 Plan Aggregation Always permissive (never required to aggregate plans for coverage testing purposes) If plans are aggregated for coverage testing purposes, the plans must also satisfy the nondiscrimination requirements on a combined basis 18

19 Plan Disaggregation Permissive disaggregation if two (or more) portions of a single plan separately satisfy coverage, these portions may be treated as separate plans for nondiscrimination testing purposes Mandatory disaggregation certain plan components and/or groups of employees must be treated as separate plans for coverage testing purposes 19

20 What is Too Disproportionate? A plan may satisfy coverage by satisfying one of two tests: Ratio Percentage Test Average Benefits Test 20

21 Ratio Percentage Test The percentage of non-hces participating in the plan must be at least 70% of the percentage of HCEs participating in the plan 21

22 Ratio Percentage Test Example Benefiting Not Benefiting Total Non-HCEs HCEs Total Non-HCE percentage = 56/100 = 56% HCE percentage = 8/10 = 80% Ratio percentage = 56%/80% = 70% The plan PASSES coverage 22

23 Average Benefits Test More complicated than the Ratio Percentage Test Takes into account the level of contributions and/or benefits under the plan, not just whether an employee is participating 23

24 ADP & ACP Testing

25 What Contributions are Tested? Actual Deferral Percentage (ADP) Test Before-tax employee contributions Roth employee contributions Actual Contribution Percentage (ACP) Test Employer matching contributions After-tax employee contributions 2 alternative formulas for each test pass either formula to pass test 25

26 What is ADP? Each eligible employee s actual deferral ratio (ADR) is Before-Tax and Roth Deferrals (no catch-ups) Compensation An eligible participant who made no deferral contributions has a 0% ADR ADP = Average of individual ADRs 26

27 ADP Tests: 1.25 Times Test Example HCE ADP NHCE ADP 1.25 NHCE ADP = 2.5% HCE ADP = 5% 5% is not 3.13% (2.5% 1.25) Therefore, 1.25 Times Test FAILED and go on to 2 Plus / 2 Times Test 27

28 ADP Tests: 2 Plus / 2 Times Test HCE ADP NHCE ADP + 2% and HCE ADP NHCE ADP 2 28

29 ADP Tests: 2 Plus / 2 Times Test Example 2 Plus Portion 2 Times Portion NHCE ADP = 2.5% HCE ADP = 5% 5% is not 4.5% (2.5% + 2%) Therefore, 2 Plus portion FAILED NHCE ADP = 2.5% HCE ADP = 5% 5% is 5% (2.5% 2) Therefore, 2 Times portion PASSED Since 2 Plus portion failed, entire 2 Plus / 2 Times Test FAILED Since both 1.25 Times Test and 2 Plus / 2 Times Test failed, ADP Test FAILED 29

30 How Can Failing Test Be Corrected? Return Deferrals to HCEs Make Additional Contributions for NHCEs Rerun test with different parameters Disaggregate test group Alternative test compensation definition 30

31 Return Excess Deferrals to HCEs 10% excise tax applies if excess deferrals are not returned within 2½ months of end of plan year 6 months for an Eligible Automatic Contribution Arrangement Excess deferrals returned 12 months after plan year can only be corrected through IRS correction program Excess deferrals for catch-up eligible participants can be reclassified as catch-up contributions and stay in plan Match on HCE excess deferrals that are distributed must be forfeited 31

32 Additional Contributions for NHCEs Qualified Nonelective Contributions (QNECs) Contributed by employer Subject to withdrawal and distribution restrictions that apply to before-tax and Roth contributions 100% vested Must be made within 12 months after plan year end Generally, must be made by October 15 of the following year for participants who terminated in the test year Different allocation methods with varying cost, but subject to restrictions 32

33 ACP Test Calculation is largely identical to ADP Test Employer matching contributions and employee after-tax contributions are used in place of deferrals Must pass either 1.25 Times Test or 2 Plus / 2 Times Test Failed test corrected by either Making QNECs to NHCEs Distributing (if vested) or forfeiting (if not vested) HCEs contributions 33

34 How To Improve Testing Results Limit amount that HCEs can contribute Encourage participation by NHCEs Auto-enrollment of employees Auto-increase of employee deferral rates Employee Education Matching contributions Safe Harbor plan design 34

35 Prior-Year Testing Tests can be run on a prior-year basis Same tests apply (1.25 Times and 2 Plus / 2 Times) However current year s HCE contribution rate is compared to prior-year s NHCE contribution rate Allows employer to anticipate how much HCEs can contribute Limits availability of QNECs as correction method Plan document must provide for current or prior-year test method 35

36 Safe Harbor 401(k) Plans

37 What is a Safe Harbor 401(k) Plan? A plan that meets certain requirements in order to avoid ADP test and/or ACP test General Requirements: Safe Harbor Employer Contribution (matching or nonelective) Vesting Rules Withdrawal Restrictions Annual Notice Significant restrictions on making changes during a plan year 37

38 Two Types of Safe Harbor Plans Safe Harbor without Qualified Automatic Contribution Arrangement ( Non-QACA Safe Harbor ) Safe Harbor with Qualified Automatic Contribution Arrangement ( QACA Safe Harbor ) 38

39 Non-QACA ADP Safe Harbor Employer Contribution Options Non-Elective Contribution 3% of compensation for all participants (whether or not participant has deferrals) Safe Harbor Match Basic or Enhanced Match Contribution Requirements: Immediate, 100% vesting No allocation conditions (no last day of plan year or 1,000 hours requirements) No in-service withdrawals prior to age 59 ½ No hardship withdrawals Can have eligibility requirements 39

40 Basic Safe Harbor Match 100% of first 3% of compensation plus 50% of next 2% of compensation (4% total match) 40

41 Enhanced Safe Harbor Match At least as generous as Basic Safe Harbor Match (e.g., 100% of 4%) Rate of match may not increase as deferral percentage increases (50% of first 3% and 100% of next 3% is not a safe harbor match) No higher rate of match for any HCE than any NHCE 41

42 Other Considerations for ADP Safe Harbor Must match catch-up contributions Can make other employer contributions in addition to safe harbor contribution Match may be made on a payroll by payroll or on a plan year basis 42

43 ACP Safe Harbor Nonelective safe harbor contribution (3% of compensation) will satisfy ACP test Safe harbor match will satisfy ACP test as long as: Do not match deferrals in excess of 6% of compensation Discretionary matching contributions do not exceed 4% of compensation 43

44 Notice Delivery Requirements Deliver annual notice between 30 and 90 days before beginning of every plan year Deliver notice to newly eligible employees No more than 90 days before employee becomes eligible, or If it is not administratively practicable to do so (e.g., plans with immediate eligibility), as soon as possible after eligibility 44

45 Notice Content Requirement Description of safe harbor contribution Description of any other contributions* How to make elective deferrals Description of plan compensation* Withdrawal and vesting provisions How to obtain additional information * Can be incorporated from SPD 45

46 Conditional Safe Harbor Wait and See Approach Applies only to 3% non-elective (not match) Plan document must provide for current year nondiscrimination testing Safe harbor notice before plan year says employer may make safe harbor contribution Must adopt safe harbor amendment and provide followup notice no later than 30 days before end of plan year If the employer does not adopt the amendment, must satisfy ADP and ACP tests for year 46

47 Safe Harbor Plan with QACA Contribution Alternatives: 3% non-elective contribution or Match of 100% of first 1% of compensation plus 50% of next 5% of compensation 3.5% total possible match vs. 4% for Non-QACA Safe Harbor Match must be made on behalf of all employees who make employee contributions, not just those who are autoenrolled Vesting: 2-year cliff vesting (or faster schedule) permitted vs. immediate, 100% vesting for Non-QACA Safe Harbor 47

48 QACA Requirements Must auto-enroll any participant who has not made an affirmative election as of QACA effective date Participant must be automatically enrolled at 3% (or more) from initial eligibility through end of following plan year Automatic deferrals must automatically increase to 4% in third year of participation, 5% in fourth year and 6% for every year thereafter Participant can always opt out of initial automatic enrollment or from automatic increases Automatic enrollment percentage cannot exceed 10% 48

49 Compensation

50 Importance of Compensation Calculation of Benefits Satisfying Legal Requirements Contribution and Benefit Limits Nondiscrimination Testing Identifying HCEs 50

51 Statutory Compensation Definition Uses: Identify highly compensated employees for testing Calculate statutory limits on contributions and benefits Can be used for ADP and ACP testing Must use an IRS-approved 415 definition 51

52 IRS-Approved 415 Definitions All amounts received for personal services and includable in income (i.e., gross income), before pretax deductions, but excluding nonqualified deferred compensation, stock options, restricted stock, group term life insurance premiums and similar items Wages subject to withholding, before pre-tax deductions W-2 wages, before pre-tax deductions 52

53 Benefits Compensation Used to calculate amount of contributions and/or benefits May also be used for ADP and ACP testing Described in plan document Must not discriminate in favor of highly compensated employees 53

54 Benefits Compensation Safe Harbors Any IRS-approved 415 definition Any IRS-approved 415 definition, but excluding all of the following: Reimbursements or other expense allowances Fringe benefits Moving expenses Deferred compensation Welfare benefits 54

55 Compensation Limit Compensation taken into account under the plan in a year may not exceed IRS dollar limit ($255,000 for 2013) Does not apply when determining HCEs Does not require participant deferrals to be cut off when the participant reaches the dollar limit Limit may be applied by prorating limit for each pay period, or based on YTD compensation 55

56 Post-Termination Pay Compensation for contributions made after termination of employment is restricted in a 401(k) plan Post-termination severance may not be deferred Post-termination trailing pay may be deferred (e.g., salary, bonus, commissions, shift premiums and similar pay) Post-termination leave payouts may be deferred Plan is not required to allow deferral post-termination The default restrictions also apply to IRS 415 definitions 56

57 Compensation and Payroll Payroll must coordinate with plan terms to ensure that correct compensation items are being used for each purpose Area of frequent errors in IRS audits Post-termination items may be different than included before termination Must be updated when payroll codes are added 57

58 Internal Revenue Service Correction Programs

59 Employee Plans Compliance Resolution System ( EPCRS ) IRS-approved corrections 3 Components: Self-Correction Program ( SCP ) Voluntary Correction Program ( VCP ) Audit Closing Agreement Program ( Audit CAP ) 59

60 General EPCRS Principles Encourages voluntary correction of errors Corrections should: Restore plan to the position it would have been in had the failure not occurred Be adjusted for earnings Not favor highly compensated employees May be more than one reasonable method of correction Must update administrative procedures to avoid recurrence of the failures 60

61 Self Correction Program ( SCP ) Allows correction without disclosure to IRS or filing fees Can self-correct insignificant failures at any time Can self-correct significant failures through the last day of the second plan year following the plan year in which the failure occurred 61

62 Self Correction Program ( SCP ) Insignificant Failures: Frequency Percentage of plan assets involved Number of affected participants Reason for the failure No single factor is determinative Example: 6 out of 80 participants receive extra profit sharing contributions during one plan year. The failure is insignificant 62

63 Voluntary Correction Program ( VCP ) Requires IRS filing and approval Filing fees based on number of plan participants Fees generally range from $750 to $25,000 Reduced fees for certain common failures VCP filings can cover more than one error Can typically add errors while VCP filing is outstanding IRS issues compliance statement after agreement is reached 63

64 Voluntary Correction Program ( VCP ) Why would you use VCP? Error not eligible for correction under SCP Retroactive plan amendments Significant failure that is beyond 2-year correction period No standard correction under EPCRS Different method of correction than as described by IRS IRS can waive excise/penalty taxes that apply to certain errors 64

65 Voluntary Correction Program ( VCP ) Streamlined submissions for common errors follow preapproved methods of correction: Nonamender Failures Correction: Execute missed amendments Missed Loan Repayments Correction: Reamortize impacted loans or allow participants to repay missed payments in one lump sum Tax relief available Failure to pay required minimum distributions Correction: Distribute missed required minimum distributions Excise tax relief available 65

66 Audit CAP Errors the IRS identifies IRS-required correction plus penalty Audit CAP penalties extremely unpredictable Failure to reach resolution with the IRS will result in plan disqualification 66

67 Common Errors and Corrections Improperly Excluded Employees Corrective contribution equal to 50% of missed deferral opportunity Based on average deferral percentage (ADP) for the year Special rules apply to safe harbor and 403(b) plans Corrective contribution equal to 100% of matching contributions participant would have received on missed deferral opportunity Can be treated as a matching contribution subject to the plan s vesting schedule 67

68 Common Errors and Corrections Overpayments Participant must return overpayment Under a defined benefit plan, if participant is receiving periodic payments, overpayment may be recovered from future payments Plan sponsor may be required to make the plan whole if participant does not return overpayment Notify participant that overpayment is not eligible for rollover 68

69 Common Errors and Corrections Plan Eligibility Errors If letting participants in early, amend the plan to conform to operations (does not require VCP submission) Example: The plan document requires 1 year of service. The employer has been allowing employees to participate after 6 months If letting participants in late, follow correction for improperly excluded employees Plan Compensation Errors If more favorable to participants, amend the plan to conform to operations (VCP submission may be required) If less favorable to participants, make corrective contribution based on plan definition of compensation 69

70 Department of Labor Correction Programs

71 Department of Labor Corrections Voluntary Fiduciary Correction Program ( VFCP ) Delinquent Filer Voluntary Compliance Program ( DFVCP ) 71

72 Voluntary Fiduciary Correction Program ( VFCP ) Voluntary correction of fiduciary breach under ERISA Only covers certain errors and correction methods 19 categories of transactions Requires Department of Labor filing No filing fees Employer will avoid civil penalties, and, in certain instances, excise taxes if it follows program requirements 72

73 Voluntary Fiduciary Correction Program ( VFCP ) Most common error late participant contributions Pay contributions to plan Adjust contributions for earnings (or, if greater, profits earned by employer from use of contributions) Use DOL online calculator to determine earnings Correction will typically eliminate excise taxes 73

74 Delinquent Filer Voluntary Compliance Program ( DFVCP ) Available to employers who fail to file Form 5500s By using correction program, eligible to pay reduced penalties $10 per day for each late filing Per Filing Cap: $750 for small plans (under 100 participants); $2,000 for large plans Per Plan Cap: $1,500 for small plans; $4,000 for large plans 74

75 Plan Audits and Common Errors

76 IRS Audits

77 IRS Audits Common Problems Missing Amendments Amendments required by law changes must be adopted by date specified by law or regulation Discretionary plan amendments design changes generally must be adopted by last day of plan year, but some amendments (e.g., those that cut back eligibility or benefits) must be adopted before they become effective 77

78 IRS Audits Common Problems Eligibility Errors Participants not timely enrolled after meeting age/service requirements Rehires improperly required to re-complete service requirements 78

79 IRS Audits Common Problems Safe Harbor Notice not provided Automatic Enrollment Notice not provided but deferrals implemented Notice provided but deferrals not implemented Automatic Deferral Increase Notice not provided Increase not properly implemented 79

80 IRS Audits Common Problems Matching Contributions Plan formula not followed Plan match eligibility rules not followed 80

81 IRS Audits Common Problems Hardship Distributions Hardships not in plan document, but allowed in practice Hardship requirements not met Suspension errors Loans Original loan terms do not comply with IRS rules Payroll errors in withholding Participants who do not repay are not timely defaulted and issued a Form 1099-R 81

82 IRS Audits Common Problems Failure to follow written plan document Compensation definition not followed in determining participant deferrals and/or employer contributions Plan document does not cover all entities whose employees participate Participation by subsidiaries may require written action of both plan sponsor and subsidiary Defined benefit plan formula not followed 82

83 IRS Audits Common Problems Vesting Vesting service not properly calculated Partial termination (20% active participant reduction) not identified Minimum Required Distributions (Age 70½) are not timely made 83

84 IRS Audits Common Problems Forfeitures Not Timely Used Forfeitures must be used to pay plan expenses, reduce employer contributions or (rarely) allocated to participants Plan document may require that forfeitures be used in the year they arise or the next following year Some documents are more flexible than others Failure to use forfeitures may be both a qualification defect and excise tax on nondeductible contributions 84

85 IRS Audits Common Problems ADP/ACP Testing Issues Incorrect compensation used to identify highly compensated employees or in performing test Other data errors affecting tests Failure to perform test for safe-harbor plan with delayed eligibility for matching contributions 85

86 IRS Audits Corrections and Penalties Insignificant errors identified in IRS audit may be corrected without penalty Significant errors may be corrected through a closing agreement ( Audit CAP ) and payment of a negotiated sanction 86

87 IRS Audits Audit CAP Sanction Amount of sanction will depend on size of plan and nature of error(s) Sponsor has no real leverage in negotiating the sanction Alternative is likely plan disqualification with far greater consequences 87

88 DOL Audits

89 DOL Audits Common Problems Late Deposit of Participant Contributions Deadline earliest date on which contributions can be reasonably segregated from sponsor s general assets 15 th business day of the following month will never be considered timely 7 business day safe harbor for plans with under 100 participants DOL will look to sponsor s shortest period as setting standard for reasonableness 89

90 DOL Audits Common Problems Improper Plan Expenses Employer ( settlor ) expenses cannot be paid from the Trust Examples: Cost of optional amendment; accounting expenses relating to preparation of the employer s financial statements Expenses paid from wrong plan (e.g., 401(k) plan expenses paid from defined benefit plan) Nonqualified plan expenses paid for by related qualified plan For multi-purpose communications, may need to allocate between different plans and plan-employer 90

91 DOL Audits Common Problems Fiduciary Oversight Issues Fiduciaries are unaware of their fiduciary roles Lack of fiduciary processes (e.g., including 401(k) investment fund review) Failure to monitor vendor expenses (e.g., annuity contract costs) 91

92 Reliance on Form 5500 Auditor Financial accounting audits are limited in scope and consistency Do not rely on Form 5500 auditors to identify errors Late contributions and other errors sometimes, but not always, identified in Form 5500 audit 92

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