MERCER 401(k) COMPLIANCE TESTING MANUAL 2013 A RESOURCE FOR TESTING INFORMATION

Transcription

1 MERCER 401(k) COMPLIANCE TESTING MANUAL 2013 A RESOURCE FOR TESTING INFORMATION

2 2013 by Mercer HR Services, LLC. All contents are the confidential and exclusive property of Mercer. All rights reserved. No part of this work may be reproduced, transmitted, or transcribed by any means, electronic or mechanical, now known or hereafter invented, including but not limited to photocopying and recording, or by any information storage or retrieval systems, except as expressly permitted by the copyright owner. Developed by the Reporting & Testing Department M /13

3 TABLE OF CONTENTS INTRODUCTION... 1 DATA REQUIREMENTS FOR TESTING... 2 Identification of Certain Employees...2 A. Highly Compensated Employees (HCEs)...2 B. Highly Compensated Employees Using the Optional Top 20% Election...2 C. Key Employees...3 Correct Compensation for Testing...4 A. ADP/ACP Testing Compensation...4 B. 415 Compensation...4 C. Deferral Compensation...4 D. Post-Severance Compensation...5 E. Employees Who Received Post-Severance Compensation...5 F. Employees Who Received Differential Pay...6 Correct Testing Population...7 A. Eligible Employees...7 B. Collectively Bargained Employees...7 C. Location Codes...7 D. Excludable Employees...8 E. Early Participation Rule...8 F. Otherwise Excludable Employees...8 ANNUAL NONDISCRIMINATION TESTING... 9 Testing Overview...9 A. ADP/ACP Test...9 B. 410(b) Minimum Coverage Test Ratio Percentage Test Average Benefits Percentage Test...13 C. 415 Annual Additions Test...13 D. Top Heavy Test...14 ADDITIONAL TESTING THAT MAY BE REQUIRED A. 401(a)(4) General Testing...15 B. 401(a)(4) Benefits, Rights & Features...15 C. 414(s) Compensation Test...16 Scenarios that May Affect Your Test Results...17 A. Mergers, Acquisitions, Spin-offs, and Other Workforce Changes...17 B. Plan Amendments or Discretionary Changes...17 C. Controlled Group Status...17 Four-Year COLA Summary...19 SAFE HARBOR PLANS ELIGIBLE AUTOMATIC CONTRIBUTION ARRANGEMENT (EACA) SHORT PLAN YEARS AND THE IMPACT ON TESTING Determining Highly Compensated Employees...23 Annual Limits Must Be Prorated...23 IMPORTANT DATES AND DEADLINES Correction Timing and Penalties...24

4 FAILED TESTS Guide to Correction Methods...26 A. ADP/ACP Nondiscrimination Testing...26 B. Section 415 Annual Additions Limits...28 C. Requirements for Top Heavy Plans...29 D. Catch-up Contributions...30 INTERIM NONDISCRIMINATION TESTING A. Compensation for Interim Testing...31 B. Plan Aggregation...32 C. Interim Testing of Matching Contributions...32 D. How Are Contributions and Compensation Projected for Interim Testing?...32 E. What to Do With Your Test Results...33 PUERTO RICO PLANS FORMS AND SAMPLE TEST Demo Test...36 Compliance Testing Services Waiver...52 Tax Withholding Waiver...53 Compliance Testing Manual

5 INTRODUCTION Mercer is pleased to offer you an online resource to provide the information needed before and after compliance testing is performed for your plan. This document is provided for informational purposes only and is not intended to be exhaustive or to constitute authoritative guidance or legal advice. Plan sponsors should consult their own legal counsel, consultants, financial advisors, actuaries or other experts for specific guidance on their individual circumstances. 1 Compliance Testing Manual

6 DATA REQUIREMENTS FOR TESTING Identification of Certain Employees A. HIGHLY COMPENSATED EMPLOYEES (HCEs) The Actual Deferral Percentage/Actual Contribution Percentage (ADP/ACP) tests compare deferral and matching contribution percentages of HCEs to those of Non Highly Compensated Employees (NHCEs). As such, the correct identification and coding of HCEs is critical to an accurate test. For the current plan year, an HCE is any employee who was: Actually paid over the gross compensation limit determined by COLA (see Four-Year COLA Summary and Correct Compensation for Testing section), during the prior plan year (or prior 12-month period, if the prior plan year was shorter than 12 months also known as the look-back period ), regardless of the amount of compensation actually paid during the plan year being tested; or An owner of more than 5% of a company sponsoring the plan, either during the plan year being tested or the look-back period; or A family member of an over-5% owner. Note: Certain family members of over-5% owners are treated as having the same share of ownership, under Section 318 of the Internal Revenue Code; this includes the over-5% owner s spouse, parents, grandparents, and children. For example, the child of an over-5% owner is also considered an over-5% owner, and is therefore an HCE regardless of the child s compensation. Mercer will perform a preliminary determination of HCEs and Key Employees for your review and validation based on the data in our recordkeeping system and any additional information you provide regarding ownership, family members, and officers. It is your responsibility to provide updates to Owner and Officer information, as well as any updates to compensation, employee data or plan provisions annually to your Client Service Representative. Failure to provide this information could result in delayed and/or inaccurate test results. B. HIGHLY COMPENSATED EMPLOYEES USING THE OPTIONAL TOP 20% ELECTION If your plan document requires you to use the Top 20% Election, the determination of this group of employees will need to be done as described below. Mercer will perform the preliminary determination of your plan s HCEs for your review and validation based on data in our recordkeeping system along with any additional data we may need to collect from you. If there are other companies in the Controlled Group whose records are not kept at Mercer, the list of HCEs must be provided to Mercer. 1. In computing the number of employees in this top-paid 20% group (Top-Paid Group), begin with all employees who were employed at any time during the look-back period, including those ineligible to participate in the plan (and including all employees of other companies in a Controlled Group or Affiliated Service Group). However, the following may be excluded: Employees with less than six months of service by the end of the look-back period; or Part-time or seasonal employees scheduled to work less than 17½ hours per week, or less than 6 months per year; or Employees under 21 years of age as of the end of the look-back period; or Employees in a collective bargaining unit (if 90% or more of all employees are collectively bargained members and they were excluded from the plan); or Non-resident aliens with no U.S.-source income. 2 Compliance Testing Manual

7 DATA REQUIREMENTS FOR TESTING 2. Determine the total number employed at any time during the look-back period, excluding any in the above categories. 3. Multiply this total by 20%, rounding up or down to a whole number, to get the total number in the Top-Paid Group (apply the same rounding rule consistently each year). 4. Look at all employees, regardless of whether they are eligible, in the order of gross compensation paid for the year before the year being tested. Starting with the highest paid employees, count down the Top-Paid Group number to determine which employees are in your Top-Paid Group. If employees that are not actually eligible for the plan are included in this count, they will not be included in the test, but are still included as HCEs in your Top-Paid Group. 5. Finally, the test will also include any eligible employees who are over-5% owners (including certain family members), whether or not they are in your Top-Paid Group. C. KEY EMPLOYEES A Key Employee is any employee who, at any time during the plan year, was: An officer with total gross compensation in excess of the annual compensation limit, (see Four-Year COLA Summary); or An over-5% owner (including certain family members); or An over-1% owner (including certain family members) with gross compensation in excess of the annual compensation limit. Note: Certain family members of owners are treated as having the same share of ownership under Section 318 of the Internal Revenue Code; this includes the owner s spouse, parents, grandparents, and children. For example, the child of a 1% owner is also considered a 1% owner, and the child would be a Key Employee if his or her compensation was also over the annual compensation limit. An officer for Top Heavy purposes means a key administrative executive of the company, not necessarily anyone who has a corporate title. For purposes of the Top Heavy test, Internal Revenue Service (IRS) guidelines allow you to limit those considered officers to 10% of the total number of employees (but not fewer than 3 or more than 50). Only officers with gross compensation over the annual compensation limit, (see Four-Year COLA Summary), are treated as Key Employees. In order for Mercer to perform a preliminary determination of HCE and Key Employees for your review and validation, you will need to provide additional information regarding ownership, family members, and officers. It is your responsibility to provide updates to Owner and Officer information annually to your Client Service Representative. Failure to provide this information could result in delayed and/or inaccurate test results. 3 Compliance Testing Manual

8 DATA REQUIREMENTS FOR TESTING Correct Compensation for Testing A. ADP/ACP TESTING COMPENSATION Please review your plan document for the definition of compensation used by your plan for ADP/ACP testing. This may or may not be the same definition used by your plan for other purposes, such as Section 415 testing or determining contribution amounts. For example, some plans exclude compensation paid before the date an employee became eligible for the plan. If your plan contains this provision, testing compensation paid for the period before the employees become eligible could be excluded for ADP/ACP testing, but must still be included for Section 415 testing (see below). Compensation earned during any period in which an employee was eligible must be included (even if he or she elected not to make salary deferrals to the plan). Compensation used for ADP/ACP testing must satisfy IRC Section 414(s). 415 compensation (see below) is a safe harbor definition for 414(s) compensation purposes. There are three allowable modifications to Section 415 compensation that would allow the modified 415 compensation to remain under the safe harbor definition for 414(s). If you are not using 415 compensation for ADP/ACP testing, then you should confirm whether the compensation you are using falls within the safe harbor definition of 414(s). If not, the compensation used needs to pass the compensation ratio test. Mercer may be able to provide this test for you. If you have questions, contact your Client Services Representative. B. 415 COMPENSATION IRC Section 415(c)(3) compensation data is needed for all employees who were employed at any time during the plan year being tested. Compensation for Section 415 testing is defined by IRS regulations and is required to be used for the determination of Highly Compensated and Key Employees and in applying the 415 limits. It includes all federal taxable compensation, plus any before-tax deductions contributed to a 401(k), Section 125, or similar tax-qualified plan. Other amounts not currently taxable to the employee (e.g., stock options, non-qualified deferred compensation, or moving expenses deductible by the employee) are not included in this definition. The 415 compensation provided will be used to determine your Highly Compensated Employees (HCEs). (View the definition of a Highly Compensated Employee.) If your plan s definition of ADP/ACP compensation is not 415 compensation, then you will need to provide more than one compensation amount for each employee. Among other mandatory plan provisions effective for years starting after December 31, 2008, the Heroes Earnings Assistance and Relief Tax Act of 2008 (the HEART Act ), directs that differential pay must be included in 415 compensation. For more information regarding differential pay, see EMPLOYEES WHO RECEIVED DIFFERENTIAL PAY in section E below. 4 Compliance Testing Manual

9 DATA REQUIREMENTS FOR TESTING C. DEFERRAL COMPENSATION If your plan document allows for catch-up contributions for employees age 50 and over, and your plan limits deferrals (either for all employees or for HCEs only) to a certain percentage of compensation less than 75%, you should also check your plan s definition of the compensation on which these deferral limits are based. It may be the same as 415 compensation or ADP/ACP testing compensation, but if it is not, you should arrange to provide us with the deferral compensation amounts as well. Otherwise, we will not be able to determine whether catch-up amounts have been accurately calculated. This can impact the validity of your other testing, since catch-up amounts can be excluded from testing only if the participant had actually exceeded a regulatory or plan-specific limit as of the end of the plan year. This is not an issue if your plan s deferral limits have been eliminated or raised to 75% or higher. D. POST-SEVERANCE COMPENSATION In general, compensation does not include compensation paid after an employee severs employment. However, there are 2 exceptions: 1. A plan can count compensation paid to former employees who are in the US military or permanently and totally disabled. 2. A plan can count compensation paid by the later of 2½ months after severance of employment or the last day of the limitation year in which the employee severed employment if: a. The payment was for services rendered (e.g., salary, commissions, overtime, bonus, etc.), which the employer would have paid if employment had continued, or b. The payment was for unused accrued sick leave, vacation pay, or other leave, which the employee could have taken if employment had continued, or c. The payment was from an unfunded nonqualified deferred compensation plan, to the extent includible in income, if the employee would have received the payments at the same time if employment had continued. Payments in 2.b. and 2.c. count as compensation only if they would have been compensation if the employment had continued. Compensation does not include any of the following amounts paid after employment termination: severance pay, parachute payments, or payments from unfunded deferred compensation plans that are triggered by severance. E. EMPLOYEES WHO RECEIVED POST-SEVERANCE COMPENSATION When employees are awarded severance pay after terminating employment, elective deferrals should not be withheld from that compensation and it should not be included in compensation for testing purposes. If the definition of ADP testing compensation used by your plan includes post-severance compensation, we suggest you include it in testing compensation for employees who terminated during the plan year being tested. However, employees who terminated in the prior plan year and have only residual compensation or post-severance compensation in the plan year being tested may be included in testing for the plan year after termination. As the plan sponsor, you must determine if eligibility relates to the year of termination or if it relates to the year of the final paycheck. 5 Compliance Testing Manual

10 DATA REQUIREMENTS FOR TESTING F. EMPLOYEES WHO RECEIVED DIFFERENTIAL PAY The Heroes Earnings Assistance and Relief Tax Act of 2008 (the HEART Act ) was signed into law on June 18, Among other mandatory plan amendments, effective for plan years starting after December 31, 2008, it requires that differential pay be considered as compensation for Section 415 purposes. This would include the use of differential pay in determining Highly Compensated Employees (HCEs). For purposes of this statutory provision, differential pay is considered to be any payments by an employer to an individual while that individual is on active military duty for more than 30 days and for which such payments would constitute a portion or all of the compensation that the individual would have earned if he or she was employed by said employer. Differential pay is not required to be included as plan compensation for determining contributions or benefits and a plan s definition of plan compensation will not be considered to have failed the compensation ratio test under 414(s) merely because the plan sponsor elects not to include differential pay under plan compensation. If differential pay is included in plan compensation, the contributions and benefits derived from differential pay are not required to be included in nondiscrimination testing or coverage testing as long as all those in the controlled group can receive differential pay on similar terms and all who receive differential pay and who are eligible to participate in the plan can contribute from differential pay on similar terms. To the extent that the plan sponsor includes contributions and benefits derived from differential pay in testing, such contributions/benefits could not allow the plan to fail. When applying either approach, i.e., taking contributions/benefits into account or not taking them into account for testing, the plan sponsor needs to be consistent with respect to all employees. For example, the plan sponsor cannot include some deferrals made from differential pay in the ADP test while excluding other deferrals made from differential pay. Section 105(c) of the HEART Act requires that plans be amended for this statutory provision by the last day of the first plan year beginning on or after January 1, Governmental plans would have to amend their plans by the last day of the first plan year beginning on or after January 1, Compliance Testing Manual

11 DATA REQUIREMENTS FOR TESTING Correct Testing Population A. ELIGIBLE EMPLOYEES Except as noted below, the ADP/ACP test must include all employees who were eligible to participate in the plan at any time during the plan year being tested, including those who terminated during the year and those who elected not to participate. Testing compensation should be provided for all employees who met the eligibility requirements of the plan and entered the plan according to the plan s entry date provision. This would include employees who met the eligibility requirements and reached an entry date but chose not to defer. These employees would be included in the ADP/ACP test at zero percent. B. COLLECTIVELY BARGAINED EMPLOYEES A Collectively Bargained plan is a plan (or portion of a plan) that is maintained pursuant to a collectively bargained agreement. Special coverage and nondiscrimination testing rules are applicable. Collectively bargained employees must not be included in the same nondiscrimination test with non-collectively bargained employees. If your plan covers both collectively bargained and non-collectively bargained employees, separate ADP tests must be performed for each group. Because of this requirement, correct identification of collectively bargained employees is critical to completing an accurate test. This is typically done by setting the employee s division/location code or a special collectively bargained identifier on our recordkeeping system. These codes need to be provided for all eligible collectively bargained employees, not just those who participate in the plan. As always, please work with your Client Service Representative to review your plan s data needs and the method of data collection. C. LOCATION CODES If employees are tested by location (e.g., multiple employer plans), it is critical to the accuracy of each test that all employees be identified with the correct location code. Employees with incorrect location codes will not be tested with the correct population and this could impact the overall test results. Please work with your Client Service Representative to ensure all employees are identified with an accurate location code. 7 Compliance Testing Manual

12 DATA REQUIREMENTS FOR TESTING D. EXCLUDABLE EMPLOYEES Plans are allowed to disregard certain employees when identifying who must be taken into account to determine whether the plan satisfies the coverage tests under IRC section 410(b) and certain non-discrimination tests under section 401(a)(4) regulations. In general, an employee is excludable if the employee falls into any of the following categories: (1) the employee fails to satisfy the plan s minimum age and service requirements for initial eligibility to participate (or re-eligibility following re-employment), (2) the employee is a collective-bargained employee, (3) the employee is a nonresident alien without U.S. source income, or (4) the employee is a participant in the plan, is no longer employed by the employer as of the last day of the plan year, does not have more than 500 hours of service for the year, and fails to benefit under the plan for the plan year. E. EARLY PARTICIPATION RULE Plans are allowed to exclude employees who are under age 21, or have not yet completed a full 12 months of service or who have never worked 1,000 hours during any plan year (the statutory minimum ). Today, most plans have less restrictive eligibility requirements, often making employees eligible as soon as they are employed, or after completing only a few months of service. If your plan does not impose the most restrictive eligibility requirements allowed by law, ADP/ACP tests may still exclude any NHCEs who have not met those requirements, even though they are able to participate in the plan. Since recently hired employees and those under age 21 typically have lower-than average deferral rates, it is often advantageous to exclude this group from testing. In performing your ADP/ACP tests, Mercer will determine whether this optional rule can improve your test results, to the extent we can accurately determine this population of excludable NHCEs. If you provide accurate birth and hire dates to our recordkeeping system for all eligible employees (including those who do not elect to defer), we will be able to apply this rule to maximum advantage. Unless the plan document specifies otherwise, and since IRS regulations do not provide guidance in this area, our standard practice is to exclude any NHCEs who would not have reached age 21 or would not have completed 12 months of service as of the last semi-annual entry date in the plan year (regardless of the plan s actual entry dates). For example, in testing for a calendar year plan, we will exclude NHCEs who were not yet age 21 or had not completed 12 months of service as of July 1st of the Testing year. F. OTHERWISE EXCLUDABLE EMPLOYEES For plans whose eligibility requirements are more liberal than the IRS maximum age and service requirements, the plan may be permissively disaggregated into two separate plans one that tests the Otherwise Excludable Employees (labeled Participants who do not meet Statutory Minimum on the test) and one that tests the Eligible employees (labeled Participants who meet Statutory Minimum on the test). When utilizing the Otherwise Excludable Employee method for testing, both the ADP/ACP and 410(b) Coverage testing must be satisfied using identical methodology. Otherwise Excludable Employees are those who have met the plan s age and service requirements but who: Have not attained age 21; Have not completed a Year of Service (i.e., hired in the current plan year, or have never worked 1,000 hours in any plan year); or Terminated in the current plan year, but before reaching age 21 or completing a Year of Service. 8 Compliance Testing Manual

13 ANNUAL NONDISCRIMINATION TESTING Testing Overview A. ADP/ACP TEST Except for plans that satisfy a 401(k) Safe Harbor or Automatic Enrollment Safe Harbor (see Safe Harbor Plans section), ADP/ACP testing is required for all 401(k) plans and for other qualified plans that allow for employee contributions or employer matching contributions. (Some plans meeting the ADP Safe Harbor requirements may still require ACP testing.) The ADP and ACP tests limit the average contribution percentages of the HCEs, in relation to the average contribution percentages of the NHCEs. Normally, the ADP (Actual Deferral Percentage) test measures before-tax salary and Roth deferrals while the ACP (Actual Contribution Percentage) test measures employee after-tax and employer matching contributions. See Correct Testing Population section for more specifics. How the ADP and ACP percentages are calculated. First, the before-tax and Roth deferrals made for each employee are divided by the employee s testing compensation to arrive at that individual s ADP. Each employee s ACP is obtained by dividing the total after-tax and matching contributions made to his or her account by his or her testing compensation. These percentages are then averaged among all NHCEs to determine the respective ADP/ACP for the NHCE group and among all HCEs to determine the respective ADP/ACP for the HCE group. Note that, if your plan has a last day and/or hours requirement to be eligible for a matching contribution, employees who do not meet these requirements may not be included in your ACP test. Plans that use the current year testing method compare the HCE group averages for the current plan year against the NHCE averages for the same year. Plans that use the prior year testing method compare the current year HCE averages against the NHCE averages for the previous plan year. Your plan can amend to change the current or prior year testing method, but there are some limitations in doing so. Generally, the amendment should be executed before the end of the year being tested. For example, if your plan is a calendar year plan, you would need to amend by December 31st of the year being tested for the change in testing method to be effective for your current calendar year test. Switching from current year testing method to prior year testing method can only be done if your plan has used the current year testing method for at least 5 plan years. Conversely, switching from the prior year method to the current year method can be done anytime. How ADP and ACP percentages are limited for HCEs. The HCE group averages for the ADP and ACP tests are compared to the respective NHCE percentages (either for the current plan year or the prior plan year depending on the testing method specified in the plan document). The average ADP or ACP for the HCE group must not exceed the greater of: The Basic Limit, which is the NHCE average times 1.25; or The Alternative Limit, which is the lesser of: The NHCE average times 2, or; The NHCE average plus 2 percentage points. Note: The requirement is that the test only pass one of these limits. 9 Compliance Testing Manual

14 ANNUAL NONDISCRIMINATION TESTING The ACP Test is conducted in the same manner as the ADP Test, taking into account matching contributions and employee after-tax contributions. The ACP Test is not required for collectively bargained groups. Below is an illustration that shows the maximum HCE ADP at different levels of NHCE ADP. NHCE Average 0.60% 1.80% 2.00% 4.30% 7.50% 8.00% 9.20% Highest Limit NHCE Avg. times 2 NHCE Avg. times 2 NHCE Avg. times 2 or plus 2 NHCE Avg. plus 2 NHCE Avg. plus 2 NHCE Avg. plus 2 or times 1.25 NHCE Avg. times 1.25 Maximum HCE Average 1.20% 3.60% 4.00% 6.30% 9.50% 10.00% 11.50% Note: In certain cases regulations allow shifting or borrowing contributions from the ADP test to the ACP test or vice-versa, to improve the ACP test results. For example, if the ADP test passes but the ACP test fails, we may be able to improve the result by including some before-tax deferrals in the ACP test instead of the ADP test. If your plan s matching contributions are immediately vested and meet the other requirements for QMACs (see Other Correction Methods), we may likewise be able to improve your ADP results by including some matching contributions in the ADP test. Failed ADP/ACP tests. If the average ADP or ACP for the HCE group exceeds both the Basic and the Alternative Limits, then the ADP/ACP test fails and corrections must be made as specified in the provisions of your plan document. If your plan allows catch-up contributions for employees who have reached age 50, then any excess amounts for HCEs who are eligible for catch-up will be recharacterized as catch-up contributions instead of being distributed, unless they have already reached the catch-up dollar limit in effect for the year (see Four-Year COLA Summary). The following correction methods are permitted in the regulations: 1. Returning excess contributions (adjusted for investment gain or loss) to the HCEs who received the highest dollar amount of contributions (see DEMO Part III - Correction Summary). Under this correction method the plan sponsor may incur a penalty tax equal to 10% of the total excess contributions, prior to gain/loss adjustment, on any distributions made (see Correction Period section and Important Dates and Deadlines section), or 2. Recharacterizing excess before-tax contributions as after-tax contributions (if after-tax contributions are allowed under the terms of the plan). Under the after-tax recharacterization method, before-tax deferrals become subject to taxation in the year they would otherwise have been distributed. Instead of being distributed as ROEs, they remain in the plan as after-tax contributions (see Important Dates and Deadlines). This correction method is only allowed within 2½ months after the end of the Plan Year being tested, or 10 Compliance Testing Manual

15 ANNUAL NONDISCRIMINATION TESTING 3. Depositing a Qualified Non-Elective Contribution (QNEC) or Qualified Matching Contribution (QMAC) in the plan for all NHCEs. This correction method is typically available for plans using the current year testing method. Note: If the ADP or ACP test fails, corrections must be made within 12 months after the end of the plan year being tested. Failure to correct a failed test in a timely manner jeopardizes the plan s qualified status and may require additional corrections and communications to the IRS under the Employee Plans Compliance Resolution System (EPCRS). At a minimum, correcting a failed test after the 12-month deadline will likely require the employer to make additional QNEC contributions to the plan for NHCEs. Aggregating separate 401(k) plans. If your company (or Controlled Group of companies) sponsors more than one 401(k) plan, you may have the option of aggregating the plans for purposes of ADP/ACP testing, as long as the plans have the same plan year and use the same testing method (current-year/prior-year). This means that two or more plans may be tested as though a single plan covered all their eligible employees. This may work to your advantage for example, if one plan fails the ADP test but another plan passes, aggregating the two tests may produce a more favorable result for the failing plan. Separate 401(k) plans sponsored by the same company or Controlled Group may also be aggregated for 410(b) coverage testing (see next page). Often, multiple plans must be combined and treated as a single plan in order to meet Minimum Coverage requirements in that case, the ADP/ACP tests for the plans must also be run on an aggregated basis. You may make a different decision about aggregating plans or testing them separately for each plan year, but for any given plan year the plans must be treated the same way in both ADP/ACP and 410(b) coverage tests. For this reason, it is critical that you inform Mercer of your inclusion in a Controlled Group or Affiliated Service Group. Failure to provide this information could result in delayed and/or inaccurate test results. See Scenarios that May Affect Your Test Results for more information. 11 Compliance Testing Manual

16 ANNUAL NONDISCRIMINATION TESTING B. 410(b) MINIMUM COVERAGE TEST The IRS requires that a minimum number of Non-Highly Compensated Employees be covered under a qualified plan. Section 410(b) of the Internal Revenue Code prescribes a Ratio Percentage test to determine if the percentage of NHCEs covered under the plan is adequate in comparison to the percentage of HCEs who are covered. This test must be run separately with respect to each of the following contribution types: Employee before-tax deferrals (including Roth); Matching contributions and employee after-tax contributions; Profit sharing contributions or any other employer contributions. RATIO PERCENTAGE TEST The 410(b) Ratio Percentage test takes into account all employees who received compensation for services during the testing year, including all employees of any other companies that belong to the same Controlled Group or Affiliated Service Group (see Scenarios that May Affect Your Test Results). As with all of the testing services provided by Mercer, coverage testing is performed only for plans that are record-kept at Mercer. If your company is a member of a Controlled Group that has additional plans not record-kept at Mercer, please keep in mind that the results provided to you may need to be aggregated with the data provided from the other recordkeeper In addition to employees who were eligible for your plan during the year, if your company (or other companies in the same Controlled Group) employed any of the following types of employees and they were excluded from your plan, then the number of excluded employees in each group (as well as the number who were HCEs for this plan year) will need to be provided in order for us to complete your 410(b) test. 1. Leased employees who had worked full time for at least one year. 2. Employees in any company or division that were excluded from participation in your plan. 3. Any other group of employees who were ineligible for the plan for reasons other than the plan s minimum age and service requirements, or because of their status as collectively bargained employees or non-resident aliens. If your plan fails the ratio percentage test, the use of special methods such as Average Benefits testing may be required to meet the 410(b) requirements. If your plan does not appear to pass Ratio Percentage testing, based on the data available to us, your Client Service Representative will contact you to discuss what additional data or special testing may be required. Qualified plans are expected to be designed to meet Minimum Coverage requirements, so the regulations do not prescribe specific methods of correction if the 410(b) test fails. Any indication that your plan may not meet these requirements should be discussed with your legal counsel to determine an appropriate remedy. Generally this would involve a plan amendment allowing additional employees to participate in the plan or contributing additional employer contributions to the plan. 12 Compliance Testing Manual

17 ANNUAL NONDISCRIMINATION TESTING AVERAGE BENEFITS TEST A plan sponsor may satisfy IRC Section 410(b) by either passing the ratio percentage test or the average benefits test (ABT). If a plan fails to satisfy 410(b) using the ratio percentage test, then satisfying the test on an average benefit basis can be applied if allowed by the plan. The average benefits test may also be a very useful too when used in conjunction with the General Test under 401(a)(4) as it can provide for lower passing thresholds. The average benefits test is comprised of two tests, both of which must be satisfied: the Nondiscriminatory Classification Test and the Average Benefits Percentage Test (ABPT). NONDISCRIMINATORY CLASSIFICATION TEST A plan will pass the Nondiscriminatory Classification Test if the group of employees benefiting under the plan is a classification of employees that is both reasonable and nondiscriminatory. AVERAGE BENEFITS PERCENTAGE TEST (ABPT) The ABPT generally compares the total benefits provided to the all the NHCEs from all the plans of the employer to the total benefits provided to all HCEs from all the plans of the employer. C. SECTION 415 ANNUAL ADDITIONS TEST The Section 415 annual additions test is conducted on an individual participant basis, and all qualified retirement plans are subject to this test. Under Section 415 of the Internal Revenue Code, the total annual additions to each participant s account for any Limitation Year cannot exceed the lesser of 100% of Section 415 compensation or the dollar limit indicated in the Four-Year COLA Summary. Annual additions include all employee and employer contributions and any forfeitures reallocated to a participant s account. Annual additions do not include catch-up contributions or rollover contributions. Where employees participate in more than one plan sponsored by the same or related employers, contributions made to all such plans must be taken into account in applying these limits. Plan sponsors should be monitoring their employees annual additions limits to ensure that excess contributions are not made. If a participant s annual additions exceed the maximum limit, correction should be made in accordance with your plan document as available under the EPCRS program. Any correction to participant allocations should be made as soon as possible after the excess has been identified, but no later than 12 months after the end of the plan year being tested. 13 Compliance Testing Manual

18 ANNUAL NONDISCRIMINATION TESTING D. TOP HEAVY TEST Section 416 of the Internal Revenue Code defines a Top Heavy plan as one in which more than 60% of total plan assets are allocated to the accounts of Key Employees. All qualified plans, other than some of those meeting safe harbor requirements, are subject to Top Heavy testing. The Top Heavy determination made at the end of a plan year establishes whether or not your plan is considered Top Heavy for the next plan year. Top Heavy plans are subject to minimum vesting and contribution standards. Many plans, whether or not they are Top Heavy, already have a vesting schedule that meets the minimum vesting standards. If your plan is determined to be Top Heavy for the next plan year, you should implement the minimum vesting schedule as soon as possible. You will also be required to make a minimum employer contribution on behalf of all Non-Key Employees for that year if your employer contributions to the plan do not already satisfy this requirement. IRC Section 416(g)(4)(H) allows for a safe harbor plan, whether under a regular safe harbor arrangement or QACA safe harbor arrangement (see the SAFE HARBOR PLANS section of this manual), to be deemed non-topheavy even though the top heavy ratio as of the last day of the previous plan year was greater than 60%. A safe harbor 401(k) plan is deemed to be non-top-heavy if the plan satisfies the ADP safe harbor requirement with a safe harbor nonelective contribution and no other contributions or forfeiture allocations are made for the plan year or, if matching contributions are made in lieu of a safe harbor nonelective contribution or in addition to a safe harbor nonelective contribution, all of the matching contributions satisfy the ACP safe harbor requirements and no other contributions or forfeiture allocations are made. The requirements for the deemed top heavy exception are applied on a year-to-year basis. For example, if the top paid ratio is found to be greater than 60% as of the last day of the 2012 plan year, the plan is considered top heavy for the 2013 plan year. In order to be deemed non-top-heavy and not need to meet the top heavy minimum contribution requirements for the 2013 plan year, the requirements above must be met in the 2013 plan year. In addition, the safe harbor requirements must be satisfied for the entire plan. For example, if otherwise excludable employees do not receive the safe harbor contribution during the plan year because the safe harbor match requires a year of service, the entire plan is not considered a safe harbor plan and the plan would not be deemed to pass top heavy testing. Precluding HCEs from receiving the safe harbor contribution does not trigger the top heavy requirements. 14 Compliance Testing Manual

19 ADDITIONAL TESTING THAT MAY BE REQUIRED A. 401(A)(4) GENERAL TEST Code Section 401(a)(4) requires a qualified plan that features employer contributions to show that it does not discriminate in favor of highly compensated employees as to contributions or benefits. Employer allocations (other than matching) that do not use a uniform 401(a)(4) Safe Harbor allocation formula, must pass the General Test of Code Section 401(a)(4) to prove the allocation is not discriminatory. TESTING METHODS Defined contribution plans (such as 401(k) plans) generally pass by showing that they do not discriminate as to contributions. Defined benefit plans generally pass by showing that they do not discriminate as to benefits. However, a qualified plan may use either test, and it is sometimes advantageous for a defined contribution plan to use the benefits test. CONTRIBUTION TESTING The employer contributions allocated under a defined contribution plan are nondiscriminatory in amount for a plan year if each rate group under the plan satisfies section 410(b). A rate group exists under a plan for each HCE and consists of the HCE and all other employees in the plan (both HCEs and NHCEs) who have an allocation rate greater than or equal to the HCE s allocation rate. Thus, an employee is in the rate group for each HCE who has an allocation rate less than or equal to the employee s allocation rate. CROSS-TESTING Treas. Reg (a)(4)-8 provides rules for testing defined contribution plans on a benefit basis (similar to a Defined Benefit plan). This method may be a helpful tool for plans that cannot pass General testing on a contribution basis. B. 401(A)(4) BENEFITS, RIGHTS & FEATURES TEST The benefits, rights and features (BRF) of a plan are subject to the nondiscrimination requirements of IRC Section 401(a)(4). Specifically, optional forms of benefits, ancillary benefits and other rights or features are subject to testing under 1.401(a)(4)-4. For example, rates of match are defined as an other right or feature that is subject to such testing. The BRF test requires that a BRF must satisfy a current availability requirement and an effective availability requirement. CURRENT AVAILABILITY The current availability requirement is satisfied if the group of employees to whom the BRF is currently available satisfies the Nondiscriminatory Classification Test of Section 410(b). EFFECTIVE AVAILABILITY The effective availability requirement is satisfied if the BRF, based on all of the relevant facts and circumstances, does not substantially favor HCEs. It is possible that a BRF could be structured in such a way that the current availability requirement is satisfied, but only HCEs ever actually qualify to receive the benefit. In those cases the effective availability requirement is not satisfied. 15 Compliance Testing Manual

20 ADDITIONAL TESTING THAT MAY BE REQUIRED Examples when BRF testing may be required: Rates of matching contributions vary among participants (i.e. age or service based match, or different formulas for different locations or classifications) Types of benefits that are not available to all employees (i.e. plan loans or distribution options that are available only to certain groups of employees) The ability to make a certain type of contribution that is not available to all participants (i.e. after tax contribution availability for only certain employees) C. IRC SECTION 414(S) COMPENSATION TESTING This test should be run to illustrate the definition of Compensation that is being used by the plan is not discriminatory in favor of the HCEs. Any definition of compensation satisfying Internal Revenue Code (IRC) 415 (c )(3) automatically satisfies the nondiscriminatory requirement. If a plan excludes certain forms of compensation (such as bonuses, commissions, or overtime) this test may need to be performed. It requires that the average of the ratio of plan compensation for the HCE group be not more than a deminimus amount higher than the average of the ratio of plan compensation to total compensation for the NHCE group. The IRS has used 3% as a safeguard, but each plan is viewed on a facts and circumstances basis. A 414(s) test would be required in the following situations: a) a non-safe harbor definition of compensation for ADP/ACP or 401(a)(4) nondiscrimination testing. b) a non-safe harbor definition of compensation for allocating matching contributions intended to be a 401(k) Safe Harbor plan c) a non-safe harbor definition of compensation for calculating profit sharing allocations 1 A plan s definition of compensation from which employees are allowed to defer, or the compensation used for allocating normal matching contributions, does not require 414(s) testing as long as the ADP/ACP compensation used to test the deferrals and match meets the definition of 414(s). 16 Compliance Testing Manual

21 ANNUAL NONDISCRIMINATION TESTING Scenarios that May Affect Your Test Results Below are examples of corporate actions and other scenarios that may occur during a plan year and may impact your annual testing. The effect of these on your testing may be seen in the year of the transaction as well as in future years. A. MERGERS, ACQUISITIONS, SPIN-OFFS, AND OTHER WORKFORCE CHANGES If a significant number of employees enter or leave the plan through a company merger, acquisition, or spin-off, this may have an impact on your test results. The number of employees, their rates of deferral, their account balances, and the HCE/NHCE breakdown could all have an impact on any or all of the tests being performed in the current year or in future years. Other changes to the workforce, such as layoffs or early retirement programs, may also make a significant difference in testing, particularly if HCEs are involved. Questions often arise as to the appropriate method of defining HCEs when companies have acquisitions or spin offs or about whether 401(k) plans that merge into or spin off from a parent company s plan may still be tested as part of that plan for the year in which the change occurs. Mercer s Reporting & Testing Specialists are available to discuss your testing options in such situations; however, because IRS guidance in this area is limited, you should also seek advice from legal counsel to be sure you are giving us appropriate instructions on testing your plan. B. PLAN AMENDMENTS OR DISCRETIONARY CHANGES Changes to your plan may also affect your test results. Changes to eligibility requirements and match formulas are two of the most common changes that could impact your test results but there are others. Please contact your Client Service Representative if you have any questions regarding any amendments to your plan. C. CONTROLLED GROUP STATUS If your company is a member of a Controlled Group or Affiliated Service Group, you must inform Mercer, as there may be an impact to your testing services. In this situation, please keep in mind that the test results provided to you may not be final results, as they may need to be aggregated with that of the other members of the Controlled Group or Affiliated Service Group. If your company becomes a member of a Controlled Group during the plan year, your Minimum Coverage test and your ADP/ACP tests may be impacted. The rules surrounding Controlled Groups are complex. Although Mercer cannot make the determination as to your Controlled Group status, some of the ways your company may become a member of a Controlled Group are noted below. Your company acquires another company in whole or in part. Your company is acquired in whole or in part by another company. There is a change in the percentage of common ownership between your company and another entity. There is a change in the percentage of ownership in your company by another entity. 17 Compliance Testing Manual

22 ANNUAL NONDISCRIMINATION TESTING Generally, all members of a Controlled Group are considered when performing your nondiscrimination testing. Companies within a Controlled Group may be tested separately for nondiscrimination purposes only if they meet certain Minimum Coverage requirements, taking into account the entire employee population of the Controlled Group. If your company becomes a member of a Controlled Group during the plan year and other members of the Controlled Group also maintain qualified retirement plans for their employees at other service providers, all plans may need to be tested together. In addition, if employees of a member of the Controlled Group are not covered by any plan, those employees will impact the results of the Minimum Coverage test. If you know that your company became a member of a Controlled Group during the plan year, please notify your Client Service Representative. If you are unsure whether your company is part of a Controlled Group, please contact your controller, tax preparer, or legal counsel. These rules may also apply if a new member joins a current Controlled Group during the plan year. Therefore, if your company is already part of a Controlled Group and a new member joins, your testing may be affected. 18 Compliance Testing Manual

23 ANNUAL NONDISCRIMINATION TESTING Four-Year COLA Summary Qualified Plan Limits (k) Limit (402(g)) $17,500 $17,000 $16,500 $16,500 Catch-Up for 401(k) 5,500 5,500 5,500 5,500 DC Annual Contributions (415) Maximum Compensation Limit 401(a)(17) Highly Compensated Employees Compensation Threshold Key Employees and Officers Compensation A More Than 1% Owner 51,000 50,000 49,000 49, , , , , ,000* 115,000* 110,000* 110,000* 165, , , , , , , ,000 Taxable Wage Base 113, , , ,800 * For example: The compensation limit from the prior year applies to the current testing year. Therefore, an employee who earned $114,000 in 2011 would be an HCE for the 2012 testing year. However, an employee who earned $114,000 in 2012 would not be an HCE for 2013, since the HCE compensation limit that must be earned in 2012 to be an HCE in the next testing year (2013) is $115, Compliance Testing Manual