Retirement Plan Administration. Mercer HR Services. SERVICE 401(k) Compliance Testing Manual. A resource for testing information

Transcription

1 Retirement Plan Administration Mercer HR Services FULL 401(k) SERVICE 401(k) Compliance Testing Manual A resource for testing information

2 Copyright 2005 by Mercer HR Services. All contents are the confidential and exclusive property of Mercer HR Services. 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. July /05

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...3 A. ADP/ACP Testing Compensation...3 B. 415 Compensation...4 C. Deferral Compensation...4 Correct Testing Population...5 A. Eligible Employees...5 B. Union Employees...5 C. Location Codes...5 D. Excludable Employees...6 E. Employees Who Received Severance Pay...6 IMPORTANT DATES AND DEADLINES...7 Correcting Failed Tests After Months of the Plan Year-End...7 GENERAL INFORMATION...9 Testing Overview...9 A. ADP/ACP Test...9 B. 410(b) Minimum Coverage Test...12 C. Section 415 Annual Additions Test...13 D. Top Heavy Test...13 Scenarios that May Affect Your Test Results...14 A. Mergers, Acquisitions, Spin-offs, and Other Workforce Changes...14 B. Plan Amendments or Discretionary Changes...14 C. Controlled Group Status...14 Four-Year COLA Summary...16 SHORT PLAN YEARS AND THE IMPACT ON TESTING...17 Determining Highly Compensated Employees...17 Annual Limits Must Be Prorated...17 FAILED TESTS...18 Guide to Correction Methods...18 A. ADP/ACP Nondiscrimination Testing...18 B. Section 415 Annual Additions Limits...20 C. Requirements for Top Heavy Plans...20 D. Catch-up Contributions...22 SAFE HARBOR PLANS...23 INTERIM NONDISCRIMINATION TESTING...24 A. Compensation for Interim Testing...24 B. Plan Aggregation...25 C. Interim Testing of Matching Contributions...25 D. How Are Contributions and Compensation Projected for Interim Testing?...25 E. What to Do with Your Test Results...26

4 FORMS...27 DEMO TEST...28 Compliance Testing Services Waiver...47 Correction Response Form...48 Tax Witholding Waiver...50 Corporate Ownership and Officer Status Worksheet...51 Compliance Testing Manual

5 INTRODUCTION Mercer HR Services 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 designed to provide you with a readily available resource for testing information. 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 2005 plan year, an HCE is any employee who was: Actually paid over $90,000 in gross compensation (see 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 HR Services will determine HCEs and Key Employees for your verification, based on the data in our recordkeeping system and any additional information you provide regarding ownership, family members, and officers. Go to the Corporate Ownership and Officer Status Worksheet if you have not previously provided this list to your Plan Service Representative. This form should be ed to your Plan Service Representative. 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 HR Services will perform the determination of your plan s HCEs based on data in our recordkeeping system and based on additional information data we will need to collect from you for this purpose. 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 hours per week, or less than six 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 union members and union employees 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 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 $135,000; or An over-5% owner (including certain family members); or A 1% owner (including certain family members) with compensation in excess of $150,000. 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 $150,000. 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, International 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 compensation of over $135,000 are treated as Key Employees. In order for Mercer HR Services to determine HCE and Key Employees for your verification, you will need to provide additional information regarding ownership, family members, and officers. Go to the Corporate Ownership and Officer Status Worksheet if you have not previously provided this list to your Plan Service Representative. This form should be ed to your Plan Service Representative. 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. 3 Compliance Testing Manual

8 DATA REQUIREMENTS FOR TESTING For example, some plans exclude compensation paid before the date an employee became eligible for the plan. If your plan contains this provision, compensation paid for the period before the employees become eligible should be excluded for ADP/ACP testing, but should 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). Example for a plan that excludes compensation prior to participation: Employee becomes eligible to join plan Compensation 1/1/05 6/30/05 Compensation 7/1/05 12/31/ Compensation ADP/ACP Compensation July 1, 2005 $20,000 $30,000 $50,000 $30,000 B. 415 COMPENSATION Annual 415 compensation data is needed for all employees who were eligible to participate in the plan at any time during the plan year being tested. Compensation for Section 415 testing is defined by IRS regulations. 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 also 415 compensation, then you only need to provide one compensation amount for each eligible employee. C. DEFERRAL COMPENSATION If your plan document implements 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. 4 Compliance Testing Manual

9 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. 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. Eligible employees who met the eligibility requirements and reached an entry date but chose not to defer must still be included in the ADP/ACP test with deferral and matching percentages of zero. B. UNION EMPLOYEES Union employees must not be included in the same nondiscrimination test with non-union employees. If your plan covers both union and non-union employees, separate ADP tests must be performed for each group (although if there are no HCEs in the union group then it will not require testing). Because of this requirement, correct identification of each employee s union status is critical to completing an accurate test. This is typically done by setting the employee s division/location code or a special union identifier on our recordkeeping system, though identifying codes can also be included in a T971 testing compensation file. Such codes need to be provided for all eligible union employees, not only those who participate in the plan. Even if there are no HCEs in the union group so no separate union ADP test is needed, all union employees must be excluded from the non-union ADP test. As always, please work with your Plan Service Representative to review your plan s data needs and the method of data collection. C. LOCATION CODES If employees are tested by location, 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 Plan Service Representative to ensure all employees are identified with an accurate location code. 5 Compliance Testing Manual

10 DATA REQUIREMENTS FOR TESTING D. EXCLUDABLE EMPLOYEES Plans are allowed to exclude from participation 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, you may still exclude from the ADP/ACP tests 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-thanaverage deferral rates, it is often advantageous to exclude this group from testing. In performing your ADP/ACP tests, Mercer HR Services 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. Since plan documents typically do not specify how to determine this excludable group, and 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 plan year from 1/1/05 through 12/31/05, we will exclude NHCEs who were not yet age 21 or had not completed 12 months of service as of 7/1/05. E. EMPLOYEES WHO RECEIVED SEVERANCE PAY Unless your plan document specifically allows it, 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 severance pay, 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 severance pay in the plan year being tested would generally not be included in the testing population. 6 Compliance Testing Manual

11 IMPORTANT DATES AND DEADLINES Correcting Failed Tests After Months of the Plan Year-End The deadline for submission of your testing data to Mercer HR Services depends on whether you intend to make corrective distributions within months of the plan year-end in the event your ADP/ACP test fails. Corrective distributions made after that date are subject to a 10% excise tax penalty. However, corrective distributions made within this month period are treated as taxable income to the HCEs for the calendar year in which the contributions were originally made. In fact, for plans with noncalendar plan years, corrective distributions made within this period will be taxable in the calendar year in which the plan year began, for HCEs who made contributions during that part of the year. As a result, making corrective distributions within the month period may require your HCEs to amend previously filed income tax returns. To avoid this, many plan sponsors choose to postpone corrections until after the month period, preferring to incur the 10% penalty tax on the distributions. Alternatively, if the plan year is the calendar year, plan sponsors may suggest to their HCEs not to file their tax returns for the prior year until ADP testing has been completed. If your year-end is in December 2005 and you intend to make corrective refunds, if applicable, within months of the plan year-end, you will need to provide Mercer HR Services with complete and accurate testing data by January 31, If your plan year-end is some other date, and you intend to make corrective refunds, if applicable, within the month period, Mercer HR Services will need complete and accurate testing data within four weeks from the end of your plan year. 7 Compliance Testing Manual

12 IMPORTANT DATES AND DEADLINES If you are not concerned with making corrective refunds within months of the plan year-end, corrective action must still be taken by the end of the following plan year to avoid potential disqualification. Your Plan Service Representative will be in touch with you in the event your ADP/ACP test fails to discuss the correction options available under your plan. The advantages and disadvantages of making corrections within the month period are outlined below. If your plan fails the ADP/ACP Test and you refund excess to HCEs: Within months after the end of the plan year being tested After months, but within 12 months of the end of the plan year being tested More than 12 months after the end of the plan year being tested Pros No 10% penalty tax to the plan sponsor HCEs report additional income for the calendar year in which they receive the distribution, eliminating problems with a prior year s tax return N/A Cons HCEs report additional income for the calendar year in which the contribution was originally made, treating the dollars refunded as the first contributions made for the HCE in the plan year being tested. This may require some HCEs to file amended returns for a prior tax year Employer must pay penalty tax equal to 10% of the excess contributions This penalty must be paid using Form 5330, which must be filed by the end of the 15th month following the plan year being tested The plan may lose its tax qualification. Also, the employer incurs the cost of additional contributions (QNECs) for NHCEs, to avoid plan disqualification, in addition to the 10% penalty on any excess amounts refunded 8 Compliance Testing Manual

13 GENERAL INFORMATION Testing Overview A. ADP/ACP TEST Except for plans that satisfy the 401(k) safe harbor (see Safe Harbor Plans section), ADP/ACP testing is required for all 401(k) plans and or other DC 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 beforetax salary 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 deferrals made for each employee are divided by the employee s 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 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. 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. 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 for the HCE group must not exceed one of the following limits: The Basic Limit, which is the NHCE average times 1.25; or The Alternative Limit, which is the lesser of: The NHCE average ADP times 2, or; The NHCE average ADP plus 2 percentage points. Note: The requirement is that the test only pass one of these limits. 9 Compliance Testing Manual

14 GENERAL INFORMATION The ACP test is conducted in the same manner as the ADP test, taking into account matching contributions and employee after-tax contributions. (Prior to 2002, a separate Multiple Use test was required that could further limit HCE percentages, but that test has been repealed.) Below is an illustration that shows the maximum HCE ADP at different levels of NHCE ADP. NHCE Average 0.60% 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% Note: In certain cases regulations allow shifting or borrowing contributions from the ADP test to the ACP test or vice-versa, to improve the 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. 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, or 2.Recharacterizing excess before-tax contributions as after-tax contributions (if after-tax contributions are allowed under the terms of the plan), or 3.Depositing a Qualified Non-Elective Contribution (QNEC) in the plan for all NHCEs. 10 Compliance Testing Manual

15 GENERAL INFORMATION If the Return of Excess (ROE) method (1) is elected, and 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. Under the ROE correction method (1) the plan sponsor incurs a penalty tax equal to 10% of the total excess contributions (prior to gain/loss adjustment) on any distributions made more than months after the end of the plan year. See Important Dates and Deadlines for the pros and cons related to this month correction period. Under the after-tax recharacterization method (2), before-tax deferrals become subject to taxation in the year they were originally made, but instead of being distributed as ROEs, they remain in the plan as after-tax contributions. The affected HCEs must be notified of this additional tax liability within months of the end of the plan year, so like the ROE method, this may require HCEs to amend prior-year income tax returns, especially in off-calendar plans (see Important Dates and Deadlines). This correction method is only allowed before the month deadline. Note: If the ADP or ACP test fails, corrections must be made within 12 months of 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 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 passing result for both plans. 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 done on an aggregate 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. 11 Compliance Testing Manual

16 GENERAL INFORMATION B. 410(b) MINIMUM COVERAGE TEST Section of 410(b) of the Internal Revenue Code prescribes a 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; Matching contributions and employee after-tax contributions; Profit sharing contributions or any other employer contributions. The data and calculations for this test must be reported on the Schedule T with your Form 5500 filing. The 410(b) test and Schedule T take 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 HR Services, coverage testing is performed only for plans that are record-kept at Mercer HR Services. If your company is a member of a Controlled Group that has additional plans not record-kept at Mercer HR Services, 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 and Schedule T. 1.Leased employees who had worked full-time for at least one year. 2.Employees in any company or division that was excluded as a group 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 union employees or non-resident aliens. Most 401(k) plans cover nearly all employees, and pass the 410(b) test easily. In some cases though, particularly in Controlled Group situations, 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, based on the data available to us, your Plan 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 receive employer contributions. 12 Compliance Testing Manual

17 GENERAL INFORMATION 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 ending in 2005 cannot exceed the lesser of 100% of compensation or $42,000. 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 member rollover contributions transferred from another qualified plan. 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. If a participant s annual additions exceed the maximum limit, correction should be made in accordance with your plan document. Although there is no correction deadline specified in the Internal Revenue Code, any correction to participant allocations should be made as soon as possible after the excess has been identified. 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. 13 Compliance Testing Manual

18 GENERAL INFORMATION 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 spinoff, 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 in recently acquired or spun-off companies, 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. Our 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 Plan Service Representative if you have any questions regarding any amendments to your plan. C. CONTROLLED GROUP STATUS 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 HR Services 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. 14 Compliance Testing Manual

19 GENERAL INFORMATION Generally, all members of a Controlled Group are aggregated together and tested as if they were a single employer. 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 Plan Service Representative. If you are unsure whether your company is part of a Controlled Group, please contact your 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. 15 Compliance Testing Manual

20 GENERAL INFORMATION Four-Year COLA Summary Qualified Plan Limits (k) Limit (402(g)) $15,000 $14,000 $13,000 $12,000 Catch-Up for 401(k) 5,000 4,000 3,000 2,000 DC Annual Contributions (415) TBD 42,000 41,000 40,000 Maximum Compensation Limit 401(a)(17) TBD 210, , ,000 Highly Compensated Employees Compensation Threshold TBD 95,000 90,000 90,000 Key Employees and Officers Compensation TBD 135, , ,000 1% Owner TBD 150, ,000 50,000 Taxable Wage Base TBD 90,000 87,900 87, Compliance Testing Manual

21 SHORT PLAN YEARS AND THE IMPACT ON TESTING Short plan years occur in a number of situations including when a new plan is established, when a plan is amended, when a plan is terminated, or when a plan merger takes place. Determining Highly Compensated Employees Highly Compensated Employees (HCEs) are determined on the basis of compensation earned for the 12-month period preceding the plan year being tested (unless the plan has an off-calendar plan year and adopts a special election to define its HCE group based on calendar-year compensation). The HCE group for a short plan year is determined as usual, based on compensation earned in the prior plan year. However, the HCE group for the plan year following the short plan year must still be based on compensation for the previous 12 months, not during the short plan year. For example, assume a plan is being amended from a 10/31/05 plan year-end to a 12/31/05 plan year-end. The period from 11/01/05 to 12/31/05 becomes a short plan year. When determining HCEs for the short plan year, compensation from 11/01/04 to 10/31/05 will be used. For the 2006 plan year, compensation from 1/1/05 to 12/31/05 will be used to determine the HCE group. The same is true when a new plan is established. Assume a new calendar-year plan is created with an effective date of 5/1/04. The period from 5/1/05 to 12/31/05 is a short plan year. Compensation used to determine HCEs will be compensation paid from the period of 5/1/04 to 4/30/05 (unless the plan document includes a calendar-year election for its first plan year). Annual Limits Must Be Prorated Some annual limits used in testing must be prorated for short plan years. These include the 401(a)(17) Annual Compensation Limit and the 415 Annual Additions Limit. (View the Four Year COLA Summary for specific annual limits.) For example, the 2005 Annual Compensation Limit when determining plan calculations is $210,000. This limit must be prorated for a short plan year. Using the example from above with a plan year beginning on 5/1/04 and ending on 12/31/05, the maximum compensation to be used is $140,000 (($210,000/12) X 8) (the number of months in the plan year being tested). The Annual Additions Limit for a short plan year would be determined in the same way. The limit for plan years ending in 2005 is $42,000. To determine the applicable limit for the short plan year, divide the annual limit by 12 and then multiply by the number of months in the short plan year. Using the example plan year above (5/1/05 to 12/31/05) the Annual Additions Limit for the short plan year would be $28,000 (($42,000/12) X 8). Because the 402(g) Deferral Limit and the 414(v) Catch-up Limit are always applied on a calendar-year basis, these limits do not change for a short plan year. Likewise, the compensation thresholds for HCEs and Key Employees are not prorated since they are always based on a 12-month period. 17 Compliance Testing Manual

22 FAILED TESTS Guide to Correction Methods Note: All corrections must be authorized by returning the Correction Response Form to your Plan Service Representative. Click here to access the Correction Response Form. Please complete and return to your Plan Service Representative. A. ADP/ACP NONDISCRIMINATION TESTING If the ADP/ACP test fails, the average deferral percentages for HCEs (or in the ACP test, the matching and after-tax contribution percentages) are too high in comparison with the averages for the NHCEs. The most common correction method is to return excess amounts to the HCEs who deferred or received the highest dollar amount of contributions. Investment gain or loss must be allocated and distributed with the excess amounts. RETURNING EXCESS CONTRIBUTIONS If correction is made by distributing excess amounts, the following rules govern penalties and tax consequences of the distributions, depending on when they are made. If any HCEs have already received a distribution of their entire vested balance before the correction is made, their corrective distributions are considered as having been completed with that distribution. These HCEs should be notified in writing that the excess contributions are not eligible for rollover. Corrective distributions made within months of the testing year-end. As explained below, there is no penalty to the plan sponsor for corrective distributions that are made within months of the end of the plan year being tested. However, the distribution amounts (adjusted for gain/loss) generally must be included in the HCEs taxable income for the testing year (or in off-calendar year plans, for the tax year in which the first contributions for the plan year being tested were made for that HCE). This may require recipients to amend their personal tax returns to report additional income. Any corrective distributions made in 2006 will be reported to the IRS by Mercer HR Services in January 2007, on Form 1099-R. The Form 1099-R will indicate the proper year in which the distribution should be included in income. Corrective distributions made after the month deadline. Corrective distributions made after the month deadline are considered taxable to the recipients in the year they are actually paid. However, the plan sponsor then becomes liable for an excise tax penalty equal to 10% of the total excess amounts distributed (excluding gain/loss). The penalty tax is payable to the IRS with Form 5330, which must be filed by the end of the 15th month following the plan year being tested. For a calendar-year 2005 test, this deadline is 3/31/07. Form 5330 and instructions are available online at Mercer HR Services can provide you with a copy of this form on request. Any corrective distributions made in 2006 will be reported to the IRS by Mercer HR Services in January 2007, on Form 1099-R. Corrective distributions made more than 12 months after the end of the plan year. If corrective distributions are not completed within 12 months of the end of the plan year being tested, a qualification failure will occur and the test must be corrected under the IRS Employee Plans Compliance Resolution System (EPCRS). This does not require any notification or filing with the IRS; however, it does generally require making additional 100% vested employer contributions (QNECs or QMACs) to NHCEs, in addition to or instead of returning excess amounts to HCEs. You should seek legal advice to ensure you meet all EPCRS requirements to avoid the tax consequences or plan disqualification. 18 Compliance Testing Manual

23 FAILED TESTS OTHER CORRECTION METHODS Two other correction methods are available under the Internal Revenue Code and Regulations if they are provided for in your plan document. Additional 100% vested employer contributions may be made to the plan. Your document may permit Qualified Non-Elective Contributions (QNECs) allocated to all eligible NHCEs, or Qualified Matching Contributions (QMACs) made only for those NHCEs who deferred for the year. The amount of the corrective contribution will depend on the allocation method specified in your plan document. QNECs and QMACs are usually available as a correction method only if the current-year testing method is used. In that case, QNECs and QMACs may be made at any time during the plan year following the year being tested, and are not subject to any penalty. QNECs and QMACs may also be used to improve test results with the prior-year testing method, but in that case the contributions must be allocated to the prior-year s NHCE group, and must be made before the end of the plan year being tested. The timing of such contributions dictates their deductibility and when they are considered annual additions for Section 415 testing. In plans that include after-tax employee contributions, the ADP test may be corrected by recharacterizing the HCEs excess before-tax deferrals as after-tax contributions, instead of distributing them to the participant. Since these recharacterized contributions must then be included in the ACP test, however, this method helps only if the ACP test initially passes with sufficient leeway to absorb the additional HCE after-tax contributions. Recharacterization must be completed within months of the end of the plan year being tested, or this method cannot be used. The HCEs affected must be notified within this period that the taxable status of their contributions has changed, and they must include these amounts as additional taxable income on their tax returns for the tax year in which the amounts were originally deferred. Therefore, as with corrective refunds, HCEs should be notified that they may wish to postpone filing their annual income tax returns until ADP testing is completed, if this will be the correction method of choice. 19 Compliance Testing Manual

24 FAILED TESTS B. SECTION 415 ANNUAL ADDITIONS LIMITS Please consult your plan document to determine whether corrective distributions of employee deferrals and after-tax contributions are permitted to correct Section 415 violations, or whether a different method is specified. No penalty applies, and no specific deadline is given, although it is advisable to make these distributions before the end of the plan year following the year being tested. If your plan allows corrective distributions, they will be taxable to the recipient as ordinary income for the tax year in which the distribution is made. An appropriate gain or loss should be allocated and distributed with the excess amounts. Any corrective distributions made in 2006 will be reported to the IRS by Mercer HR Services in January 2007, on Form 1099-R. Regulations do not permit distribution of employer contributions to correct these violations. Your plan document may allow that the excess amounts be held in a suspense account, and then be reallocated to participants or used to offset future employer contributions in the next plan year. Please note that the regulations specifying these correction methods presume that any excess contributions over the Section 415 limits are due either to a reallocation of forfeitures, or a reasonable error in estimating participants compensation or the amount they would be able to defer within the 415 limits. If this is not the case, the excess may need to be corrected under the EPCRS compliance program. If any participants have already received a distribution of their entire vested balance before the correction is made, their corrective distributions are considered as having been completed with that distribution. However, excess contributions are not eligible for rollover to an IRA or other qualified plan. Any participants with excess contributions who have taken a distribution of their entire vested balance should be notified in writing. C. REQUIREMENTS FOR TOP HEAVY PLANS A plan s Top Heavy status is determined as of the last day of the prior plan year. If your plan became Top Heavy for the first time as of the end of your 2005 plan year, the Top Heavy requirements will apply for your 2006 plan year. However your plan may already satisfy the minimum vesting and contribution requirements outlined below. If so, no further action is necessary. 20 Compliance Testing Manual

25 FAILED TESTS Top Heavy plans must vest all employer contributions at least as rapidly as one of the following schedules: Six-year graded vesting employees become 20% vested after two years of service, increasing 20% per year thereafter, with 100% after 6 years; or Three-year cliff vesting employees are not vested until they have three years of service, at which point they become 100% vested. Your plan document will specify the Top Heavy schedule applicable to your plan. Top Heavy plans must also generally make minimum employer contributions of 3% of plan-year gross compensation for every eligible Non-Key Employee. The following rules apply: If every Key Employee s total contributions, including deferrals, are less than 3% of compensation, then the required minimum contribution for all Non-Key Employees is reduced to the highest percentage for any Key Employee. No minimum contribution is required for a plan year in which no deferrals or contributions are made for any Key Employee. Some employer contributions already made can be used to satisfy the 3% minimum requirement. For example, if you make profit sharing contributions of 3% or more every year, for all Non-Key Employees, no additional contributions are needed. Reallocated forfeitures and company matching contributions may also be counted toward the minimum, but participants own contributions may not. Note that, beginning with the 2002 limitation year, matching contributions used to satisfy the Top Heavy minimum contribution requirement may also be used in the ACP test for the plan. Minimum contributions must be made for all Non-Key Employees who were eligible for the plan, and were still employed at the end of the plan year even if they did not work enough hours during the year to receive a normal employer contribution. Employees who terminated before the end of the plan year, are not required to receive a minimum contribution. Key Employees may also receive these contributions. The contribution must also be made within the normal deductibility and annual addition rules. If you have more than one plan covering the same employees, Top Heavy minimum contributions are required in only one plan so long as they are made for each Non-Key Employee who was employed at year-end. Check your plan documents to determine to which plan the contribution must be made. 21 Compliance Testing Manual

26 FAILED TESTS D. CATCH-UP CONTRIBUTIONS Beginning in 2002, plan sponsors were able to offer participants age 50 or older the opportunity to make catch-up contributions. The maximum catch-up amount for 2005 was $4,000. This limit will increase $1,000 in 2006 to reach $5,000. Catch-up contributions are not included in calculating the ADP for individual employees and are therefore not included in the ADP test. For HCEs who have not reached the catch-up limit but have excess deferrals due to a failed ADP test, regulations permit the excess to be recharacterized as catch-up contributions up to the annual limit. Only amounts that actually exceeded either a regulatory limit or a plan-specific deferral limit may be treated as catch-up contributions and be excluded from ADP testing. Likewise, if your plan allows catch-up contributions, any excess over a regulatory or plan-specific limit must be treated as a catch-up contribution for members who meet the age requirement and have not already reached the annual catch-up limits. Because catch-up contributions based on the 402(g) annual limit on deferrals ($14,000 for 2005) are determined on a calendar-year basis, regardless of the plan year, catch-up tracking is greatly simplified for plans that do not impose plan-specific deferral limits on members (or where the deferral limit is so high that no employees will reach it). Where plans do impose plan-specific deferral percentage limits (on all participants or only on HCEs), those limits must be calculated on a plan-year basis as of the last day of the plan year. For plans with off-calendar plan years this complicates matters considerably, since catch-up calculations must take into account limits imposed both on a calendar-year and a plan-year basis. If you are transmitting contributions to Mercer HR Services pre-coded as catch-up contributions, they will be reflected as such on our recordkeeping system. However be aware that we may need to recharacterize some contributions as of the end of your plan year to comply with regulations. If your plan allows for catch-up contributions, Mercer HR Services will calculate the correct catch-up amounts for participants based on regulatory and plan-specific limits, in order to ensure the correct amounts are excluded from testing. If your plan limits deferrals (either for all employees or for HCEs only) to a percentage of compensation less than 75%, you should be sure you are providing us with the compensation amounts on which these deferral limits are based (read about Deferral Compensation). If we do not receive separate Deferral Compensation amounts for your plan, we will assume the deferral percentage limit is based on the same compensation used for ADP/ACP testing. If the ADP test fails, Mercer HR Services will automatically recharacterize any excess deferral amounts for catch-up eligible HCEs as catch-up contributions, to the extent those deferral amounts have not already reached the catch-up limit in effect for the calendar year in which the plan year ends. If your plan allows for catch-up contributions, Mercer HR Services will recharacterize any excess deferral amounts that do not exceed the catch-up limit, at the time of the corrective distribution. 22 Compliance Testing Manual