Testing 101: Understanding Compliance Testing Susan M. Wright, CPA, APM, Director of Compliance & Consulting Jason Frey, QPA, Consultant
Topics of Discussion The Annual Information Form The importance of complete and accurate census data Overview of required plan testing Plan design considerations Important dates to remember for 2012 Questions and answers 2
What is the Annual Information Form? The Annual Information Form (AIF) includes important plan information necessary to complete annual testing and the Form 5500 We will not commence annual testing for your plan (or contribution calculations) until after we have received your completed AIF 3
When is the AIF due to DailyAccess? The AIF is due to DailyAccess no later than the 15 th day of the month following your plan year end AIFs for calendar year plans were due by Monday, January 17 th What happens if the AIF is returned to DailyAccess after the due date? We cannot guarantee to provide your testing results or government filings by their respective deadlines. If you have a calendar year plan and have not submitted your AIF, it is crucial to do so immediately! 4
Testing Data Your Plan s Census Complete and accurate census data is a fundamental requirement for year-end testing Review the plan census report via the Plan Sponsor Website to ensure that: Termination dates and rehire dates for each participant are properly reflected in our system Annual hours worked are accurate for each participant All compensation and deferral amounts for each participant have been properly included Report any necessary corrections to your Account Executive 5
Compensation/Payrolls Does your plan exclude any types of compensation? Were the excluded amounts included in your payroll uploads? Gross compensation is still needed for testing purposes Check your payroll system and payroll upload file format for the upcoming year Check to make sure new compensation types are included Check to make sure the appropriate plan limits are in place If the definition of compensation in your plan has changed, make sure the payroll file format has been updated 6
Compliance Testing Basic Definitions What is a Highly Compensated Employee (HCE)? More than 5% owners (and direct relatives) An employee with compensation greater than $110,000 in the prior year What is a Key Employee? More than 5% owners (and direct relatives) Officers with compensation greater than $160,000 1% owners earning greater than $150,000 7
Required Annual Compliance Testing The Plan must pass certain annual testing to prove that the plan does not discriminate in favor of HCEs or exceed certain limitations. Some of the most common tests include: ADP/ACP Test 402(g) Limit Test 415 Annual Additions Test Coverage Test Top Heavy Test 8
What is the ADP/ACP Test? The Average Deferral Percentage (ADP) test is performed to determine whether the plan is discriminating in favor of HCEs with respect to employee deferrals (pre-tax/roth) The Average Contribution Percentage (ACP) test is performed to determine whether the plan is discriminating in favor of HCEs with respect to employer matching contributions The ADP Test compares the ADP of the HCEs against the ADP of the Non-Highly Compensated Employees (NHCEs) to determine whether the plan is discriminating in favor of the HCEs Note: This test is not required for Safe Harbor 401(k) Plans 9
How are the ADP/ACP percentages calculated? The ADP/ACP is determined separately for the HCE group and the NHCE group The ADP is calculated by taking each participant s elective deferrals, net of catch-up contributions, and dividing the deferrals by his/her compensation The percentages are then added up and divided by the number of eligible participants within that group The calculation is performed in the same manner for ACP testing 10
How are the ADP/ACP percentages calculated? Employee Compensation 401(k) Amount ADP % NHCE 1 25,000.00 2,500.00 10.00% NHCE 2 50,000.00 1,500.00 3.00% NHCE 3 50,000.00 0.00 0.00% Average Deferral Percentage (13% divided by 3) 4.33% 11
ADP /ACP Test Case Study Employee Status Comp 401(k) ADP % Match ACP % Joe Smith Owner 245,000.00 16,500.00 6.74% 7,350.00 3.00% Mary Smith Wife 50,000.00 10,000.00 20.00% 1,500.00 3.00% Bill Smith Son 50,000.00 0.00 0.00% 0.00 0.00% HCE ADP/ACP 8.91% 2.00% Jane Brown NHCE 50,000.00 10,000.00 20.00% 1,500.00 3.00% Steve Orr NHCE 30,000.00 2,000.00 6.67% 900.00 3.00% Susan Deen NHCE 25,000.00 1,000.00 4.00% 500.00 2.00% Billy Jones NHCE 35,000.00 0.00 0.00% 0.00 0.00% NHCE ADP/ACP % 7.67% 2.00% 12
ADP/ACP Testing Results The Plan uses the current year testing method. Therefore the maximum ADP for the HCEs is determined as follows: 7.67% (NHCE ADP) x 2 = 15.34% 7.67% (NHCE ADP) + 2% = 9.67% The maximum ADP for the HCEs is the lesser of the two percentages, or 9.67% Since the HCE ADP was 8.91%, the Plan passes this required test The calculations for the ACP test are done in the same manner as the ADP test Note: If the Plan used the prior year method, the maximum percentage would be calculated using the prior year NHCE ADP % 13
ADP /ACP Test Case Study Different Facts Employee Status Comp 401(k) ADP % Match ACP % Joe Smith Owner 245,000.00 16,500.00 6.74% 7,350.00 3.00% Mary Smith Wife 50,000.00 10,000.00 20.00% 1,500.00 3.00% Bill Smith Son 50,000.00 5,000.00 10.00% 1,500.00 3.00% HCE ADP/ACP 12.25% 3.00% Jane Brown NHCE 50,000.00 10,000.00 20.00% 1,500.00 3.00% Steve Orr NHCE 30,000.00 2,000.00 6.67% 900.00 3.00% Susan Deen NHCE 25,000.00 1,000.00 4.00% 500.00 2.00% Billy Jones NHCE 35,000.00 0.00 0.00% 0.00 0.00% NHCE ADP/ACP % 7.67% 2.00% 14
What happens if the Plan fails the ADP/ACP test? Corrective measures will be required to comply with the law Reclassify corrective distributions as catch-up contributions Issue corrective distributions to HCEs ( refunds ) Make an additional contribution to the plan, known as a Qualified Non-Elective Contribution (QNEC) 15
How are corrective distributions determined? Corrective distributions are calculated based on the participants with the highest deferral rates. However, the amounts are distributed to those participants with the largest dollar amount of deferrals. Employee Comp 401(k) ADP % Max ADP % Step 1 Excess Amt Step 2 Refund Amt Reclassify to Catch-up Deferrals Remaining in Plan Joe Smith 245,000 16,500 6.74% 6.74% 0 3,865 3,865 16,500 Mary Smith 50,000 10,000 20.00% 12.27% 3,865 0 0 10,000 Bill Smith 50,000 5,000 10.00% 10.00% 0 0 0 5,000 12.25% 9.67% 3,865 3,865 3,865 31,500 Note: In this example, Joe was catch-up eligible so the amount that he would have otherwise been distributed was reclassified as a catch-up contribution. Had he been under age 50, this amount (adjusted for earnings) would have to be distributed to him. 16
Is there a deadline for making corrective distributions? Generally, corrective distributions must be issued within 2½ months after the close of a plan year to avoid a federally imposed 10% excise tax on the excess amounts. The deadline is March 15, 2012 for plans with year ending 12/31/11 Additionally, corrective distributions must be made within 12 months following the close of the plan year 17
What if corrective distributions are not made by the deadline? Corrective actions must be taken to maintain the qualified status of the plan. Most plans may use the IRS s self-correction program to correct this operational error. However, this can be costly. Corrective distributions must still be issued IRS 10% excise tax must be paid The employer must make an additional QNEC contribution to the NHCEs equal to the amount of corrective distributions 18
What is the 402(g) limit? The 402(g) limit is an annual limit on the amount that an individual may defer into the plan through pre-tax or Roth deferrals. This is a calendar year, individual limit - it is determined on a calendar year basis, covering all plans in which the employee participates Pre-tax and Roth contributions are combined to determine whether the limit has been exceeded Catch-up contributions are not included in the limit The 2011 402(g) limit is $16,500 The 2011 catch-up limit is $5,500 19
What if the 402(g) limit is exceeded? The excess deferrals must be refunded before April 15 th of the year following the year in which the deferrals were made A participant who exceeds the limit for 2011 must be refunded the excess amount (adjusted for earnings) by April 15, 2012 If pre-tax deferrals are refunded after this date, the participant is taxed in both the year of deferral and the year of distribution If a participant participates in more than one plan, she/he must notify the plan sponsor regarding which plan should make the corrective distribution 20
What is the 415 limit? Individual participants are subject to an overall annual contribution limit, known as the 415 limit. This limit includes all contributions made to the plan for a particular year on behalf of a participant, including: Pre-tax and Roth deferrals Employer match and employer base contributions Safe harbor contributions Forfeiture allocations Note: Rollover contributions and catch-up contributions are not included as contributions for this purpose. The 415 limit for the 2011 plan year is the lesser of 100% of gross compensation or $49,000. 21
What if the 415 limit is exceeded? It depends on the plan document provisions. However, typically the following actions are required: Excess deferrals are refunded Excess employer contributions are forfeited Note: Forfeited contributions generally must be used to reduce future employer contributions 22
What is the Coverage Test? The Coverage Test is required to prove that the plan meets certain minimum coverage standards set forth under the Internal Revenue Code Generally, this test must be run separately for each distinct component of the plan 401(k), employer match, and profit sharing components independently of one another Generally, the plan must cover 70% of employees who have met the minimum age and service requirements set forth under the Internal Revenue Code (even if they are otherwise excluded from the plan or a portion of the plan) 23
What is the Coverage Test? There are several different tests that can be applied to determine whether the plan satisfies the coverage requirements Note: The plan is required to pass the Coverage Test corrective measures must be taken should the plan fail this required testing A plan may satisfy coverage requirements using either the Ratio Percentage Test or the Average Benefits Test 24
What is the Coverage Test? If the plan fails the Ratio Percentage Test (the 70% test), the Average Benefits Test is applied If the plan continues to fail, typically an additional employer contribution is required to satisfy this test Cross-tested plans are subject to additional coverage testing requirements 25
What is the Top Heavy Test? A defined contribution plan is generally considered top heavy if, as of the last day of the prior plan year, the account values of key employees represent more than 60% of the account values of all employees. For example, a calendar year plan with a top heavy ratio of 75% as of 12/31/10 would be top heavy for the 2011 plan year. 26
What happens if the plan is Top Heavy? The employer is required to make a 3% top heavy contribution to all non-key employees that are actively employed on the last day of the plan year All match and profit sharing contributions count toward the top heavy minimum contribution Safe harbor plans are not required to make a top heavy minimum if the only employer contribution is the safe harbor contribution (this is true whether the plan provides for a safe harbor match or safe harbor nonelective contribution) 27
What happens if the plan is Top Heavy? If no Key Employees benefit under the plan for a particular plan year, then the top heavy minimum contributions are not required for that plan year. Note: A Key Employee is considered to be benefitting for this purpose if he makes 401(k) or Roth deferrals into the plan, even if the employer does not make any other contributions to the plan. 28
Are there any other required tests? A number of additional tests may be required for your plan. Common examples include: If your plan provides for a cross-tested profit sharing allocation, additional coverage testing must be performed If your plan uses a definition of compensation other than a 414(s) safe harbor definition, additional testing must be performed to prove that the definition of compensation is nondiscriminatory (typically applies where a plan excludes such items as bonuses or overtime pay) 29
Are there any other required tests? If your plan provides for different rates of matching contributions or profit sharing contributions for different groups of employees, additional testing will apply. This is a broad overview of basic testing requirements - additional testing may be required for your plan based on your plan design. 30
Achieving the design goals for your plan Retirement plan law is constantly changing Economic conditions have impacted businesses Plans that have stopped making employer contributions are considering resuming this benefit Plan Sponsors may have changes in their workforce demographics 31
Achieving the design goals for your plan Options to consider Increase your matching contribution Allow for more liberal eligibility requirements Amend your plan to include a safe harbor formula Utilize a cross-tested profit sharing formula Consider implementing a cash balance plan 32
Achieving the design goals for your plan The Bottom Line: It is a good time to review your current plan design to determine if changes would be beneficial to achieve the overall goals of your Company. Please contact your Account Executive if you would like to schedule a call with one of our Compliance Consultants to discuss your plan design: Design options Prepare a design study to demonstrate the cost associated with various alternatives 33
Important Deadlines for 2012 For plan years ending December 31, 2011: March 15 Corrective distributions must be made for ADP/ACP failures to avoid the 10% Excise Tax April 15 Deadline for corrective distribution of 402(g) excess deferrals (all plans) July 31 Request for Automatic Extension-5500 Series & 8955-SSA (2½ months) August 30 Initial annual participant disclosure regarding plan investments and expenses October 15 Extended deadline for filing Form 5500 & 8955-SSA December 1 For 2013 Plan Year: Due date for distributing Safe Harbor notices and QDIA notices to participants 34
New Limits for the 2012 Plan Year Annual Deferral Limit (402(g)) $ 17,000 Catch-up Contribution Limit $ 5,500 Annual DC Contribution Limit (415) $ 50,000 Annual Compensation Limit $250,000 Social Security Taxable Wage Base $110,100 Highly Compensated Income Threshold $115,000 Key Employee Income Threshold $165,000 Maximum DB - annual benefit $200,000 35
Questions & Answers Please contact your DailyAccess Account Executive at 888-535-4322 with questions or to request a plan design study. A recorded version of this presentation will be available at www.dailyaccess.com. We appreciate this opportunity to be of service to you and your plan participants. Thank You. 36