401k IRS Compliance Testing

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Did you know that every year your company’s 401k takes a test? Actually it’s 2 tests that I’ll be discussing and there are actually even more. And, if it fails to comply with IRS guidelines certain employees have money removed from their retirement savings, taxed, and returned to them during the following year?

The 2 compliance tests I want to talk about are the ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) tests. Both of these are designed to prevent discrimination in favor of highly compensated employees (HCE’s). For the 2010 period, a highly compensated employee is defined as:

• one who during the preceding year had compensation of more than $110,000 (for 2009 and 2010) and, if the employer chooses, was in the top 20% of paid employees OR
• one who owns greater than 5% of the business, or a family member of a 5% owner

OK, now we have a working definition of an HCE. What do the tests test for?

ADP (Actual Deferral Percentage) – The gist of the ADP test is that the ADP of the HCE group may not exceed the ADP for the non-HCE group by 1.25 percent or 2 percentage points. If it does, then corrective action must be taken. More info here

ACP (Actual Contribution Percentage) – The ACP test is basically the same as the ADP test. The only difference is that instead of looking at salary deferral percentage, you are examining matching contributions and/or employee after-tax contributions. This test has the same limits between HCE’s and Non-HCE’s as the ADP test.

So, what happens when your 401k fails to meet the compliance test requirements? Your employer has some choices:

• Return funds to HCE’s to make the ratio of HCE:non-HCE compliant
• Recharacterize salary deferral contributions of HCE’s as after-tax contributions
• Contribute additional amounts to non-HCE 401k’s to make up the difference and get the ratio of HCE:non-HCE compliant

No matter what you do you’re going to piss someone off. The first 2 piss off the HCE’s and the third pisses off the CFO. Guess which one my company chose? Option 1. Luckily I am not so much of an HCE that I can’t contribute to a Roth so I will still be putting the money towards retirement, just not in my 401k.

I have to think that the recession has likely made this problem more profound with companies reducing their match thus reducing employee’s incentive to save in addition to the greater pressure on incomes borne by the middle class. Many simply stopped contributing altogether in order to have more cash on hand if they lost their jobs. In doing so, however, the retirement goals of others are essentially being crippled because they cannot put the money into retirement accounts that they would like.

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