Getting ready to offer a 401k retirement plan to your employees? Way to go!
Offering benefits your employees want and need is a foolproof way to attract and maintain incredible talent. Along with an uptick in employee satisfaction, you’ll also gain more tax-deferred savings – it’s a win-win.
Before you go skipping into a field of “I’m-the-best-boss” bliss, keep in mind that offering a 401k plan comes with added responsibilities. One of these tasks is making sure your plan is run fairly, and that everyone has the opportunity to fully participate – not just owners and other company bigwigs.
Contributing to a 401k comes with significant tax advantages, so the government wants to make sure your plan doesn’t unfairly benefit the company owners and the highest earners. (You may hear these groups referred to as “highly compensated employees” or “HCEs.”) The IRS set up a series of nondiscrimination tests to ensure your plan is fair and encourages participation from all employees.
The IRS Gives Tests?!
There are 3 annual nondiscrimination hoops to jump through.
- The Actual Deferral Percentage (ADP) test: This limits the percentage of compensation that HCEs can defer into their 401k based on the average contribution rates of the non-highly paid employees.
- The Actual Contribution Percentage (ACP) test: This ensures that the employer matching contributions and any after-tax employee contributions contributed for HCEs are not disproportionately higher as compared to non-highly paid employees.
- The Top Heavy Test: This ensures that HCEs cumulatively hold less than 60% of the total plan balance.
In essence, ADP and ACP testing both make sure your plan doesn’t unfairly benefit HCEs, while the Top-Heavy test ensures they aren’t the main people contributors to your plan.
If your plan fails one of these tests, it’s an administrative nightmare filled with costly correctives and piles of paperwork. You may have to return a portion of the contributions made to HCEs or make additional contributions for the lower paid employees. But hurry, if you take too long to make the plan corrections, youâll owe a 10% penalty. The IRS has Fix-it guides for both ADP/ACP failure and Top Heavy failure but itâs best to prevent problems before they happen.