Despite the poor economic climate of the last decade, employees are investing in 401(k)s in record numbers. Their simplicity and rate of return make these plans attractive, as do the nondiscrimination requirements built in by the US government. These requirements ensure that everyone stands to benefit equally from investing in a plan, regardless of annual income.
However, these nondiscrimination requirements can be a heavy burden for employers. Annual testing to ensure compliance is a necessity, but it requires constant tweaking in order to ensure compliance at the end of a plan year. Accounting and finance teams play a critical role in this process.
Navigating 401(k) Nondiscrimination Regulations
When creating the 401(k) policy, the government’s intent was to ensure that low and middle-income employees would reap the biggest tax benefit and would not disproportionately impact highly-compensated employees (HCEs).
There are thresholds in place limiting the amount that HCEs can invest into a plan as compared to the contributions made by non-highly compensated employees (NHCEs) in the same company. Thus, you have the process of testing against nondiscrimination rules.
Organizations must test two ratios throughout the year:
- Average Deferral Percentage (ADP): Percentage of employees’ annual pre-tax compensation into a 401(k).
- Average Contribution Percentage (ACP): Ratio of matching and after-tax contributions to employees’ pre-tax compensation.
The tests ensure that the ADP and ACP of HCEs do not outpace those of lower-income employees. As contributions increase, limitations change in the following ways:
- If NHCE ADP/ACP ≤ 2%: HCE ADP/ACP ≤ NHCE ADP/ACP × 2
- If NHCE ADP/ACP = 2-8%: HCE ADP/ACP ≤ NHCE ADP/ACP + 2%
- If NHCE ADP/ACP > 8%: HCE ADP/ACP ≤ NHCE ADP/ACP × 1.25
In order to manage these changes, companies should test quarterly to ensure the organization is on target to maintain compliance by the end of the plan year. This helps manage the documentation required to show the government that companies are hitting their targets and that the testing itself meets proper standards.
These quarterly tests should yield a positive outcome. When ratios are out of line, companies have a few options for correcting the issue, including:
- Corrective Distributions: Lowering HCE contributions by issuing refunds to HCEs based on contribution amount.
- Corrective Contributions: The employer makes additional contributions to the plans of lower-paid workers in order correct ratios.
Who Is Keeping You Compliant?
Compliance with nondiscrimination rules is absolutely necessary in order to stay on the right side of the law. Working with an outsourced third-party administrator is attractive, but there are risks involved with trusting the process to someone else. Keeping the process in-house can help ensure that enough NHCEs participate to keep ratios intact, and to allow finance teams to get out in front of any issues as they arise in quarterly tests.
Managing 401(k) compliance can be a complicated process. It takes the right professionals to ensure regulatory compliance and long-term employee satisfaction with the plan. If your company is seeking top accounting and finance talent, or you want to improve your accounting and finance hiring processes, contact the expert A&F recruiters at Contemporary Staffing Solutions today.