This blog post addresses retirement plans that are intended to be tax-qualified under Section 401(a) of the Internal Revenue Code (Code).
Specifically, this post will provide information related to:
- “Coverage Testing” rules under Code Section 410(b)
- Related “Controlled Group” rules under Code Section 414
Quite often, we see employers, particularly smaller employers, design and implement tax-qualified retirement plans without a basic understanding of how these rules apply to their plans. This results in confusion over if the plan is required to take corrective action under these rules in a particular plan year.
This blog post is intended to provide employers with a fundamental understanding of these rules, so that the plan sponsor can mitigate potential compliance issues at the time of the plan’s implementation.
In order for an employer sponsored retirement plan to be “tax-qualified,” the plan must not discriminate in favor of “highly compensated employees” (HCEs), in either the plan design or administration.
“Discrimination” in favor of HCEs is generally measured in two fundamental ways:
- The group of employees who are covered by the plan cannot discriminate in favor of HCEs (Coverage Testing)
- The benefits provided within the plan cannot discriminate in favor of HCEs (Benefits Testing)
Plan administration service providers will usually include Benefits Testing for the plan, and most plan providers do a terrific job of monitoring compliance with the Benefits Testing rules.
For example, in a typical 401(k) plan, the provider will conduct the average deferral percentage (ADP) and average contribution percentage (ACP) tests for the plan, which measure whether contributions to the plan (both employee and employer matching contributions) discriminate in favor of HCEs. The plan provider also will examine the plan’s compliance with other tax law rules, such as the “top-heavy” rules, and rules that limit maximum deferrals of participants and maximum benefits for participants.
However, quite often, and particularly with smaller employers, we do not see anyone focusing on Coverage Testing for the plan. This can create significant issues pertaining to the tax-qualification of the plan. Below is a primer on the Coverage Testing rules.