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401(K) Testing Review David Hiss

401(K) Testing Review David Hiss. The Ritz-Carlton, Bachelor Gulch, Colorado September 17-19, 2003. 401(K) Testing Review. Agenda for Session Review of 4 Key Testing Issues ADP/ACP Top Heavy Controlled Groups Coverage Testing Correction Procedures Examples

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401(K) Testing Review David Hiss

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  1. 401(K) Testing ReviewDavid Hiss The Ritz-Carlton, Bachelor Gulch, Colorado September 17-19, 2003

  2. 401(K) Testing Review • Agenda for Session • Review of 4 Key Testing Issues • ADP/ACP • Top Heavy • Controlled Groups • Coverage Testing • Correction Procedures • Examples • Using Testing Issues to Increase Sales

  3. ADP/ ACP Testing • ADP/ ACP Testing • Quick Review: Definitions • ADP: Actual Deferral Percentage • A test designed to test the ratio of elective contributions made by highly compensated employees to non-highly compensated employees. • ACP: Actual Contribution Percentage • A test designed to test the ratio of employer matching contributions made to highly compensated employees to non-highly compensated employees.

  4. ADP/ACP Testing • Definitions (Cont’d) • Highly Compensated Employee (HCE): • An Employee who is either a 5% owner, • Received compensation in excess of $85,000/ prior year • Is in the Top 20% of compensation for all employees

  5. ADP/ ACP TestingExample of an ADP Test

  6. ADP/ ACP Testing • Question: In the previous example would the group pass the ADP Test? • What are the rules regarding this test? • Times 2 Test: If less than 2% NHCE deferral. • 1.25 Test: Multiply the NHCE average times 1.25 to get the HCE max. • 2% Spread Test: Add 2% to the NHC average to get the HCE Max • Do any of the above work?

  7. ADP/ACP Testing • Rules - continued: • Current Year vs Prior Year Methods • Current Year: Use data during current plan year • Prior year: Use the data from the previous year to determine NHC % for testing purposes • Prior year default for plans written after 1997 • Switching Testing methods

  8. ACP/ADP Testing • Correction Methods • Refunds to Highly Compensated Employees • Re-characterization of contributions • Catch-up Contributions • Safe Harbor (More Details Later) • QNECs

  9. Sales IdeaBottom Up QNECs A Different Approach to Passing a 401(k) Discrimination Test

  10. Bottom Up QNECs Assumptions • Eligibility: Immediate • Each HCE defers 7% of pay • Each NHCE defers 3% of pay • After discrimination testing, plan fails by 2% points

  11. Bottom Up QNECsIllustration: QNEC Eligible Avg Trad. Pick & Bottom- Employee Income Deferral ADP% ADP QNEC Choose Up HCE 1 $170,000 $12,000 7.00% HCE 2 170,000 12,000 7.00% HCE 3 170,000 12,000 7.00% HCE 4 170,000 12,000 7.00% 7% NHCE 1 60,000 1,800 3.00% 2% 0% 0% NHCE 2 55,000 1,650 3.00% 2% 0% 0% NHCE 3 50,000 1,500 3.00% 2% 0% 0% NHCE 4 45,000 1,350 3.00% 2% 0% 0% NHCE 5 40,000 1,200 3.00% 2% 0% 0% NHCE 6 35,000 1,050 3.00% 2% 0% 0% NHCE 7 30,000 900 3.00% 2% 0% 0% NHCE 8 25,000 750 3.00% 2% 0% 0% NHCE 9 20,000 600 3.00% 2% 10% 0% NHCE 10 5,000** 150 3.00% 3% 2% 10% 20% $7,300 $2,500 $1,000 **(termination date 5/01/01)

  12. Bottom Up QNECs Benefits Total NHCE compensation $365,000 Additional contribution of $7,300 required to raise NHCE deferral to 5% But, by making a bottom-up QNEC of $1,000 you pass the ADP test And HCEs keep their contributions in the plan

  13. Bottom Up QNEC’s • Proposed New IRS Regulations For QNEC’s • Contributions allocated to one NHCE would be limited • Current 100% of Income • Proposed: • NHCE’s compensation for the plan year Multiplied by the Greater of 5% • Twice the Plan Representative Contribution Rate • Regulations are Proposed and Subject to Change • Effective 2005 (at the earliest)

  14. Top Heavy Testing • Top Heavy Testing • Quick Review: Definitions • Top Heavy: The total accrued benefits for “Key Employees” exceeds 60% of total of all accounts. (Rollovers are excluded for this calculation) • Key Employee: • Officer who earned in excess of $130,000 • A 5% owner of the company • A 1% owner with compensation in excess of $150,000

  15. Top Heavy Testing • Top Heavy Testing • Basic Rule: 60% of the benefits are accrued to the “Key Employees”. • “Key Employees” are different then “Highly Compensated Employees”. • “Top Heavy” is determined on the last day of the preceding plan year.

  16. Top Heavy Testing • Top Heavy Correction Procedures • Excluding “Key Employees” from participating. • Minimum Vesting Required. • Minimum Contributions. • Safe Harbor (More details Later).

  17. 401(K) Testing - Top Heavy • Minimum Vesting • 3 year Cliff Vesting (100% after 3 Years) • 6 year Graded Vesting (20% per year after year 2, 100% after 6 years) • Minimum Contribution • Lessor of 3% of compensation for each non-key employee or the highest key employee contribution. • Matching now counts.

  18. Top Heavy Testing • Sales Idea: • Safe Harbor Provision • Biggest Advantages • Elimination of ADP/ACP Tests • Elimination of Top Heavy Tests • Sales Impact • Allows Key Decision Makers to maximize contributions to Pension Plan and reduce administration to plan

  19. Safe Harbor Plans • Safe Harbor Rules • Safe Harbor Contribution Requirement • Vesting Requirement • Withdrawal Restrictions • Annual Notice Requirement

  20. Safe Harbor • Safe Harbor Contribution Requirement • Two Options • 100% Match on first 3% plus 50% on next 2% • Satisfies ACP, ADP & Top Heavy • Flat 3% Contribution to all Eligible Participants • Satisfies ACP, ADP & Top Heavy

  21. Safe Harbor • Safe Harbor Vesting Requirement • All employees must be 100% vested in all employer contributions. • Withdrawal Restrictions: • No Hardship withdrawals to employer contributions. • Hardships allowed for employee contributions. • Notice Requirements • Plan must provide all eligible employees a notice of their rights on a annual basis

  22. 401(K) Testing • What is a controlled Group? • The Concept of a Controlled Group was established to prevent taxpayers from avoiding qualification requirements through use of multiple entities. • Very common in the $1-5 Million Market

  23. Controlled GroupsHow many kinds of Controlled Groups are there? • There are two Types of Controlled Groups: • Parent-Subsidiary Controlled Group • Brother-Sister Controlled Group

  24. Controlled GroupsWhat is a Parent-Subsidiary Controlled Group • One or more chains of organizations in which controlling interest in each of the organizations is owned by another organization. • Controlling interest is defined as follows: • 80% of the total value of shares • 80% of the voting power

  25. Controlled GroupsWhat is a Brother-Sister Controlled Group? • A Brother-Sister Controlled Group consists of two or more organizations satisfying both of the following requirements: • Same 5 or fewer individuals/entities own controlling interest (80%). • Ownership must be identical with respect to each organization.

  26. Controlled GroupsWhy is This Important? • Section 414(b) treats employees of a Controlled Group of corporations as employed by a single employer.

  27. Controlled GroupImplications of Being Part of a Controlled Group! • Must consider all employees within the Controlled Group for testing purposes. • Can’t segregate management groups. • Owners of multiple companies must aggregate qualified plans. • Companies unrelated for business purposes, may be related by ownership.

  28. Controlled Groups • Sales Idea: Two most common issues • A Controlled group does not exist, but the group wishes to put multiple companies together: • Answer: Multiple Employer Document, which allows for multiple companies to be under one plan to gain economies of scale • A Controlled group does exist, but the group wishes to split the group and treat them separately: • Answer: New Comparability Plan by division. This will allow the employer to make different profit sharing contributions to the different divisions

  29. 401(K) Testing • Coverage Test: • A qualified plan does not have to cover all employees. However, it must cover a minimum percentage of the company’s Non-Highly Compensated Employees. • The two tests are: • Ratio Percentage Test • Average Benefit Test

  30. Coverage Test • Coverage Rules: • Ratio Percentage Test • The % of NHCEs who benefit (are eligible for the plan) must be equal to, or greater than 70% of the percentage of HCEs who benefit. • Example • 100% of HCEs are covered • 50 NHCEs (40 ees) are covered (80% benefit) • 80% X 100% = 80% (Ratio Test Passed)

  31. Coverage Test • Coverage Rules • Average Benefit % Test • To pass this test the benefits provided to the NHCEs must be at least 70% as great on average as the benefits provided to HCEs. • The most common test is the ratio % test. • If the ratio % test fails, the Average Benefits test may be used.

  32. Coverage Test • Coverage Test • Potential Pitfalls/ Multiple Corporations • Owners of Multiple Corporations must include all their organizations in passing this test. • Owners that offer Qualified plans to some companies and not to others may be in violation of this rule. • Consistency is the key.

  33. Q & A

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