Plans must be tested each year to ensure that they are compliant with the laws governing retirement plans. To understand the testing performed for your plan, it may be helpful to review some of the terms that are commonly used. First, let’s examine how your plan’s noteworthy individuals are identified.
Highly Compensated Employees (HCE): There are two factors that determine which employees are HCEs for a plan year:
- Ownership: An employee who owns more than 5% of the company in a plan year, or the year preceding it, is an HCE. A spouse, child, parent, or grandparent who participates in the plan will likewise be considered an HCE due to family attribution rules.
- Compensation: An employee is considered an HCE in a plan year based on their earnings the preceding year. An employee is an HCE for 2023 if they earned at least $135,000 in 2022; for 2024, the employee must have earned at least $150,000 in 2023. Plan document provisions may further limit this definition to the top 20% of earners.
Key Employees: There are three factors that determine which employees are considered key employees:
- Ownership: An employee who owns more than 5% of the company in a plan year, or the year preceding it, is a key employee. A spouse, child, parent, or grandparent who participates in the plan will likewise be considered a key employee.
- Owner compensation: An employee who owns more than 1% of the company and earned more than $150,000 in the prior plan year is a key employee.
- Officer compensation: An officer of the company is considered key in a plan year based on their earnings the preceding year. In 2023, the officer must have earned at least $200,000 in 2022; for 2024, the officer must have earned at least $215,000 in 2023.
Now that these individuals have been categorized, let’s explore some of tests that might be performed on your plan:
Deferral testing: The average deferral percentage for all highly compensated employees (HCE) is compared to the average deferral percentage for all non-highly compensated employees (NHCE) to ensure the gap between the two groups is not too wide. If this test fails, there are several methods to correct the test, including refunding deferrals and earnings for HCEs or making contributions for the NHCEs. This test is known as the Actual Deferral Percentage (ADP) test. Safe harbor 401(k) plans are designed to pass the ADP test.
Match testing: This form of testing is similar to deferral testing but compares employer match instead of deferrals. This is known as the Actual Contribution Percentage (ACP) test. Safe harbor 401(k) plans are also designed to pass the ACP test.
Maximum deferral testing: An employee’s deferrals cannot exceed a yearly maximum; this limit was $22,500 for 2023 and will be $23,000 for 2024. An additional $7,500 catch-up contribution can be deferred in 2023 and 2024 by participants who are at least 50 years old. If a participant has deferred more than the limit, a corrective distribution of the excess deferrals and earnings must be processed by April 15th. This limit is known as the 402(g) limit.
Maximum individual contribution testing: Similar to maximum deferral testing, the combined amount of a participant’s employee and employer contributions cannot exceed a yearly maximum. This combined limit is the lesser of $66,000 for 2023, $69,000 for 2024, or the participant’s total compensation. Catch-up deferral contributions are not included in this limit. This limit is known as the annual additions limit or 415 limit and is an important factor when calculating a maximum company contribution.
Maximum employer contribution: The employer’s tax deduction cannot exceed 25% of compensation for plan participants. This is known as the 404 limit and is also an important factor in the calculation of a maximum company contribution.
Top-heavy testing: A plan is considered top-heavy if 60% or more of the plan assets belong to key employees. A minimum contribution may be required if the plan is top-heavy. Many safe harbor plans are designed to satisfy top-heavy testing.
When calculating a contribution for a participant or the plan, these are some of the parameters that determine the permitted amount. Understanding this terminology may provide clarity to the contribution options provided for a plan year.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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