Continuing with our 401(k) rules series, we will address: vesting, employee classifications,  three of the tests (ADP/ACP/Top Heavy), the test corrections and Safe Harbor. 

• Vesting.  Employee deferrals, rollovers and certain employer contributions (Safe Harbor and Prevailing Wage) are always 100% vested.  Other discretionary employer contributions (match and profit sharing) may be subject to a vesting schedule.  Every year an employee works 1000 or more hours, they earn another year of vesting credit.  Vesting may be credited for all years of service, or only years that the plan is in effect.  These schedules may vary, but the longest allowable vesting schedule is over a 6-year period: 

                        0-1 years                                             0%

                        2 years                                              20%

                        3 years                                              40%

                        4 years                                              60%

                        5 years                                              80%

                        6 or more years                                100%

• Employee classifications.  To perform most of the compliance tests under the 401(k) rules, we must determine the classification of each participant in the plan:
  • Highly Compensated Employees (HCE). A person is in the HCE group in 2012 if he can answer “yes” to one of two questions:
    • I own more than 5% of the company, or I am the spouse or child of the owner; or
    • I earned more than $110,000 from the company in 2011
  • Non-Highly Compensated Employees (NHCE).  A person is in the NHCE group in 2012 if he answered “no” to both of the questions.
  • Key Employee.  A person is a Key Employee if any of the following apply:
    • Owns more than 5% of the company, or is a spouse or child of the owner; or
    • Owns more than 1% of the company and has compensation over $150,000
    • Is an officer of the company, and earned more than $165,000 in 2012

• Actual Deferral Percentage (ADP) test.  This test analyzes the deferral ratio (annual deferral amount divided by annual pay) for all employees eligible for the plan.  The average ratio for the HCE group cannot be more than the average ratio of the NHCE group by more than the amount stipulated in this chart:

                        If the NHCE AVERAGE is:              The HCE AVERAGE can be:           

                        0%-2%                                           200% of the NHCE average            

                        2%-8%                                           2% more than the NHCE average   

                        8% or more                                    125% of the NHCE average            

• Actual Contribution Percentage (ACP) test.  This is the same as the ADP test, but compares the ratio of matching contributions instead o the ratio of elective deferrals. 
• ADP/ACP Corrections.  Sometimes the HCE average is more than the limits outlined in the chart above.  If either the ADP or ACP test fails, the company has until 2 ½ months after the end of the plan year to decide on a correction option.  There are two ways to correct a failed test:
  • Return deferrals (ADP) or match (ACP) to the HCEs to reduce their average; or
  • The company can make a contribution to the NHCE group to bring their average up.

Failure to return funds to the HCE group within 2 ½ months of the end of the plan year will result in an excise tax penalty of 10% of the amount that is returned.  If the funds are not returned to the HCEs by the end of the plan year, then the amounts will still need to be returned, and a contribution will be required to the NHCE group equal to the amount returned to the HCEs.

• Top heavy test.  A plan is Top Heavy if more than 60% of the plan assets are held in the accounts of Key Employees.  This determination is made on the last day of the previous plan year.  When a plan is top heavy, a minimum employer contribution must be made to the non-key employees.  This contribution is the lower of:
  • 3% of pay, or
  • The percentage of contributions made to the Key Employee with the highest contribution percentage for the year.  In this calculation, elective deferrals are counted in the contribution percentage.
• Safe Harbor.  Safe Harbor 401(k) rules allow for a company to make a small contribution to each participant in the plan so that they can avoid the ADP, the ACP and the Top Heavy test rules.  Under Safe Harbor, the employer elects before the beginning of each plan year to make one of the following contributions for the following year:
  • 3% of pay to all eligible participants
  • A matching contribution equal to 4% of pay for participants who defer at least 5% of their pay

Safe Harbor contributions carry a couple of additional requirements:  Funds are 100% vested at all times, and no restrictions can be placed on an employee for receiving the Safe Harbor once he is eligible for the plan.

CLICK TO VIEW 401(K) RULES - PART 1 OR 401(K) RULES - PART 3

Photo courtesy of Michelle Meiklejohn.

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