Ashley S. Bell, CPA
Partner
As a business owner or plan sponsor, ensuring that your company’s retirement plan is compliant with IRS regulations is critical to maintaining its tax-advantaged status. Compliance testing plays an essential role in meeting these requirements, and it applies to various retirement plans, including 401(k) Plans, Safe Harbor 401(k) Plans, 403(b) Plans, and SIMPLE Plans. In this article, we will provide an overview of what compliance testing is, why it matters, when it needs to be completed, and what steps you can take if your plan fails any tests. Additionally, we will discuss how you can implement early compliance testing to stay ahead.
What is Compliance Testing?
Compliance testing ensures that retirement plans meet the IRS’s requirements and do not disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). These tests are designed to make sure the plan is fair, nondiscriminatory, and compliant with regulations that govern tax-qualified retirement plans.
Retirement plans that require compliance testing typically undergo several types of tests, including the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, the Top-Heavy Test, and others. These tests measure the contributions made by employees to ensure that the plan does not favor HCEs too heavily.
401(k) Plans (Traditional)
Testing Required: These plans are subject to ADP and ACP tests to ensure contributions are not disproportionately made by or for HCEs. Additionally, they must pass the Top-Heavy Test.
Safe Harbor 401(k) Plans
Testing Required: Safe Harbor 401(k) plans are exempt from ADP and ACP testing because they automatically meet the nondiscrimination rules. However, they still need to pass the Top-Heavy Test.
403(b) Plans
Testing Required: Like traditional 401(k) plans, 403(b) plans must also pass the ADP/ACP tests, unless they are structured as Safe Harbor plans. The Top-Heavy Test is also required for 403(b) plans.
SIMPLE 401(k) Plans
Testing Required: SIMPLE 401(k) plans are exempt from ADP and ACP testing but must still meet other requirements under IRS rules, including certain contribution limits.
When is Compliance Testing Due?
The timeline for completing compliance testing depends on the plan year. For calendar-year plans, compliance testing must be completed by the last day of the plan year (December 31), and corrections must be made no later than March 15 of the following year. If the plan is on a fiscal year cycle, the deadlines will depend on the fiscal year end.
To ensure that your plan remains in compliance, it is recommended to start compliance testing well in advance of the March 15 deadline, giving you enough time to review the results and make any necessary corrections.
What Happens If Your Plan Fails Compliance Testing?
If a plan fails one of the required tests (such as the ADP or ACP tests), it may jeopardize its tax-qualified status, leading to potential penalties. However, there are corrective measures available to bring the plan back into compliance. Here’s how you can address common compliance failures:
ADP/ACP Failures
- If the plan fails the ADP or ACP tests, the employer may need to refund contributions from highly compensated employees (HCEs) or make additional contributions to non-highly compensated employees (NHCEs) to balance the contributions.
- Correction Deadline: These corrections must be made by March 15 for calendar-year plans, or within 2½ months after the end of the plan year.
Top-Heavy Failures
- If the plan fails the Top-Heavy Test, the employer must contribute a minimum of 3% of eligible compensation to non-key employees’ accounts.
- Correction Deadline: Employers generally have until the due date of their tax return, including extensions, to make the necessary contributions.
Other Testing Failures
- For other types of compliance failures, employers may be required to take corrective actions such as adjusting eligibility requirements or plan provisions to align with IRS regulations.
It is important to note that if failures are not corrected within the required time frame, the plan risks losing its tax-qualified status, which can result in serious tax consequences for both employers and employees.
How to Implement Early Compliance Testing?
One effective way to stay ahead of potential compliance issues is by implementing early compliance testing. By completing testing before the end of the plan year, you can identify and address issues well in advance of the correction deadline. Here’s how to approach early testing:
- Pre-Year-End Testing: Many plan providers offer pre-year-end testing to help plan sponsors identify any compliance issues before the close of the year. This allows you to take corrective actions as needed, avoiding last-minute scrambling to fix any problems.
- Monitor Contributions and Plan Design: Regularly reviewing employee contributions and ensuring that plan design features align with IRS requirements can help minimize the likelihood of test failures. This can include making sure that contribution limits are being adhered to and that the plan is structured in a way that promotes broad participation.
- Work with Your Plan Provider or Administrator: Your plan administrator or recordkeeper may have tools and resources to help facilitate early testing. Additionally, they can advise you on plan design changes or other modifications to ensure compliance.
- Engage in Regular Education and Communication with Employees: Educating your employees about contribution limits and eligibility rules can help reduce the likelihood of issues arising during testing. The more informed your employees are about how the plan works, the less likely it is that they will make errors that could trigger compliance issues.
Final Thoughts
Compliance testing is a critical part of maintaining the tax-advantaged status of your company’s retirement plan. Whether you sponsor a 401(k), Safe Harbor 401(k), 403(b), or SIMPLE 401(k) plan, understanding your testing requirements and deadlines can help you avoid penalties and ensure the continued success of your retirement offering.
By conducting early compliance testing, staying proactive, and working closely with your plan administrator, you can minimize the risk of failing any tests and correct any issues quickly. If you have any questions or need assistance with compliance testing for your retirement plan, don’t hesitate to reach out. We are here to help you navigate the complexities of retirement plan compliance and ensure your plan remains in good standing.
