Continued Introduction
Another difficulty in complying with
the testing rules is the timing. The
result of the ADP and ACP tests are
not known until after the end of the
plan year, usually the calendar year. If
the test(s) are failed, there are several
remedies available to adjust the
results. The most common are refunds
to the HCE's and/or additional contributions for the NHCEs. In an attempt
to avoid these potentially costly and
complex remedies, SBJPA allows current year ADP and ACP testing to be
based on the prior year's results.
Beginning in 1997, the limit for the
HCE group can be based on the prior
year's NHCE ADP, or, optionally, the
test can be done as in the past. As a
result of this change, all plans can
guarantee passing the ADP and ACP
test by limiting the deferrals for each
of the HCE's for the current year based
on the NHCE average for the prior
year. If, for example, it is known that
the NHCE actual percentage for 1996
was 5.25%, a limit of 7.25% for each
HCE will guarantee compliance. The
disadvantage of this approach is that it
results in underuse of the allowable
HCE percentage. If some of the HCEs
defer less than 7.25%, this would normally allow others to defer more than
7.25% because the test is based on an
average. If all HCEs are individually
limited to 7.25% to guarantee compliance, the average may be less than
7.25%, thereby not taking maximum
advantage of the limits. For 1997 and
1998, either approach may be used in
either year. Rules still must be issued
by the IRS for plans that use current-year data for 1998, or a later year, and
want to switch to prior-year data for a
subsequent year.
One other item of importance
regarding existing 401(k) plans deals
with one of the corrective mechanisms
for failed ADP or ACP tests. Under current law, if the ADP test is failed, a
refund can be made to the HCEs to
reduce their ADP to the allowable level. This process is sometimes referred
to as "top down"
approach. (See Table 2)
Under current law,
the first step would be
to reduce the highest
percentage deferral to the
next highest level and test
again. If the test is not satisfied, the process is repeated until the test is
met. In the example in
Table 2, HCE #3 would
be reduced to 9%
and the HCE average recalculated
to 7.979% ((5.938
+ 9 + 9)/3). We still
haven't passed the
test so HCE #2 and HCE
#3 are reduced further until
the test is passed. If that
reduction is below the
5.938% of HCE #1 then
HCE #1 also is reduced. So
step two is to reduce HCE #2 and HCE #3 to
8.281%, and the test is passed (((5.938
+ 8.281+ 8.281)/3)= 7.500%).
As you can see, the lowest-paid HCE
received the highest refund. The IRS
has believed for some time that this
result is not equitable, and SBJPA has
corrected that inequality. Beginning in
1997, the refund will be calculated the
same but will be allocated beginning
with the highest
deferral amount,
not the highest
deferral percentage.
In our example, HCE #1 first
received $500 to bring him to the level
of HCE #2. Next, both HCE #1 and
HCE #2 receive refunds of equal
amounts ($797). Even though when the
test is rerun it doesn't satisfy the ADP
test guidelines, it is assumed to pass
when this process is followed correctly
Another change now allows plans to
include short-service, nonhighly compensated-
employees (less than one year
of service), yet exclude them from the
ADP or ACP tests. This provision will
allow companies to open the plan to all
employees without the risk of failing
the test because, generally short-service employees tend not to participate
(see Table 3).
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