Milliman Benefits Perspectives explores a broad range of employee benefits practices. The August 2012 issue contains articles on:
- Nondiscrimination testing, illustrating some of the challenges that plan sponsors can encounter, along with possible counter measures
- Nonqualified deferred compensation plans (NDCPs), highlighting some of the toughest timing tests for the satisfactory operation and administration of NDCPs under section 409A of the tax code
Download and read the entire issue here.
This post marks the third in a three-part series on nondiscrimination testing. See Part 1 here and Part 2 here.
Benefits testing demonstrates that the level of benefits provided by a plan does not discriminate in favor of highly-compensated employees (HCEs). Certain benefit structures that make use of a “safe harbor” design (such as a defined benefit [DB] plan that provides 1% of final average pay for each year of service, or a defined contribution [DC] plan with an employer contribution of 4% of compensation) are exempt from benefit testing.
If the safe harbor design is not met, then detailed testing is required. §401(k) deferrals are subject to the average deferral percentage (ADP) test, and §401(m) matching contributions are subject to the average contribution percentage (ACP) test. All other types of benefits (such as DB plan accruals or DC profit-sharing allocations) will be subject to a numerical test known as the general nondiscrimination test (GNT). Catch-up deferrals are exempt from testing requirements.
Earlier this week we offered Part 1 of a three-part series on nondiscrimination testing. Today, Part 2 looks at the kinds of testing required.
The three main nondiscrimination tests are:
Participation testing is designed to ensure that a defined benefit (DB) plan is not excessively small for the size of the organization (the testing is not required for defined contribution [DC] plans). Defined benefit plans that are currently providing accruals must generally provide them to (at a minimum) the lesser of 50 employees or 40% of all employees.
Employers who sponsor qualified defined benefit (DB) and defined contribution (DC) plans are responsible for making sure that their plans remain in compliance with IRS requirements, as failure to do so can result in excessive costs, penalties, or even plan disqualification. These requirements include the nondiscrimination rules, which are complex and can cause problems for plan sponsors that are unfamiliar with the details. Part 1 of this series outlines the framework for the testing. Parts 2 and 3 will explain the basic requirements of the testing and describe common pitfalls to be avoided. UPDATE: Part 2 is available here and Part 3 is available here.
What is nondiscrimination testing?
Certain benefit plans may be deemed qualified by the IRS and therefore eligible for favorable tax treatment, as long as they do not provide excessive benefits to upper management at the expense of the lower-paid employees. The nondiscrimination rules were established to give plan sponsors a framework for demonstrating that their plans do not provide benefits that discriminate in favor of the highly compensated employees (HCEs).
HCEs are generally those employees with total compensation in excess of a specified limit. For example, if an employee earns more than $110,000 in 2011, the employee would be considered to be an HCE in 2012. (There is an alternative “top 20%” definition that applies for some plans.) Employees who own more than 5% of the organization are also considered to be HCEs. The remainder of the employees would be non-highly compensated employees (NHCEs).