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The MC Academy
The Employee Benefits and Executive Compensation Series
June 4, 2013
Qualified Plans
Part 2
Nondiscrimination in General
Qualified Retirement Plans may not Impermissibly
Discriminate in Favor of Highly Compensated Employees
(“HCEs”)
3
Who is an HCE?
An HCE is an employee who either:
Received more than $115,000 in compensation from the
employer in the prior year; or
Was a 5% owner in either the current year or the prior
year
The $115,000 threshold is indexed annually
4
HCE Example
2012 Compensation = $105,000
2013 Compensation = $120,000
Not an HCE for 2013
5
Note: Unless an individual is a 5% owner, he will never be an
HCE in his first year of hire (because no compensation
from the employer in the prior year)
Top-Paid Group Election
Can limit HCEs under the first prong (i.e., by
compensation instead of ownership) to top 20% of all
employees by compensation
Cannot expand the group of HCEs (i.e., will not pick up
an individual with less than $115,000 in compensation
in the prior year)
6
Plan Features Subject to
Nondiscrimination Requirements
Contributions to a Defined Contribution Plan
Benefits under a Defined Benefit Plan
Coverage
Benefits, Rights and Features
8
Examples of Benefits, Rights and
Features
Optional Forms of Payment
Death Benefits
Investment Options
Deferral Limits
Rates of Match
Vesting Schedules
9
Minimum Coverage in General
The number of an employer’s HCEs who benefit under
a plan cannot be too disproportionate to the employer’s
other employees who benefit under that plan
11
Minimum Coverage in General
Five basic questions:
Who is an HCE?
Who is the employer?
Which employees are counted?
What is the plan?
What is “too disproportionate”?
12
Who is the Employer?
To prevent employers from avoiding the coverage rules
by moving all non-HCEs to a related company, certain
related companies are treated as a single company for
coverage purposes
13
Which Employees Are Counted?
Subject to 4 specific exceptions, all employees of the
employer are taken into account for coverage purposes
14
Employees Not Taken Into
Account in the Coverage Test
Employees who do not satisfy the plan’s age and
service requirements
Union employees (but subject to separate testing)
Nonresident aliens with no U.S. source income
15
Employees Not Taken Into
Account in the Coverage Test
For a plan with a last-day or minimum service accrual
requirement, employees who:
Are eligible but do not benefit under the plan
Are not employed on the last day of the plan year and
Complete less than 500 hours of service during the plan
year
16
What is the Plan?
Multiple plans may be combined for coverage testing
purposes (“aggregation”)
A single plan may be treated as separate plans for
coverage testing purposes (“disaggregation”)
17
Plan Aggregation
Always permissive (never required to aggregate plans
for coverage testing purposes)
If plans are aggregated for coverage testing purposes,
the plans must also satisfy the nondiscrimination
requirements on a combined basis
18
Plan Disaggregation
Permissive disaggregation – if two (or more) portions of a single plan separately satisfy coverage, these portions may be treated as separate plans for nondiscrimination testing purposes
Mandatory disaggregation – certain plan components and/or groups of employees must be treated as separate plans for coverage testing purposes
19
What is “Too Disproportionate”?
A plan may satisfy coverage by satisfying one of two
tests:
Ratio Percentage Test
Average Benefits Test
20
Ratio Percentage Test
The percentage of non-HCEs participating in the plan
must be at least 70% of the percentage of HCEs
participating in the plan
21
Ratio Percentage Test
Example
Benefiting Not Benefiting Total
Non-HCEs 56 44 100
HCEs 8 2 10
Total 64 46 110
22
Non-HCE percentage = 56/100 = 56%
HCE percentage = 8/10 = 80%
Ratio percentage = 56%/80% = 70%
The plan PASSES coverage
Average Benefits Test
More complicated than the Ratio Percentage Test
Takes into account the level of contributions and/or
benefits under the plan, not just whether an employee
is participating
23
What Contributions are Tested?
Actual Deferral Percentage (ADP) Test
Before-tax employee contributions
Roth employee contributions
Actual Contribution Percentage (ACP) Test
Employer matching contributions
After-tax employee contributions
2 alternative formulas for each test – pass either formula
to pass test
25
What is ADP?
Each eligible employee’s actual deferral ratio (ADR) is
An eligible participant who made no deferral contributions
has a 0% ADR
ADP = Average of individual ADRs
26
Before-Tax and Roth Deferrals (no catch-ups)
Compensation
ADP Tests: 1.25 Times Test
27
Example
HCE ADP NHCE ADP 1.25
NHCE ADP = 2.5%
HCE ADP = 5%
5% is not 3.13% (2.5% 1.25)
Therefore, 1.25 Times Test FAILED and go on to 2 Plus / 2 Times Test
ADP Tests: 2 Plus / 2 Times Test
Example
2 Plus Portion 2 Times Portion
NHCE ADP = 2.5% HCE ADP = 5% 5% is not 4.5% (2.5% + 2%) Therefore, 2 Plus portion FAILED
NHCE ADP = 2.5% HCE ADP = 5% 5% is 5% (2.5% 2) Therefore, 2 Times portion PASSED
Since 2 Plus portion failed, entire 2 Plus / 2 Times Test FAILED
Since both 1.25 Times Test and 2 Plus / 2 Times Test failed, ADP Test FAILED
29
How Can Failing Test Be Corrected?
Return Deferrals to HCEs
Make Additional Contributions for NHCEs
Rerun test with different parameters
Disaggregate test group
Alternative test compensation definition
30
Return Excess Deferrals to HCEs
10% excise tax applies if excess deferrals are not
returned within 2½ months of end of plan year
6 months for an Eligible Automatic Contribution Arrangement
Excess deferrals returned 12 months after plan year
can only be corrected through IRS correction program
Excess deferrals for catch-up eligible participants can
be reclassified as catch-up contributions and stay in
plan
Match on HCE excess deferrals that are distributed
must be forfeited
31
Additional Contributions for NHCEs
Qualified Nonelective Contributions (QNECs)
Contributed by employer
Subject to withdrawal and distribution restrictions that apply to before-tax and Roth contributions
100% vested
Must be made within 12 months after plan year end
Generally, must be made by October 15 of the following year for participants who terminated in the test year
Different allocation methods with varying cost, but subject to restrictions
32
ACP Test
Calculation is largely identical to ADP Test
Employer matching contributions and employee after-tax
contributions are used in place of deferrals
Must pass either 1.25 Times Test or 2 Plus / 2 Times
Test
Failed test corrected by either
Making QNECs to NHCEs
Distributing (if vested) or forfeiting (if not vested) HCEs’
contributions
33
How To Improve Testing Results
Limit amount that HCEs can contribute
Encourage participation by NHCEs
Auto-enrollment of employees
Auto-increase of employee deferral rates
Employee Education
Matching contributions
Safe Harbor plan design
34
Prior-Year Testing
Tests can be run on a prior-year basis
Same tests apply (1.25 Times and 2 Plus / 2 Times)
However current year’s HCE contribution rate is
compared to prior-year’s NHCE contribution rate
Allows employer to anticipate how much HCEs can
contribute
Limits availability of QNECs as correction method
Plan document must provide for current or prior-year
test method
35
37
What is a Safe Harbor 401(k) Plan?
A plan that meets certain requirements in order to
avoid ADP test and/or ACP test
General Requirements:
Safe Harbor Employer Contribution (matching or non-
elective)
Vesting Rules
Withdrawal Restrictions
Annual Notice
Significant restrictions on making changes during a plan
year
38
Two Types of Safe Harbor Plans
Safe Harbor without Qualified Automatic Contribution
Arrangement (“Non-QACA Safe Harbor”)
Safe Harbor with Qualified Automatic Contribution
Arrangement (“QACA Safe Harbor”)
39
Non-QACA ADP Safe Harbor
Employer Contribution Options
Non-Elective Contribution – 3% of compensation for all
participants (whether or not participant has deferrals)
Safe Harbor Match – Basic or Enhanced Match
Contribution Requirements:
Immediate, 100% vesting
No allocation conditions (no last day of plan year or
1,000 hours requirements)
No in-service withdrawals prior to age 59 ½
No hardship withdrawals
Can have eligibility requirements
40
Basic Safe Harbor Match
100% of first 3% of compensation
plus
50% of next 2% of compensation
(4% total match)
41
Enhanced Safe Harbor Match
At least as generous as Basic Safe Harbor Match (e.g.,
100% of 4%)
Rate of match may not increase as deferral percentage
increases (50% of first 3% and 100% of next 3% is not
a safe harbor match)
No higher rate of match for any HCE than any NHCE
42
Other Considerations for ADP
Safe Harbor
Must match catch-up contributions
Can make other employer contributions in addition to
safe harbor contribution
Match may be made on a payroll by payroll or on a
plan year basis
ACP Safe Harbor
Nonelective safe harbor contribution (3% of compensation)
will satisfy ACP test
Safe harbor match will satisfy ACP test as long as:
Do not match deferrals in excess of 6% of compensation
Discretionary matching contributions do not exceed 4%
of compensation
43
Notice Delivery Requirements
Deliver annual notice between 30 and 90 days before
beginning of every plan year
Deliver notice to newly eligible employees
No more than 90 days before employee becomes
eligible, or
If it is not administratively practicable to do so (e.g.,
plans with immediate eligibility), as soon as possible
after eligibility
44
Notice Content Requirement
Description of safe harbor contribution
Description of any other contributions*
How to make elective deferrals
Description of plan compensation*
Withdrawal and vesting provisions
How to obtain additional information
45
* Can be incorporated from SPD
Conditional Safe Harbor –
“Wait and See” Approach
Applies only to 3% non-elective (not match)
Plan document must provide for current year non-
discrimination testing
Safe harbor notice before plan year says employer
may make safe harbor contribution
Must adopt safe harbor amendment and provide follow-
up notice no later than 30 days before end of plan year
If the employer does not adopt the amendment, must
satisfy ADP and ACP tests for year
46
47
Safe Harbor Plan with QACA
Contribution Alternatives:
3% non-elective contribution
or
Match of 100% of first 1% of compensation
plus 50% of next 5% of compensation
3.5% total possible match vs. 4% for Non-QACA Safe Harbor
Match must be made on behalf of all employees who make employee contributions, not just those who are auto-enrolled
Vesting: 2-year cliff vesting (or faster schedule) permitted vs. immediate, 100% vesting for Non-QACA Safe Harbor
QACA Requirements
Must auto-enroll any participant who has not made an affirmative election as of QACA effective date
Participant must be automatically enrolled at 3% (or more)
from initial eligibility through end of following plan year
Automatic deferrals must automatically increase to 4% in
third year of participation, 5% in fourth year and 6% for
every year thereafter
Participant can always opt out of initial automatic enrollment or from automatic increases
Automatic enrollment percentage cannot exceed 10%
48
Importance of Compensation
Calculation of Benefits
Satisfying Legal Requirements
Contribution and Benefit Limits
Nondiscrimination Testing
Identifying HCEs
50
Statutory Compensation Definition
Uses:
Identify highly compensated employees for testing
Calculate statutory limits on contributions and benefits
Can be used for ADP and ACP testing
Must use an IRS-approved 415 definition
51
IRS-Approved 415 Definitions
All amounts received for personal services and
includable in income (i.e., gross income), before pre-
tax deductions, but excluding nonqualified deferred
compensation, stock options, restricted stock, group term
life insurance premiums and similar items
Wages subject to withholding, before pre-tax deductions
W-2 wages, before pre-tax deductions
52
Benefits Compensation
Used to calculate amount of contributions and/or benefits
May also be used for ADP and ACP testing
Described in plan document
Must not discriminate in favor of highly compensated
employees
53
Benefits Compensation –
Safe Harbors
Any IRS-approved 415 definition
Any IRS-approved 415 definition, but excluding all of
the following:
Reimbursements or other expense allowances
Fringe benefits
Moving expenses
Deferred compensation
Welfare benefits
54
Compensation Limit
Compensation taken into account under the plan in a
year may not exceed IRS dollar limit ($255,000 for 2013)
Does not apply when determining HCEs
Does not require participant deferrals to be cut off when
the participant reaches the dollar limit
Limit may be applied by prorating limit for each pay
period, or based on YTD compensation
55
Post-Termination Pay
Compensation for contributions made after termination
of employment is restricted in a 401(k) plan
Post-termination severance may not be deferred
Post-termination trailing pay may be deferred (e.g., salary,
bonus, commissions, shift premiums and similar pay)
Post-termination leave payouts may be deferred
Plan is not required to allow deferral post-termination
The default restrictions also apply to IRS 415 definitions
56
Compensation and Payroll
Payroll must coordinate with plan terms to ensure that
correct compensation items are being used for each
purpose
Area of frequent errors in IRS audits
Post-termination items may be different than included
before termination
Must be updated when payroll codes are added
57
Employee Plans Compliance
Resolution System (“EPCRS”)
IRS-approved corrections
3 Components:
Self-Correction Program (“SCP”)
Voluntary Correction Program (“VCP”)
Audit Closing Agreement Program (“Audit CAP”)
59
General EPCRS Principles
Encourages voluntary correction of errors
Corrections should:
Restore plan to the position it would have been in had
the failure not occurred
Be adjusted for earnings
Not favor highly compensated employees
May be more than one reasonable method of correction
Must update administrative procedures to avoid
recurrence of the failures
60
Self Correction Program (“SCP”)
Allows correction without disclosure to IRS or filing
fees
Can self-correct “insignificant” failures at any time
Can self-correct “significant” failures through the last
day of the second plan year following the plan year in
which the failure occurred
61
Self Correction Program (“SCP”)
“Insignificant” Failures:
Frequency
Percentage of plan assets involved
Number of affected participants
Reason for the failure
No single factor is determinative
62
Example: 6 out of 80 participants receive extra profit sharing
contributions during one plan year. The failure is
insignificant
Voluntary Correction Program (“VCP”)
Requires IRS filing and approval
Filing fees based on number of plan participants
Fees generally range from $750 to $25,000
Reduced fees for certain common failures
VCP filings can cover more than one error
Can typically add errors while VCP filing is outstanding
IRS issues compliance statement after agreement is
reached
63
Why would you use VCP?
Error not eligible for correction under SCP
Retroactive plan amendments
Significant failure that is beyond 2-year correction period
No standard correction under EPCRS
Different method of correction than as described by IRS
IRS can waive excise/penalty taxes that apply to certain
errors
64
Voluntary Correction Program (“VCP”)
Streamlined submissions for common errors follow pre-
approved methods of correction:
Nonamender Failures
Correction: Execute missed amendments
Missed Loan Repayments
Correction: Reamortize impacted loans or allow participants to
repay missed payments in one lump sum
Tax relief available
Failure to pay required minimum distributions
Correction: Distribute missed required minimum distributions
Excise tax relief available
65
Voluntary Correction Program (“VCP”)
Audit CAP
Errors the IRS identifies
IRS-required correction plus penalty
Audit CAP penalties extremely unpredictable
Failure to reach resolution with the IRS will result in
plan disqualification
66
Common Errors and Corrections
Improperly Excluded Employees
Corrective contribution equal to 50% of “missed deferral
opportunity”
Based on average deferral percentage (ADP) for the year
Special rules apply to safe harbor and 403(b) plans
Corrective contribution equal to 100% of matching
contributions participant would have received on
“missed deferral opportunity”
Can be treated as a matching contribution subject to the
plan’s vesting schedule
67
Common Errors and Corrections
Overpayments
Participant must return overpayment
Under a defined benefit plan, if participant is receiving
periodic payments, overpayment may be recovered from
future payments
Plan sponsor may be required to make the plan whole if
participant does not return overpayment
Notify participant that overpayment is not eligible for
rollover
68
Common Errors and Corrections
Plan Eligibility Errors
If letting participants in early, amend the plan to conform
to operations (does not require VCP submission)
If letting participants in late, follow correction for
improperly excluded employees
Plan Compensation Errors
If more favorable to participants, amend the plan to conform to operations (VCP submission may be required)
If less favorable to participants, make corrective contribution based on plan definition of compensation
69
Example: The plan document requires 1 year of service. The employer has been allowing employees to participate after 6 months
Department of Labor Corrections
Voluntary Fiduciary Correction Program (“VFCP”)
Delinquent Filer Voluntary Compliance Program (“DFVCP”)
71
Voluntary Fiduciary Correction
Program (“VFCP”)
Voluntary correction of fiduciary breach under ERISA
Only covers certain errors and correction methods
19 categories of transactions
Requires Department of Labor filing
No filing fees
Employer will avoid civil penalties, and, in certain instances,
excise taxes if it follows program requirements
72
Voluntary Fiduciary Correction
Program (“VFCP”)
Most common error – late participant contributions
Pay contributions to plan
Adjust contributions for earnings (or, if greater, profits
earned by employer from use of contributions)
Use DOL online calculator to determine earnings
Correction will typically eliminate excise taxes
73
Delinquent Filer Voluntary
Compliance Program (“DFVCP”)
Available to employers who fail to file Form 5500s
By using correction program, eligible to pay reduced
penalties
$10 per day for each late filing
Per Filing Cap: $750 for small plans (under 100
participants); $2,000 for large plans
Per Plan Cap: $1,500 for small plans; $4,000 for large
plans
74
IRS Audits – Common Problems
Missing Amendments
Amendments required by law changes must be adopted by
date specified by law or regulation
Discretionary plan amendments – design changes generally
must be adopted by last day of plan year, but some
amendments (e.g., those that cut back eligibility or benefits)
must be adopted before they become effective
77
IRS Audits – Common Problems
Eligibility Errors
Participants not timely enrolled after meeting age/service
requirements
Rehires improperly required to re-complete service
requirements
78
IRS Audits – Common Problems
Safe Harbor Notice not provided
Automatic Enrollment
Notice not provided but deferrals implemented
Notice provided but deferrals not implemented
Automatic Deferral Increase
Notice not provided
Increase not properly implemented
79
IRS Audits – Common Problems
Matching Contributions
Plan formula not followed
Plan match eligibility rules not followed
80
IRS Audits – Common Problems
Hardship Distributions
Hardships not in plan document, but allowed in practice
Hardship requirements not met
Suspension errors
Loans
Original loan terms do not comply with IRS rules
Payroll errors in withholding
Participants who do not repay are not timely defaulted and
issued a Form 1099-R
81
IRS Audits – Common Problems
Failure to follow written plan document
“Compensation” definition not followed in determining
participant deferrals and/or employer contributions
Plan document does not cover all entities whose
employees participate
Participation by subsidiaries may require written action of
both plan sponsor and subsidiary
Defined benefit plan formula not followed
82
IRS Audits – Common Problems
Vesting
Vesting service not properly calculated
Partial termination (20% active participant reduction) not
identified
Minimum Required Distributions (Age 70½) are not
timely made
83
IRS Audits – Common Problems
Forfeitures Not Timely Used
Forfeitures must be used to pay plan expenses, reduce
employer contributions or (rarely) allocated to participants
Plan document may require that forfeitures be used in
the year they arise or the next following year
Some documents are more flexible than others
Failure to use forfeitures may be both a qualification
defect and excise tax on nondeductible contributions
84
IRS Audits – Common Problems
ADP/ACP Testing Issues
Incorrect compensation used to identify “highly
compensated employees” or in performing test
Other data errors affecting tests
Failure to perform test for safe-harbor plan with delayed
eligibility for matching contributions
85
IRS Audits –
Corrections and Penalties
“Insignificant” errors identified in IRS audit may be
corrected without penalty
Significant errors may be corrected through a closing
agreement (“Audit CAP”) and payment of a
negotiated sanction
86
IRS Audits – Audit CAP Sanction
Amount of sanction will depend on size of plan and
nature of error(s)
Sponsor has no real leverage in negotiating the
sanction
Alternative is likely plan disqualification with far
greater consequences
87
DOL Audits – Common Problems
Late Deposit of Participant Contributions
Deadline – earliest date on which contributions can be
reasonably segregated from sponsor’s general assets
15th business day of the following month will never be
considered timely
7 business day safe harbor for plans with under 100
participants
DOL will look to sponsor’s shortest period as setting
standard for reasonableness
89
DOL Audits – Common Problems
Improper Plan Expenses
Employer (“settlor”) expenses cannot be paid from the
Trust
Expenses paid from wrong plan (e.g., 401(k) plan
expenses paid from defined benefit plan)
Nonqualified plan expenses paid for by related qualified
plan
For multi-purpose communications, may need to allocate
between different plans and plan-employer
90
Examples: Cost of optional amendment; accounting expenses
relating to preparation of the employer’s financial
statements
DOL Audits – Common Problems
Fiduciary Oversight Issues
Fiduciaries are unaware of their fiduciary roles
Lack of fiduciary processes (e.g., including 401(k)
investment fund review)
Failure to monitor vendor expenses (e.g., annuity
contract costs)
91
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