As 2020 winds down, it is time to start thinking about annual compliance testing! One of the more intractable pieces of the testing puzzle each year is the ADP (Actual Deferral Percentage) Test. The SECURE Act, which was passed into law in December 2019, added some new options to help plan sponsors comply with the ADP Test.
The ADP Test
The ADP Test is a test that is used to demonstrate that 401(k) plans do not discriminate in favor of Highly Compensated Employees (HCE). The test looks at the 401(k) contribution rate for each employee, determined on an annual basis, then takes the average of the contribution rates for the highly compensated and non-highly compensated employee groups. If the average for the HCE is greater than the average for the non-HCE by more than a certain amount, the test fails.
A failed test is generally corrected in one of two ways: either the employer can make additional contributions (known as Qualified Non-Elective Contributions or QNECs) to the non-HCEs’ accounts to bring up the average for that group, or the HCEs can take refunds of a portion of their contributions for the year. QNECs can be prohibitively expensive, depending on the size and contribution rates of the non-HCE group, and refunds are detrimental to HCEs’ retirement savings.
Another non-discrimination test, the ACP test, is similar to the ADP test except that it tests employer matching contributions, rather than employee deferral contributions.
Safe Harbor 401(k) Plans
What makes the ADP Test particularly irksome is that since it is based on employee contribution rates, and because employees can generally start, stop, or change their contributions at any time, it is often difficult, if not impossible to know what the outcome of the test will be in advance, and therefore to plan for it. Rather than face this uncertainty each year, some plan sponsors choose to adopt a safe harbor plan design which allows them to automatically satisfy the ADP test, in exchange for making safe harbor contributions to the employees’ accounts. Safe harbor plan designs come in two varieties: a safe harbor match (or “SHMAC”), where the employer makes a contribution to those employees who defer into the plan, and a safe harbor non-elective (or “SHNEC”) where the employer makes a contribution to all eligible employees, even those who were not contributing themselves. A SHMAC is typically capped at 4% of the employee’s compensation, whereas the SHNEC is generally equal to 3% of compensation.
A major limitation of safe harbor plan designs is their inflexibility. Merely making the contribution is not enough; the plan administrator must also provide a notice to participants before the beginning of the year stating their commitment to provide the contribution. Since the notice must be provided before the beginning of the year, it would make it impossible for a non-safe harbor plan to decide that they want to become a safe harbor plan after the beginning of the year. On the other hand, if the sponsor of a safe harbor plan decides during the plan year that they no longer wish to have a safe harbor plan, they may only terminate the safe harbor under certain limited circumstances.
The SECURE Act, which was passed into law in December of 2019, offered some welcome flexibility to sponsors of safe harbor non-elective plans. Section 103 of the SECURE Act does two things: first, it eliminates the notice requirement, and second, it allows plan sponsors to add SHNEC provisions to their plans not just mid-year, but even retroactively after the end of the year, by increasing the employer contribution to 4%.
Notice Requirement
The requirement to provide a notice was eliminated, but only with respect to safe harbor non-elective plans, and only to the extent the safe harbor is being used to satisfy the ADP test. If the plan sponsor wishes to use the safe harbor non-elective contribution to satisfy the ACP test, because they are making a discretionary matching contribution, then the advance notice is still required. SHMAC plans were not affected by this change and must continue to provide the notice.
Plan sponsors may wish to continue providing the notice on an annual basis, even if it is no longer required. As mentioned, providing the notice allows the sponsor to make a matching contribution without being subject to the ACP test. Providing the notice also gives the sponsor an opportunity to revoke the plan’s safe harbor status mid-year, should they wish to do so, without the need to be operating at an economic loss. Furthermore, the timing of the notice aligns with the timing of other required notices, such as the QDIA notice, so continuing to provide the safe harbor notice should not place too much additional burden on plan sponsors.
Retroactive Safe Harbor Amendment
The ability to decide, up until 30 days before the end of the plan year, whether or not to have a SHNEC for the current year has always existed via the so-called “Conditional SHNEC” in which the sponsor provides a notice (sometimes called the “maybe” notice) before the beginning of the year informing participants that the plan might be safe harbor, then follows it up with a supplemental notice before the end of the year that contains the final decision. The SECURE Act did away with the need for the “Maybe” notice (although sponsors may still wish to provide it, for the reasons mentioned earlier), but the more interesting effect of this new rule is that it allows even a plan which did not contain any safe harbor provisions at all to become a SHNEC plan. The added flexibility will be especially appreciated by sponsors who experience a change in plan demographics or contribution patterns which causes them to unexpectedly be in danger of failing the ADP test.
Perhaps the biggest change to come out of section 103 of the SECURE Act is the all-new ability to adopt SHNEC provisions within 30 days of the end of the year, all the way up until the last day of the following plan year. This deadline to retroactively adopt SHNEC provisions is the same as the deadline under the 401(k) regulations to make a QNEC that will count towards the ADP test, or to refund excess contributions. In other words, adopting retroactive SHNEC provisions gives plan sponsors a new way to correct a failed ADP test. In many cases, a 4% SHNEC can turn out to be less costly than a QNEC. Contributions made to satisfy a SHNEC may also be used in the plan’s 401(a)(4) test, to help satisfy nondiscrimination of the plan’s profit sharing contribution, whereas QNECs may not be included in the 401(a)(4) test.
Mid-Year Changes Affecting HCEs
Back in 2016, the IRS issued guidance on what types of changes may and may not be made to safe harbor plans mid-year. Among the restrictions is a prohibition on any amendment that reduces the group of employees eligible for a safe harbor contribution. What was not clear, however, was how this applied to any HCEs covered by a safe harbor plan. Because a plan is permitted to, but is not required to provide safe harbor contributions to HCEs, it would stand to reason that since the contributions to HCEs are not required in order for the plan to have safe harbor status, it should be permissible to suspend those contributions without jeopardizing safe harbor status. However, if the plan defines the contributions to HCEs as safe harbor contributions, then suspending them for any group of employees, even HCEs, might violate the mid-year amendment rule.
IRS notice 2020-52, while mostly focusing on relief related to the COVID-19 pandemic, also provided clarification on this topic. The notice states clearly that, for purposes of the 2016 rules, contributions made to HCEs are not included in the definition of safe harbor contributions. Therefore, a mid-year amendment to suspend safe harbor contributions to HCEs would be permissible under those rules. The 2020 notice did point out, however, that if the employees were provided with a notice stating that HCEs would receive a safe harbor contribution, and if after the amendment that notice is no longer accurate, then an updated notice must be provided.
Safe Harbor plan designs are a great way for employers to offer the advantages of a 401(k) plan to their employees, while being able to meet their obligations under the ADP test in a straightforward way. The new flexible safe harbor options under the SECURE Act add another tool to the compliance toolbox and are sure to be useful going forward. If you would like to learn more about how the SECURE Act can be put to work in your 401(k) plan, please contact us.