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      Improving 401(k) Testing: Don't Shoot The Messenger

      Some HR managers hate this time of year because January through March is when they're forced to tell their company's highly compensated employees (HCEs) that they'll be refunded a portion of last year's deferrals because – once again – the 401(k) plan failed testing for the last calendar year. And – gulp – the refunded money is taxable.

      Once the plan year has ended, there's little that can be done about a failed actual deferral percentage (ADP) test – other than refunding HCEs' deferrals or providing additional fully vested qualified nonelective contributions (QNECs) to the plan's non-highly compensated participants (something most employers are reluctant to do). This article points out a number of operational and design changes that 401(k) sponsors may wish to adopt in order to avoid 401(k) testing altogether, or at least to improve the likelihood that the annual test will be met in subsequent years.

      Ways To Avoid 401(k) Testing

      There are a few ways to avoid annual 401(k) testing:

      • Convert your 401(k) plan into a "safe-harbor" 401(k) plan. Because this usually can be done only before the beginning of a plan year, you may have to wait until your next plan year to make this change. However, if you want to consider the pros and cons of going safe harbor, don't wait until the end of this year. Start now.
      • If you'll have 100 or fewer employees for the foreseeable future, you also can convert a traditional 401(k) plan into a SIMPLE 401(k), which is also exempt from annual testing. Because any conversion must be done for an upcoming calendar year, it's a good idea to analyze this option well before the end of this calendar year.
      • Add a qualified automatic contribution arrangement (QACA) to your 401(k) plan. For more on QACAs, see Automatic Enrollment – Time To Plan And Act (link, right).

      Ways To Improve 401(k) Testing Results

      There also are a number of techniques which can be used separately or together, that can prevent (or minimize the extent to which) an ADP test will fail:

      • Analyze why your testing fails. If your non-highly compensated employee (NHCE) deferrals are just a bit too low, the addition of something as simple as a limited matching contribution for the NHCEs (or a particular group of NHCEs) only may be enough to help you pass.
      • If your business has a disproportionately high number of high-paid professionals (e.g., doctors, lawyers, engineers, architects), consider making a "top-paid group" election. This will limit the number of high-paid employees that will be treated as HCEs for testing purposes.
      • If your plan tests using full-plan year compensation, consider the difference that would result by using participation compensation.
      • More closely monitor (or pre-test) HCE and NHCE actual deferral percentages. If you check your relative deferral percentages several times a year, you can take preemptive actions to prevent the HCEs from deferring too much.
      • If you're using current year testing, consider moving to prior year testing. This lets you know the relevant NHCE average deferral percentage for testing purposes at the beginning of each year. As a result you can more easily control whether HCE deferrals will result in a failed test. Note that you will have to amend your plan and that there are restrictions on switching from current year to prior year testing. Furthermore, prior year testing may not work well with plans that have an irregular discretionary match.
      • If you have a plan that includes employees who otherwise could have been excluded under the general participation rules (e.g., employees with less than one year of service or employees under age 21), you may be able to improve your testing results by testing this group separately.
      • You can limit HCE deferrals by design. If you are having a difficult time monitoring or controlling rates of HCE deferrals, consider limiting the rate of HCE deferrals as a matter of plan design. Because the nondiscrimination rules do not prohibit discrimination among HCEs, you can be creative in establishing these limits. For example, you could limit a particular HCE or group of HCEs from deferring the maximum amount or some lesser amount.
      • If your business does "prevailing wage" work and you maintain a separate retirement plan for you prevailing wage employees, you may be able to improve your testing results by combining your prevailing wage plan with your non-prevailing wage 401(k) plan.

      Unlike the techniques used to avoid 401(k) testing altogether, these techniques can be employed for the current year – so talk with your benefits counsel as soon as you can.

      What To Do

      If you are the unfortunate HR manager described above, don't just sit there and take the abuse year after year. Start now to change things for next year, or perhaps even this year. As you can see, a failed 401(k) test and the corresponding refunds to HCEs aren't inevitable.