401(k)ology – Gaps in Coverage Testing Can Sink the Ship

Coverage testing is a critical yet often overlooked component of retirement plan qualification. Coverage testing sets the minimum standards to ensure that retirement plans benefit both Highly Compensated and Non-Highly Compensated Employees, and plan sponsors must regularly demonstrate that plans include a broad range of employees, not just those at the top. Special rules apply to those who must be included in the testing and also for complex situations involving related employers, mergers or acquisitions. Does your 401(k) plan have a coverage gap sinking the ship?

Coverage testing protects retirement fairness and maintains the tax qualification of the plan for all employees who participate. Plan sponsors may not realize there is a gap in coverage, especially in situations involving related employers who maintain separate 401(k) plans. One of the most common errors in coverage testing is not counting all of the employees who are required to be included in the tests, which includes employees of related employers even if they are not participating in that entity’s plan.

Single employers may also run into coverage testing issues if there are allocation conditions imposed on employer contributions or employee class exclusions. There may be a coverage gap if the plan does not provide retirement benefits to a significant portion of otherwise eligible employees. Too large of a gap may require life jackets to be distributed to keep the plan from sinking into non-compliance.

This post will provide a general overview of coverage testing, testing failures and best practices for both single employer plans and plans of related employers. Time to report to the muster stations and learn the drills conducted for compliance in coverage testing!

410(b) Coverage Testing

Internal Revenue Code Section 410(b) is a regulation designed to make sure that a company’s 401(k) plan offers retirement benefits to a broad range of employees—not just the company’s owners or higher-paid staff. 401(k) plans qualify for favorable tax benefits only if they cover a fair share of everyday workers. For purposes of this post, 401(k) plans will be specified; however, IRC §410(b) applies to all types of qualified retirement plans.

Each year, plan sponsors must compare the coverage rates of two groups of employees:

• Highly Compensated Employees (HCEs, like executives or owners)

• Non-Highly Compensated Employees (NHCEs, your everyday workers)

The plan will pass coverage testing if enough NHCEs are covered compared to the HCEs. If the plan fails, the company may be required to make additional contributions to the NHCEs who were not initially covered by the terms of the plan. In simplest terms, if 100% of the HCEs benefit under the plan, then at least 70% of the NHCEs must benefit. “Benefitting” means an eligible employee is allowed the opportunity to make deferrals and/or is eligible for a matching contribution (or other employer contribution).

Plans must pass at least one of the following coverage tests:

• Ratio Percentage Test: The percentage of NHCEs benefiting under the plan must be at least 70% of the percentage of HCEs who benefit.

• Average Benefit Test: There are two parts to this test:
  1) The plan needs to use a non-discriminatory classification for employees covered by the plan, AND
  2) The average benefit percentage for NHCEs must be at least 70% of the average for HCEs. The “average benefit percentage” looks at the employer’s contributions or benefits as a percentage of each employee’s compensation and averages it across each group.

When determining which employees to use in the coverage tests, there are certain employees that are excluded (referred to as “excludable employees”):

• Those who have failed to satisfy the eligibility & entry date requirements

• Nonresident aliens with no U.S. source income

• Union employees

• Terminated participants who complete less than 501 hours of service* (if the plan requires 1,000 hours of service and/or a last day of the plan year employment requirement for employer contributions)
  
  *Only applies to the coverage test applicable to the match or employer contribution allocations, not deferrals.

When testing for coverage, the 401(k) portion (deferrals) of a retirement plan and the non-401(k) portion (profit sharing or non-elective) are treated as separate plans. The same goes for the 401(m) portion (match) and the non-match portion (profit sharing or non-elective). This is referred to as “Mandatory Disaggregation.” Similarly, union and non-union plans must also be tested separately.

If a single retirement plan includes the following contributions types, three separate coverage tests are required (one for each source):

• Employee salary deferrals (401(k) contributions)

• Company matching and employee after-tax contributions (401(m) contributions)

• Other types of employer contributions (nonelective or profit sharing)

Each of these sources is treated as its own separate plan for the purposes of 410(b) testing. As a result, each piece must meet the coverage and non-discrimination requirements on its own.

Impact on Single Employer’s 401(k) Plan

The vast majority of single employer 401(k) plans will easily pass the coverage test on deferrals. In fact, most plans have 100% coverage on the deferral component of the plan because all employees who have met the plan’s eligibility and entry date requirements are eligible to make deferrals.

The deferrals coverage test can become more challenging if the employer excludes groups of employees that do not fall into the “excludable employees" category (i.e., have not met eligibility and entry dates, nonresident aliens and union employees). Common exclusions that impact coverage testing on the deferral component of the plan are leased employees, employees of an excluded division, and employees of an excluded class who would otherwise be eligible for the plan. Nonetheless, if all employees are eligible to make deferrals and all employees are eligible to receive a match, the plan likely satisfies coverage easily (notwithstanding the exclusions noted).

Let’s review the impact of allocation conditions on employer matching contributions where coverage testing could be at risk of failing. For example, assume a company named Saga Seas has 60 employees, of which 10 are HCEs and 50 are NHCEs. All employees are eligible to make deferrals. In order to receive an allocation of the matching contributions, employees must be employed on the last day of the plan year and must have worked at least 1,000 hours of service during the plan year. Saga Seas is cruising along, assuming that the 401(k) plan is operating smoothly, when the third-party administration (TPA) firm sends them a report warning that the coverage testing has failed for the year.

The coverage test results in this example are as follows:

Saga Seas asks 'how this could have happened?' The TPA explains that a) 5 NHCEs terminated employment before the last day of the plan year, and b) 15 NHCEs did not work at least 1,000 hours during the plan year (but worked more than 501 hours so they are not excludable). Due to the allocation conditions imposed, 20 NHCEs are not eligible for a match under the current plan provisions. This causes the match coverage test to fail, and Saga Seas must correct it by including some of the NHCEs in the match allocation even though they did not satisfy the allocation conditions. Free drinks on the promenade deck!

At least 5 additional NHCEs need to be included in the match for the year to reach the requisite 70% ratio percentage test threshold (70% of 50 = 35). One solution is to retroactively amend the plan for that plan year to reduce the hours requirement to 501 hours (rather than 1,000 hours). Another option is to perform the Average Benefits Test. Both of these correction methods are highlighted later in the post.

Impact on Related Employers with Multiple 401(k) Plans

Things get more complex when a business owns, controls, or is affiliated with other companies, and/or when several related businesses offer multiple retirement plans. Some 401(k) plans cover all related entities, with one entity being the primary sponsor of the plan and the other related entities adopting the plan as participating employers. However, it is also common for related entities to sponsor separate 401(k) plans. One prefers Festival Seas Cruise Line, and the other prefers Regal Isles, which is not an issue as long as the plans satisfy coverage testing.

While each entity may be under the impression that their 401(k) plan has zero to do with the other’s 401(k) plan, the reality is that the IRS treats all these entities as a single “employer” for coverage testing, even if they operate separately. Separate cruise ships, but the destination is the same for all passengers.

In other words, employers cannot establish separate plans for different companies to avoid these coverage requirements. All employee groups, across all related employers, must be considered together when determining if each individual plan satisfies coverage. If one plan in the group fails, it can impact the compliance of all plans in the group.

Related Employer Coverage Testing Explained

Coverage testing is quite complicated, and to illustrate let’s assume Festival Seas and Regal Isles are owned by the same holding company (controlled group of related employers). Each run separate cruise ships with different benefits. Festival Seas’ plan allows all employees to make deferrals but does not offer any matching contributions. Regal Isles allows all employees to make deferrals and provides a generous matching contribution.

Option 1: The Ratio Percentage Test

The HCEs and NHCEs of each cruise ship are broken down as follows with the coverage test for each plan:

Since the NHCE average must be more than 70%, the Festival Seas Plan passes.

• There are 10 out of 60 total HCEs benefiting in the Festival Seas Plan

• There are 400 out of 550 total NHCEs benefiting in the Festival Seas Plan

Since the NHCE average must be more than 70%, the Regal Isles Plan fails.

• There are 50 out of 60 total HCEs benefiting in the Regal Isles Plan

• There are 150 out of 550 total NHCEs benefiting in the Regal Isles Plan

Mayday, Mayday! Regal Isles ship is sinking! If failing the ratio percentage test, where one or more plans cannot separately satisfy testing, the next step would be to aggregate the plans for coverage AND nondiscrimination testing (if permitted) and to run the Average Benefits Test (ABT).

Plan Aggregation

Not all plans may be permissively aggregated to satisfy coverage. In order to permissively aggregate plans, the following must be the same:

• HCE Determination (i.e., use of the Top Paid Group Election)

• ADP/ACP Testing Methods (Current Year, Prior Year or Safe Harbor)

• Plan Year (must run on same 12 month period)

In addition, for safe harbor plans to be aggregated they must have the same formula for satisfying the safe harbor 401(k) plan requirements (same nonelective percentage, same basic match or same enhanced match).

Practice Note: If plans are aggregated to satisfy coverage, all other required annual testing must be performed as if the plans were a single 401(k) plan. That means the ADP/ACP Testing must also include all participants in the plans that are aggregated.

Option 2: The Average Benefits Test

This section comes with a warning - if all your time has been spent on the lido deck, this just might make your head spin more than the fruity cocktails. The mechanics of the ABT are as follows:

• Determine each participant’s average benefits percentage (total allocations divided by plan year compensation). In determining the total allocated to a participant for the year, catch up contributions and employee voluntary after-tax contributions are excluded.

• For each group (NHCEs and HCEs), calculate the “average benefit percentage.” This looks at the average rate of employer contributions (deferrals, match and nonelective) or benefits each group receives.

• The ratio of the average benefit percentages for NHCEs to HCEs must be at least 70% for the test to pass. Example: If NHCEs have an average benefit percentage of 8% and HCEs have 10%, the ratio is 8/10 = 80%, so the plan passes.

When calculating the average benefit percentage test, the participants included in the test must be those that satisfy the lowest minimum age and service condition of any of the plans being tested. If one plans uses age 21 and 12 months of service, but the other plan has immediate entry upon date of hire, then none of the employees would be excluded from the test even if they were not eligible for any contributions.

Recall that the ABT has two components, the Average Benefits Percentage Test and the Nondiscriminatory Classification Test (both of which must be satisfied to pass). There are two parts to the classification test:

• Reasonable Classification: The group must be based on a reasonable, job-related category (e.g., job title, location, division).

• Numerical Test: The percentage of NHCEs covered by the plan must be at least a certain minimum, compared to all NHCEs eligible to participate. This minimum is called the “safe harbor percentage,” which varies depending on the plan's demographics.

In summary, to pass the whole ABT the plans must:

• First pass the Nondiscriminatory Classification Test (employee groupings are reasonable and the percentage of NHCEs covered is high enough).

• Then, it must pass the Average Benefits Percentage Test (the average benefit ratio for NHCEs vs. HCEs is at least 70%).

For purposes of this example, let’s assume that the ABT fails because of the number of Festival Seas employees who are not eligible for a matching contribution. Since both the Ratio Percentage Test and the Average Benefits Test have failed, there is a coverage failure that the employers must correct to keep the ship afloat.

Failed Coverage – Saving the Sinking Ship

Failed coverage testing, either for a single employer plan or for related employer plans, is a Demographic Failure correctable either under the Internal Revenue Code (by statute) or under the IRS’ Employee Plans Compliance Resolution System (EPCRS). The good news is that if a Demographic Failure is discovered and corrected within 9.5 months after the end of the plan year (October 15^th for calendar year plans), it may be corrected by retroactively amending the plan to include enough NHCEs in the allocations such that the plan will satisfy the requirements.

The retroactive amendment is commonly referred to as an “11g amendment” because the Treasury Regulation permitting such correction is found under §1.401(a)(4)-11(g).

Conditions for 11g Amendments

• May increase allocations for NHCES who benefit under the plan to pass

• May provide allocations to NHCEs who did not benefit under the plan to pass

• Must have substance – cannot select only zero vested terminated participants to bring into the allocations

• Cannot target NHCEs with the lowest compensation or shortest service

• Must be effective retroactively to the first day of the plan year being corrected

• Cannot reduce any participant’s benefit based on the plan terms in effect before the amendment

A critical component of using the 11g amendment is that it must be adopted by the 15^th day of the 10^th month after the plan year end being corrected. That means the plan sponsor must execute the amendment on or before October 15^th for calendar year plans. If the 11g amendment is not adopted by the deadline, the plan sponsor must use EPCRS to correct the failure. The key difference here is that if corrected by the 15^th day of the 10^th month following the plan year end, coverage is “self-corrected” under the Code with no earnings adjustments required on the corrective allocations. However, if the plan sponsor misses the 9.5-month deadline, EPCRS requires that the corrective allocations be adjusted for earnings.

Going back to the Festival Seas and Regal Isles example, assume that Regal Isles corrects by providing allocations to NHCEs who did not benefit under that plan, and it timely adopts the 11g amendment. How are the allocations to NHCEs who participate in the Festival Seas plan made in the Regal Isles plan?

For illustrative purposes, assume that 170 NHCEs from Festival Seas are required to benefit in the Regal Isles plan. Because that plan provides deferrals and match, there will be two types of corrective allocations owed to each of those 170 employees. The first corrective contribution is calculated by using each employee’s compensation for the plan year, times the Average Deferral Percentage (ADP) for all of the NHCEs in the Regal Isles plan (pre-correction). If the ADP for the NHCEs that year is 4.50%, then all 170 Festival Seas employees are due a contribution of 4.50% of compensation. In addition, the same calculation is applied for the match. If the Average Contribution Percentage (ACP) of the NHCEs is 3.50%, each of those 170 Festival Seas employees are due a contribution of 3.50% of compensation. Yes, that is 8% of compensation contributed to 170 employees that do not work for Regal Isles. If the average compensation of those 170 employees is $50,000, then the estimated corrective contribution due would be $680,000.

The plan sponsor of Regal Isles is feeling seasick at this point, so it is time to take some Dramamine and call their favorite ERISA attorney. Unfortunately, there may be more rough seas ahead if the failure spans multiple plan years.

Coverage Testing - Transition Period for Mergers & Acquisitions

IRC §410(b)(6)(C) provides a temporary "transition period" exception to coverage testing when a plan sponsor experiences certain business events (such as mergers, acquisitions, or similar corporate transactions). It gives time to adjust the plan(s) before having to meet the coverage rules for the newly combined or split group.

Transition Period Application

• Trigger: The transition rule applies after a merger, acquisition, or similar transaction affecting plan coverage.

• Transition Period: The plan does not have to pass the coverage test (under 410(b)) for a limited period—generally until the end of the plan year following the year of the transaction.

• Plan Amendment Restrictions: If you significantly change the plan (other than the changes required to conform to the business transaction itself), you could lose eligibility for the transition relief. The IRS calls these "significant amendments affecting coverage."

• Multiple M&A Transactions: If there are multiple plans from merging entities, the transition period applies separately to each plan.

This means you have time to bring the plan into compliance, even if the employee group has changed and would otherwise make the plan fail the coverage test right away. After the transition period, the plan(s) must pass the regular coverage tests under 410(b).

Key Points for Sponsors

• Review coverage testing annually. It is not a one-time event; it must be performed every plan year (there are some very limited exceptions for 1-3 year testing across very large entities IF the coverage has not changed across the entire group).

• Report all related entities to the plan’s service providers and determine the party responsible for conducting the combined coverage testing when multiple plans exist.

• The plan sponsor should take corrective action as soon as it discovers the failure to ensure the plan maintains qualified status.

• Thorough and accurate record-keeping is crucial for substantiating coverage compliance.

Conclusion

Regular muster drills are conducted to keep passengers and crew safe when a ship experiences an emergency. Employers take on the same responsibility to safeguard retirement plans, with regular testing and procedures in place to address coverage testing, especially among related employers. Corrective contributions can be expensive and may quite literally sink the ship. Newfront Retirement Services’ team of advisors and dedicated service team can assist in finding service providers that have the experience to handle these very complicated situations. Feel free to contact me or just connect to keep up to date on all things ERISA 401(k): Joni_LinkedIn and 401(k)ology

Helpful Links:

• 401(k)ology – Related Employers

• 401(k)ology – Highly Compensated Employees

• 401(k)ology – Safe Harbor 401(k) Plans

• 401(k)ology – Impact of a Failed ADP/ACP Test

• 401(k)ology – Catch Up Contributions

• 401(k)ology – After-Tax Contributions

• EPCRS Overview

• Treatment of otherwise excludable employees for coverage and ADP testing

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