Retirement Services University 401(K) Testing Review David Hiss The Ritz-Carlton, Bachelor Gulch, Colorado September 17-19, 2003

Retirement Services University 2 401(K) Testing Review Agenda for Session Review of 4 Key Testing Issues ADP/ACP Top Heavy Controlled Groups Coverage Testing Correction Procedures Examples Using Testing Issues to Increase Sales

Retirement Services University 3 ADP/ ACP Testing Quick Review: Definitions ADP: Actual Deferral Percentage –A test designed to test the ratio of elective contributions made by highly compensated employees to non-highly compensated employees. ACP: Actual Contribution Percentage –A test designed to test the ratio of employer matching contributions made to highly compensated employees to non-highly compensated employees.

Retirement Services University 4 ADP/ACP Testing Definitions (Cont’d) Highly Compensated Employee (HCE): An Employee who is either a 5% owner, Received compensation in excess of $85,000/ prior year Is in the Top 20% of compensation for all employees

Retirement Services University 5 ADP/ ACP Testing Example of an ADP Test EmployeeComp.DeferralDeferral %Avg. of Grp. Owner 1150,00011,0007.3% Owner 2150,00011,0007.3% EE 150,0002,5005% EE 240,0002, % EE 330,00000 EE 430,0001,5005% %

Retirement Services University 6 ADP/ ACP Testing Question: In the previous example would the group pass the ADP Test? What are the rules regarding this test? Times 2 Test: If less than 2% NHCE deferral Test: Multiply the NHCE average times 1.25 to get the HCE max. 2% Spread Test: Add 2% to the NHC average to get the HCE Max Do any of the above work?

Retirement Services University 7 ADP/ACP Testing Rules - continued: Current Year vs Prior Year Methods –Current Year: Use data during current plan year –Prior year: Use the data from the previous year to determine NHC % for testing purposes Prior year default for plans written after 1997 Switching Testing methods

Retirement Services University 8 ACP/ADP Testing Correction Methods Refunds to Highly Compensated Employees Re-characterization of contributions –Catch-up Contributions Safe Harbor (More Details Later) QNECs

Retirement Services University 9 Sales Idea Bottom Up QNECs A Different Approach to Passing a 401(k) Discrimination Test

Retirement Services University 10 Bottom Up QNECs Assumptions Eligibility: Immediate – Each HCE defers 7% of pay – Each NHCE defers 3% of pay After discrimination testing, plan fails by 2% points

Retirement Services University 11 Bottom Up QNECs Illustration: QNEC Eligible Avg Trad. Pick & Bottom- Employee Income Deferral ADP% ADP QNEC Choose Up HCE 1 $170,000 $12, % HCE 2 170,000 12, % HCE 3 170,000 12, % HCE 4 170,000 12, % 7% NHCE 1 60,000 1, % 2% 0% 0% NHCE 2 55,000 1, % 2% 0% 0% NHCE 3 50,000 1, % 2% 0% 0% NHCE 4 45,000 1, % 2% 0% 0% NHCE 5 40,000 1, % 2% 0% 0% NHCE 6 35,000 1, % 2% 0% 0% NHCE 7 30, % 2% 0% 0% NHCE 8 25, % 2% 0% 0% NHCE 9 20, % 2% 10% 0% NHCE 10 5,000** % 3% 2% 10% 20% $7,300 $2,500 $1,000 **(termination date 5/01/01)

Retirement Services University 12 Bottom Up QNECs Benefits Total NHCE compensation $365,000 Additional contribution of $7,300 required to raise NHCE deferral to 5% But, by making a bottom-up QNEC of $1,000 you pass the ADP test And HCEs keep their contributions in the plan

Retirement Services University 13 Bottom Up QNEC’s Proposed New IRS Regulations For QNEC’s Contributions allocated to one NHCE would be limited –Current 100% of Income –Proposed: NHCE’s compensation for the plan year Multiplied by the Greater of 5% Twice the Plan Representative Contribution Rate Regulations are Proposed and Subject to Change –Effective 2005 (at the earliest)

Retirement Services University 14 Top Heavy Testing Quick Review: Definitions Top Heavy: The total accrued benefits for “Key Employees” exceeds 60% of total of all accounts. (Rollovers are excluded for this calculation) Key Employee: –Officer who earned in excess of $130,000 –A 5% owner of the company –A 1% owner with compensation in excess of $150,000

Retirement Services University 15 Top Heavy Testing Basic Rule: 60% of the benefits are accrued to the “Key Employees”. “Key Employees” are different then “Highly Compensated Employees”. “Top Heavy” is determined on the last day of the preceding plan year.

Retirement Services University 16 Top Heavy Testing Top Heavy Correction Procedures Excluding “Key Employees” from participating. Minimum Vesting Required. Minimum Contributions. Safe Harbor (More details Later).

Retirement Services University (K) Testing - Top Heavy Minimum Vesting 3 year Cliff Vesting (100% after 3 Years) 6 year Graded Vesting (20% per year after year 2, 100% after 6 years) Minimum Contribution Lessor of 3% of compensation for each non-key employee or the highest key employee contribution. Matching now counts.

Retirement Services University 18 Top Heavy Testing Sales Idea: Safe Harbor Provision Biggest Advantages –Elimination of ADP/ACP Tests –Elimination of Top Heavy Tests Sales Impact –Allows Key Decision Makers to maximize contributions to Pension Plan and reduce administration to plan

Retirement Services University 19 Safe Harbor Plans Safe Harbor Rules Safe Harbor Contribution Requirement Vesting Requirement Withdrawal Restrictions Annual Notice Requirement

Retirement Services University 20 Safe Harbor Safe Harbor Contribution Requirement Two Options –100% Match on first 3% plus 50% on next 2% Satisfies ACP, ADP & Top Heavy –Flat 3% Contribution to all Eligible Participants Satisfies ACP, ADP & Top Heavy

Retirement Services University 21 Safe Harbor Safe Harbor Vesting Requirement All employees must be 100% vested in all employer contributions. Withdrawal Restrictions: No Hardship withdrawals to employer contributions. Hardships allowed for employee contributions. Notice Requirements Plan must provide all eligible employees a notice of their rights on a annual basis

Retirement Services University (K) Testing What is a controlled Group? The Concept of a Controlled Group was established to prevent taxpayers from avoiding qualification requirements through use of multiple entities. Very common in the $1-5 Million Market

Retirement Services University 23 Controlled Groups How many kinds of Controlled Groups are there? There are two Types of Controlled Groups: 1)Parent-Subsidiary Controlled Group 2)Brother-Sister Controlled Group

Retirement Services University 24 Controlled Groups What is a Parent-Subsidiary Controlled Group One or more chains of organizations in which controlling interest in each of the organizations is owned by another organization. Controlling interest is defined as follows: 80% of the total value of shares 80% of the voting power

Retirement Services University 25 Controlled Groups What is a Brother-Sister Controlled Group? A Brother-Sister Controlled Group consists of two or more organizations satisfying both of the following requirements: Same 5 or fewer individuals/entities own controlling interest (80%). Ownership must be identical with respect to each organization.

Retirement Services University 26 Controlled Groups Why is This Important? Section 414(b) treats employees of a Controlled Group of corporations as employed by a single employer.

Retirement Services University 27 Controlled Group Implications of Being Part of a Controlled Group! Must consider all employees within the Controlled Group for testing purposes. Can’t segregate management groups. Owners of multiple companies must aggregate qualified plans. Companies unrelated for business purposes, may be related by ownership.

Retirement Services University 28 Controlled Groups Sales Idea: Two most common issues A Controlled group does not exist, but the group wishes to put multiple companies together: –Answer: Multiple Employer Document, which allows for multiple companies to be under one plan to gain economies of scale A Controlled group does exist, but the group wishes to split the group and treat them separately: –Answer: New Comparability Plan by division. This will allow the employer to make different profit sharing contributions to the different divisions

Retirement Services University (K) Testing Coverage Test: A qualified plan does not have to cover all employees. However, it must cover a minimum percentage of the company’s Non-Highly Compensated Employees. The two tests are: –Ratio Percentage Test –Average Benefit Test

Retirement Services University 30 Coverage Test Coverage Rules: Ratio Percentage Test –The % of NHCEs who benefit (are eligible for the plan) must be equal to, or greater than 70% of the percentage of HCEs who benefit. Example –100% of HCEs are covered –50 NHCEs (40 ees) are covered (80% benefit) –80% X 100% = 80% (Ratio Test Passed)

Retirement Services University 31 Coverage Test Coverage Rules Average Benefit % Test –To pass this test the benefits provided to the NHCEs must be at least 70% as great on average as the benefits provided to HCEs. The most common test is the ratio % test. –If the ratio % test fails, the Average Benefits test may be used.

Retirement Services University 32 Coverage Test Potential Pitfalls/ Multiple Corporations –Owners of Multiple Corporations must include all their organizations in passing this test. –Owners that offer Qualified plans to some companies and not to others may be in violation of this rule. –Consistency is the key.

Retirement Services University 33 Q & A

Retirement Services University 34