Overview of Nondiscrimination Testing for 401(k) Plans John D. Lestock, CPP, CEBS

Annual Testing Top-Heavy Status Minimum Coverage Testing – IRC § 410(b) Minimum Participation Requirement – IRC § 401(a)(26) For defined benefit plans only Nondiscrimination Testing § 415 Limits

Definitions Nondiscrimination testing – plan must not discriminate in favor of highly compensated employees in terms of percentage of compensation actually deferred by participants. Nonhighly compensated employee (NHCE) – someone who is not an HCE Highly compensated employee (HCE): 5% owner of employer’s stock or capital at any time during current or preceding year, or received annual compensation greater than $120,000 (for 2015 or 2016) during the preceding year employer can limit employees fitting second definition to those in top-paid 20% of employees during preceding year – top-paid group election

Definitions Elective deferrals – may be pre-tax, after tax (designated Roth contributions), or combination of two. § 402(g) limit for 2016 is $18,000 Nonelective contributions – employer contribution made on participant’s behalf; no election by participant is required. Annual compensation limit – employee compensation to be included in calculation of pension benefit or employer contribution is limited under IRC § 401(a)(17). For 2016, annual compensation limit is $265,000. Compensation limit also used in nondiscrimination testing. Excess Deferrals – elective deferrals that exceed individual deferral limit Excess Contributions – failure of ADP test results in excess contributions for HCEs Excess Aggregate Contributions – failure of ACP test results in excess aggregate contributions for HCEs

Definitions “Catch-up” contributions – employees eligible to make elective deferrals and who would be at least 50 years old by the end of the plan year can defer an additional amount as a “catch-up” contribution beyond limits set by law or by the plan itself (i.e. statutory limit, employer-provided limit, actual deferral percentage (ADP) limit). Limit is lesser of “applicable dollar amount” or employee’s compensation for the year reduced by other elective deferrals made during the year. Applicable dollar limit for 401(k) plans for 2016 is $6,000. Elective deferrals are treated as catch-up contributions if they exceed any “otherwise applicable limit” determined as of the end of the plan year Statutory limit is IRC limit on elective deferrals or annual additions Employer-provided limit is limit on elective deferrals contained in the plan provisions that is not statutory limit (i.e. lower limit) Actual deferral percentage (ADP) limit is highest dollar amount of elective deferrals that may be retained in plan by HCE after ADP testing

Actual Deferral Percentage (ADP) Test Discrimination test for 401(K) plans – actual deferral percentage test (ADP) of employees who are eligible to participate in the plan; calculate actual deferral ratio (ADR) Employee’s annual elective deferrals Employee’s ADR = -------------------------------------------------------- x 100 Employee’s total annual compensation Catch-up contributions are not included in employee deferrals and employees’ total annual compensation taken into account cannot exceed annual compensation limit ($265,000 for 2016) Then, ADPs for nonhighly compensated employees (NHCEs) and highly compensated employees (HCEs) are averaged for each group by adding them together and dividing by number of employees Average ADP for HCEs may not be greater than: 1.25 x average ADP of NHCEs or Lesser of: 2 x average ADP for NHCEs or 2% more than average ADP for NHCEs

Actual Deferral Percentage (ADP) Test Plan document defines compensation for ADP testing; does not have to be same as compensation used for other purposes (i.e. elective deferrals) Ratios are calculated to two decimal places (nearest 1/100th of a percent) Eligible participants who chose not to defer have ADRs of zero when calculating group averages In calendar year plan, level at which HCEs may defer is determined by NHCE’s ADP from prior year – prior year testing method; allows plan sponsor to know what HCE’s ADP limit is for year Alternatively, plan can use current year testing method, where current year HCE’s ADP is measured against current year NHCE’s ADP; may need mid-year test to estimate results

Actual Deferral Percentage (ADP) Test If 401(k) plan meets one of ADP tests, it is deemed to have met general nondiscrimination tests regarding contributions that apply to all qualified retirement plans under § 401(a)(4) Parallel tests for matching and after-tax contributions – IRC § 401(m) contains tests similar to ADP test that show whether there has been discrimination in favor of HCEs in terms of employer matching contributions and employee after-tax contributions – actual contributions percentage (ACP) test ADP and ACP tests are exclusive nondiscrimination tests for 401(k) plans – cannot use general nondiscrimination test of § 401(a)(4)

Actual Deferral Percentage (ADP) Test Example: Prior Year ADP Test Name Current Year Compensation (2016) Current Year Elective Deferrals (2016) Current Year ADR (2016) Prior Year Compensation (2015) Prior Year Elective Deferrals (2015) Prior Year ADR (2015) HCE 1 150,000 7,000 4.67% NHCE 1 45,000.00 2,000.00 4.44% HCE 2 6,000 4.00% NHCE 2 32,500.00 - 0.00% HCE 3 95,000 5,000 5.26% NHCE 3 30,000.00 1,500.00 5.00% Total 13.93% NHCE 4 28,000.00 840.00 3.00% NHCE 5 25,000.00 1,250.00 2016 ADP for HCEs = 13.93% / 3 = 4.64% NHCE 6 24,000.00 6.25% NHCE 7 16,500.00 23.69% 2015 ADP for HCEs = 23.69% / 7 = 3.38%

Actual Deferral Percentage (ADP) Test Example (Cont): Test Results 1. Basic Test - 125% of NHCE ADP 3.38% x 125% = 4.23% 2. Alternative Test - lesser of NHCE ADP + 2% 3.38% + 2% = 5.38% or NHCE ADP x 2 3.38% x 2 = 6.76% Greater of "1" or "2" 5.38% HCE ADP 4.64% Since ADP for HCEs is less than 5.38%, test is satisfied

Actual Deferral Percentage (ADP) Test What if the test fails? Two options: Raise NHCE averages to achieve passing results; or Distribute sufficient excess contributions to affected HCEs so that HCE averages are lowered to acceptable levels To raise NHCE averages – plan makes qualified nonelective contributions (QNECs) for NHCEs that can be taken into consideration for ADP test purposes QNECs must be 100% vested when made and subject to same withdrawal restrictions as elective deferrals Example – provide all NHCEs QNEC of 3%

Actual Deferral Percentage (ADP) Test To lower HCE average – accomplished in two steps: First, total dollar amount of correction is calculated by lowering individual ADRs in turn, beginning with the HCE who deferred the highest percentage of compensation, until the HCE’s ADP reaches the required level – in this step, no HCE actually receives a distribution Second, total dollar amount of correction from Step 1 is apportioned among HCEs, beginning with the HCE who deferred the highest dollar amount into plan – HCEs who receive corrective distributions are those who deferred the highest dollar amounts into plan (not necessarily same HCEs who deferred highest percentage of compensation)

Actual Deferral Percentage (ADP) Test HCE 2016 Compensation Elective Deferral ADR A 100,000 8,000 8.00% B 265,000 18,000 6.79% C 171,428 12,000 7.00% Step 1: HCE A with 8% ADR would have deferrals limited to $7,000 ($100,000 x 7%) – adds $1,000 to total dollar amount of correction ($8,000 - $7,000); HCE A does not actually receive distribution of $1,000 Step 2: HCE B, deferring $18,000, would receive corrective distribution of $1,000 since HCE B deferred highest dollar amount into plan, exceeding next highest dollar contribution by more than total amount of correction

Actual Deferral Percentage (ADP) Test Note – if plan allows catch-up contributions, reaching an ADP test limit would trigger catch-up contribution eligibility for HCEs who are at least age 50 by end of calendar year. Thus, corrective distribution must be reclassified as catch-up contribution and retained in the plan. Catch-up contributions are not included in ADP or ACP tests – reclassification is considered correction of test failure

Actual Deferral Percentage (ADP) Test Example: ADP Test Correction Name Current Year Compensation (2016) Current Year Elective Deferrals (2016) Current Year ADR (2016) HCE 1 150,000 7,000 4.67% HCE 2 6,000 4.00% HCE 3 95,000 5,000 5.26% Total 18,000 13.93% 2016 ADP for HCEs = 13.93% / 3 = 4.64% If maximum ADP was 4.38%, HCEs’ ADP must be lowered by 0.26%

Actual Deferral Percentage (ADP) Test Step 1: Determine amount to be refunded by reducing highest ADR to next highest ADR or by full 0.26% Current Year Compensation (2016) Maximum Deferral Limited ADRs HCE 3 95,000 4,341.50 4.57% HCE 1 150,000 6,855.00 HCE 2 6,000.00 4.00% Total 17,196.50 13.14% Maximum ADP for HCEs = 13.14% / 3 = 4.38% Dollar Amount of Correction = $18,000 - $17,196.50 = $803.50

Actual Deferral Percentage (ADP) Test Step 2: Allocate amount determined in Step 1 among HCEs by reducing highest dollar amount of deferrals to next highest dollar amount of deferrals or by full required correction Elective Deferrals Corrective Distribution Deferrals Remaining HCE 1 7,000.00 803.50 6,196.50 HCE 2 6,000.00 - HCE 3 5,000.00 Total 18,000.00 17,196.50

Actual Deferral Percentage (ADP) Test Corrective distributions of excess contributions must be provided to affected participants within 2 ½ months after close of plan year for which ADP test failed. If corrective distributions are made later, employer must pay 10% excise tax on total amount of excess contributions. Under no circumstances should corrective distributions be made more than 12 months after end of plan year being tested – plan will be considered discriminatory and could be disqualified

Actual Contribution Percentage (ACP) Test Parallel tests for matching and after-tax contributions – IRC § 401(m) contains tests similar to ADP test that show whether there has been discrimination in favor of HCEs in terms of employer matching contributions and employee after-tax contributions – actual contributions percentage (ACP) test Qualified matching contributions (QMACs) – matching contributions that are “qualified” by satisfying rules that normally apply to elective deferrals (i.e. 100% vested and subject to withdrawal restrictions – QMACs can be tested with elective deferrals under ADP test instead of ACP test – possible to avoid ACP test Calculating ACP test – similar to ADP test, but using actual contribution ratios (ACR) instead of actual deferral ratios – divide sum of after-tax employee contributions and matching contributions by total compensation Eligible participants who choose not to make after-tax contributions or receive no matching have ACRs of zero when deriving averages

Actual Contribution Percentage (ACP) Test Same basic test and alternative test as ADP test Either prior year or current year testing method is specified by plan If test fails, must either raise NHCE averages or distribute sufficient excess aggregate contributions to affected HCEs to lower HCE averages Can provide QNECs to NHCEs to raise NHCE averages Excess aggregate contributions are either distributed from the plan, or in the case of nonvested employer matching contributions, forfeited as necessary – corrections must be done within 2 ½ months after close of plan year tested to avoid excise tax – at minimum correction must be made within 12 months after end of plan year tested

Alternative to Nondiscrimination Testing Safe-harbor plan design – plan avoids nondiscrimination testing (ADP/ACP testing). Employer contributions to NHCEs are either a matching contribution of 100% of each employee’s elective deferral up to 3% and 50% of employee’s elective deferral over 3% and up to 5% of compensation (basic matching formula), or employer makes 3% nonelective contribution of 3% to all NHCEs regardless of whether the employee contributes to plan. Can use enhanced matching formula only if, at any rate of elective contributions, it provides total amount of matching contributions at least equal to basic matching formula. Requires notice to employees and 100% immediate vesting of employer contributions. Can be more expensive for a sponsoring employer than annual testing

Questions? John D. Lestock, Senior Accountant – Lake Washington Partners, LLC Work email: johnl@lkwp.com Home email: john@thelestocks.com Work number (206)770-5682