401k Minimum Coverage Test Explained

The 401k minimum coverage test is a crucial aspect of retirement planning for employers. The test ensures that employers are providing adequate retirement benefits to their employees.

The test focuses on the percentage of eligible employees who are covered by the plan. According to the IRS, a plan is considered to be a "top-heavy" plan if more than 60% of the plan's assets are held by key employees.

In a top-heavy plan, the employer must provide additional benefits to non-key employees to ensure they are receiving a fair share of the plan's assets. This helps prevent key employees from dominating the plan's assets.

Employers must also consider the plan's coverage ratio, which is calculated by dividing the number of non-key employees by the number of key employees. A coverage ratio of at least 2:1 is generally considered to be adequate.

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To pass the minimum coverage test, a plan must meet a certain ratio percentage. This percentage is 70% or greater.

The first step in determining which employees are part of the testing group is to identify all employees who must be considered, including those from related companies. The plan's eligibility requirements are then applied to this group.

The testing group is divided into four subsets: Highly Compensated Employees (HCEs) who benefit, HCEs who do not benefit, Non-HCEs who benefit, and Non-HCEs who do not benefit.

Any categories of employees who are completely excluded from the plan will fall into the non-benefitting subsets, but only those who would have otherwise joined the plan if they weren’t specifically excluded impact the test.

Here's a breakdown of how the testing group is divided:

The plan passes the minimum coverage test as long as the ratio percentage for the plan is at least 70%.

A plan must pass one of two coverage tests to satisfy the minimum coverage requirements. This includes the ratio percentage test or the average benefit test.

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To determine if a plan needs to identify otherwise excludable employees, it's essential to consider the special testing rules for these employees. These rules are outlined in IRC Sections 401(k)(3)(F) and 410(b)(4)(B), as well as Treas. Reg. Section 1.410(b)-7(c)(3).

Plan language is required to perform the special testing methodology for otherwise excludable employees. This is specified in Treas. Reg. Section 1.401(k)-1(e)(7).

The special testing rules for otherwise excludable employees can also be used for the Actual Contribution Percentage (ACP) test. This is mentioned in IRC Section 401(m)(5)(C) and Treas. Reg. Section 1.401(m)-1(b)(4)(iv).

A plan will typically use special testing rules for otherwise excludable employees when it cannot satisfy the coverage requirements in IRC Section 410 and/or the ADP test in IRC Section 401(k) by considering all participants in the plan.

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Retirement plans come in various forms, including IRAs and other types of retirement plans. These plans are subject to rules and regulations, such as required minimum distributions.

IRAs and other retirement plans have specific rules to follow, including published guidance and forms to use. For example, the IRS provides guidance on operating a retirement plan through various publications.

To ensure compliance, it's essential to understand the rules surrounding retirement plans, including those related to ADP testing. According to the Office of Chief Counsel, certain plan testing methods are permissible, as stated in Chief Counsel Advice 201615013.

Here are some key retirement plan details:

A plan must satisfy minimum coverage requirements, and one way to do this is by benefiting at least 70% of the employer's non-highly compensated employees (NHCEs).

Employees not meeting a plan's minimum age and service requirements are disregarded in determining if a plan meets the minimum coverage requirements.

Section 410(b)(4)(B) provides an exception for plans that cover employees not meeting the minimum age or service requirements, allowing them to be excluded from the coverage test.

This exception is only available if the plan satisfies the minimum coverage requirements separately with respect to these employees, and if the plan is treated as two separate plans, one for the otherwise excludable employees and one for the other employees.

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A plan must satisfy certain minimum coverage requirements to meet the standards set by Section 410(b).

Section 410(b)(1)(A) states that a plan satisfies these requirements if it benefits at least 70% of the employer's non-highly compensated employees (NHCEs).

Employees not meeting a plan's minimum age and service requirements are disregarded in determining if a plan meets the minimum coverage requirements.

Section 410(b)(4)(C) specifies that an employee is not treated as meeting these requirements until the first date on which they would be eligible to start participating in the plan under the plan's rules.

Two coverage tests are performed if a plan covers employees not meeting the minimum age or service requirements of IRC Section 410(a)(1) without regard to certain conditions.

One test looks at plan participants who have not reached age 21 and completed one year of service, while the other test looks at all other plan participants.

Employers can exclude NHCEs who have not met the minimum age and service requirements from the ADP test if they apply a specific rule in determining whether the plan meets the coverage requirements.

Treas. Reg. Section 1.410(b)-6(b)(3) allows employers to treat a plan benefitting otherwise excludable employees as two separate plans.

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In January 2016, the Office of Chief Counsel issued an advice memorandum regarding the treatment of "otherwise excludable employees" for coverage and actual deferral percentage (ADP) testing. This memorandum provides clarity on how to identify and test these employees.

The term "otherwise excludable employees" refers to a group of employees who are participants in a plan but could otherwise be excluded because the plan's eligibility requirements are more liberal than the requirements set forth in the Code and the regulations thereunder.

A plan will use special testing rules for otherwise excludable employees when it cannot otherwise satisfy the coverage requirements in IRC Section 410 and/or the ADP test in IRC Section 401(k) taking into account all of the participants in the plan.

The advice memorandum discusses an acceptable method of identifying the group of otherwise excludable employees, and identifies two additional methods that may also be acceptable. This provides plan sponsors with a clear understanding of how to handle these employees in their testing.

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Section 410(a)(1)(A) provides that participation in a plan cannot be conditioned on the employee completing a period of service with the employer maintaining the plan that extends beyond the later of the employee's attainment of age 21 or completion of one year of service.

Treas. Reg. Section 1.410(b)-7(c)(3) similarly provides for disaggregation and separate testing of plan populations consisting of employees who have satisfied the plan's age and service conditions but not the greatest minimum age and service conditions permitted under IRC Section 410(a), and employees who have satisfied the greatest minimum age and service conditions permitted under IRC Section 410(a).

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When reviewing a 401k plan, it's essential to understand how the coverage and ADP tests will be performed. Review the plan provisions that specify how these tests will be done.

To ensure compliance, you need to consider the plan's structure. If the plan doesn't use all participating employees, determine if it's disaggregated and identify the criteria for determining the employees in each component.

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The IRS has specific rules for identifying the group of otherwise excludable employees in a component plan. Verify that the criterion for this identification is permissible pursuant to CCA 201615013.

Each disaggregated plan component must meet the coverage test in IRC Section 410(b) on its own. This means verifying that the component plan satisfies the coverage test independently.

Here are the key steps to follow when auditing a 401k plan: