We once took over a retirement plan from another Third Party Administrator. The business sponsoring the plan was a small family owned business with several family members working in the business and few rank and file employees. During the transfer process, we assessed the plan design and encouraged this client to switch to a Safe Harbor 401(k) Plan. By doing so, they could bypass ADP/ACP testing, because we knew that their plan would potentially fail testing causing the owners to have to take refunds of their salary deferrals. However, in spite of our advice, the client thought the Safe Harbor plan would be too expensive, because it required a slightly higher employer matching contribution than the matching contribution they were already providing. What happened next would later change their minds…
Our client’s plan had been in existence for 15 years, and they thought all was well and they were in full compliance. It wasn’t long after taking over their plan that we performed the annual ADP/ACP testing and their plan failed the tests as expected. When a 401(k) plan fails these tests, the highly compensated employees must either be refunded a portion of the deferrals they made to the plan and/or the employer must make an additional contribution to eligible employees’ accounts. We also ran Top Heavy Testing which is required by the regulations to be run each year. The plan failed that test as well, and they failed it significantly. When a plan fails Top Heavy Testing, the employer must make a minimum contribution to all eligible employees employed on the last day of the plan year (even those who do not make salary deferrals) equal to 3% of their gross annual compensation. When you consider this plan had 40 eligible employees at the time, 3% of compensation is a substantial amount of money! In fact, for one year alone, it exceeded $21,000 in addition to what they had already contributed as a matching contribution. A Safe Harbor plan would have allowed this employer to forego this minimum contribution as well.
After the client failed the Top Heavy Test, we referred to the client’s former TPA to collect the Top Heavy Test history for the previous years. Unfortunately, the former TPA had never performed a Top Heavy Test in any of the previous years. Because of this, we had to go back and test every year the plan had been in existence. What we found was astounding. Our client had failed Top Heavy Testing for 14 of the 15 years. This meant that our client would have to make a 3% Top Heavy Minimum Contribution to all eligible employees for every year they failed testing. Yes, that means our client owed money to eligible employees for all 14 years they were out of compliance, and they would have to submit an application to the IRS under their Voluntary Compliance Program.
Obviously this is a drastic example, but we find that compliance issues like this are not that uncommon. Switching to a Safe Harbor plan design could have saved this client a substantial amount of money. Fortunately, we were able to find and correct this mistake for our client before it was discovered by the IRS or DOL on audit.
If you have questions about the compliance of your 401(k) plan, you should seek the advice of a qualified professional.