It’s that time again — testing time. One of the things that can help a plan pass testing is known as restructuring by using the “otherwise excludable employees” rules.

Among the keys to a successful 401(k) program are the ADP and ACP test results.  These tests will determine the level at which the HCEs may contribute. Special rules and opportunities are available to those performing the test that will help maximize test results.

The rules affecting otherwise excludable employees are a special area of opportunity.  Otherwise excludable employees are employees who are eligible to participate by plan terms, but whose age and/or service are less than the maximum eligibility requirements that are allowed by law.  Accordingly, these are employees who are not yet age 21 or who have not yet completed a year of service.  Many 401(k) plans provide for immediate or very quick eligibility, at least with respect to the elective deferral feature of the plan. The Internal Revenue Code provides special rules to assure that permitting early participation does not impact a plan’s ADP/ACP test results negatively.

ADP/ACP Testing
Otherwise excludable HCEs are generally included in the ADP and/or ACP test with all the participants who have met the statutory eligibility requirements.

However, otherwise excludable NHCEs may be excluded from the ADP and ACP tests. Often the excludable employees are the lowest paid and least likely to defer and their early entry to the plan could be detrimental. Their exclusion makes it easier to pass testing.  There are differences of opinion as to how long they may be kept out of the tests. 

Under the more conservative approach, when an NHCE participant is making elective deferrals after satisfying a less than one-year eligibility requirement and then satisfies the statutory age and 1 year of service requirement before the plan year end, they are included in the ADP or ACP test even if the NHCE’s statutory entry date has not yet been reached.  Others take the position that these individuals do not have to be brought into the test until after their statutory entry date.  The following examples will illustrate this point:

Example 1
A plan has immediate eligibility for deferral and match. An NHCE is hired on November 1, 2007 and begins making elective deferrals and is matched as of hire date. That NHCE is not in the 2007 calendar year tests because they are in the “otherwise excludable” group. However, under the more conservative approach, because they have satisfied the one year and age 21 requirements by the end of the 2008 plan year, they are in the 2008 ADP and ACP tests. This is true even though the statutory entry date would not have been met until January 1, 2009. Obviously, those who take the approach that they do not have to be tested until after they would have entered the plan, applying statutory entry dates would not include them in the test until the 2009 test year. 

Example 2
Assume the facts are the same as the above example except there is a one-year and age 21 requirement with dual entry dates for the matching contribution.  In this situation, the employee will not become a participant for the matching contribution under the terms of the plan until January 1, 2009 and will not be in the ACP test for 2008. Under the more conservative approach referenced above, they are still in the ADP test for 2008 because the 1 year of service statutory requirement was met prior to the plan year end.

Safe Harbor 401(k) Plan Issue
A safe harbor 401(k) plan which has an eligibility requirement of 1 year of service and age 21 for the safe harbor matching contribution or the safe harbor nonelective contribution and yet permits earlier entry into the plan for elective deferrals, must test those who have not met the statutory requirements separately from those who have achieved the statutory requirements. For a safe harbor 401(k) plan, the non-statutory group to be tested would include both the HCEs and NHCEs.

Therefore, the HCEs in the under age 21 and/or under 1 year of service group would be limited by the ADP/ACP of the NHCEs in the non-statutory group. Why? Since there is no safe harbor contribution made for participants making elective deferrals who have not satisfied the 1 year and age 21 requirements; testing must be done for the non-statutory group if there are any HCEs similarly situated.