Testing
Otherwise Excludable Employees
March 6, 2003
The key to a successful 401(k) program is its ADP and ACP test results. These results 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 concern. Otherwise excludable employees are employees who are eligible to participate but whose age and/or service is less than the maximum allowed by law. Accordingly, these are employees who are not yet age 21 or who have failed to complete 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 ADP/ACP test results negatively.
The rules affecting otherwise excludable employees are different depending on whether they are being used for coverage or ADP/ACP testing purposes.
Coverage Testing
In order to be considered qualified, a plan must meet certain
minimum coverage standards. These standards are set forth in Code Section
410(b). Code Section 410(b) defines two coverage tests, of which only one must
be passed, the ratio percentage test and the more complex average benefits
test. A plan that includes “otherwise excludable employees,” is permitted by
Code Section 410(b)(4)(B) to test this group separately. The results will
normally aid the plan in passing since the “otherwise excludable group” many
times consists solely of nonhighly compensated individuals and is deemed to
pass. The remaining group has been purged of very young and short term
employees.
When applying this rule, it is important to note that otherwise excludable employee group is determined also by taking into consideration the statutory entry date. The statutory entry date is defined as the earlier of the first day of the next plan year or the date six months after satisfying the maximum age and service requirements.
ADP/ACP Testing
Otherwise excludable HCEs are included in the ADP and/or ACP test
with all the participants who have met the statutory eligibility requirements.
When performing ADP and ACP testing, 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 would be detrimental. Their exclusion makes it easier to pass testing.
In the situation where an NHCE participant is making elective deferrals after meeting 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. The following examples will illustrate this point:
Example1
A plan has immediate eligibility for deferral and
match. An NHCE is hired on November 1, 2001 and begins making elective deferrals
and is matched as of hire date. That NHCE is not in the 2001 calendar year tests
because they are in the “otherwise excludable” group. However, because they have
satisfied the one year and age 21 requirements by the end of the 2002 plan year,
they are in the 2002 ADP and ACP tests. This is true even though the statutory
entry date would not have been met until January 1, 2003.
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, 2003 and will not be
in the ACP test for 2002. They are still in the ADP test for 2002 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 of 1 year of service and
age 21 for the safe harbor matching contribution or the safe harbor
nonelective contribution and yet permits entry into the plan for elective
deferrals without the one year of service and age 21 statutory requirements 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 in the
non-statutory group.