Review 2022 Nondiscrimination Testing Results ASAP

Even though the 2022 plan year is over (for calendar-based plans), plan sponsors can’t close the door on 2022 just yet. Year-end nondiscrimination testing must be conducted and any failures corrected before plan sponsors can turn their full attention to 2023. Although third-party administrators (TPAs) and recordkeepers will typically guide plan sponsors through the testing process and contribution limits each year, plan sponsors have a fiduciary responsibility to ensure that the plan meets testing requirements and plan limits, and to properly correct any excesses.

ADP/ACP Tests
A 401(k) plan must be tested each year to ensure that it isn’t disproportionately benefiting or discriminating in favor of highly compensated employees (HCEs). Two tests are used to compare the benefits received by HCEs and non-HCEs: the actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test.

Correction: There are several options for correcting a failed ADP or ACP test, but most plans will distribute to HCEs enough contributions, plus attributable investment earnings, to bring the HCEs’ rate to a level that will pass the test. Alternatively, the plan sponsor may provide an extra employer contribution to non-HCEs to raise their ADP/ACP.

  • Correct by March 15, 2023, to avoid a plan sponsor excise tax. Corrective distributions to HCEs will be taxable to the HCE for 2023 (excluding Roth contributions).

  • Correct after March 15 but before December 31, 2023, and pay a 10 percent excise tax on the excess amount.

  • If not corrected by December 31, 2023, the plan sponsor must go through the IRS’s Employee Plans Compliance Resolution System (EPCRS) to correct the failure.

Top-Heavy Test
A plan is top heavy if more than 60 percent of its total assets are held by key employees as of the last day of the preceding plan year. If a plan is deemed top heavy, the company must make a contribution for each non-key employee equal to at least 3 percent of the employee’s compensation for the coming year. Profit sharing contributions, matching contributions, nonelective contributions, and allocated forfeitures count toward the 3 percent requirement.

Correction: If the 3 percent contribution isn’t made, the plan sponsor must correct the failure under EPCRS.

Salary Deferral Limit
A participant in a 401(k) plan may contribute up to $20,500 of their compensation as pretax and Roth salary deferrals for 2022. This limit applies to salary deferrals across all 401(k), 403(b), and SIMPLE plans in which an employee participates. If a participant is age 50 or older, they may defer an additional $6,500 for 2022. Deferrals won’t be categorized as catch-up contributions unless the 402(g) limit, a plan-imposed limit, or an ADP test limit is reached.

Correction: Distribute the excess and earnings by April 15, 2023. The excess deferral is taxable to the participant in the year contributed and the earnings are taxable in the year distributed. If corrected after April 15, the excess is taxable to the participant in the year contributed, and the entire distribution (excess deferral and earnings) is taxable in the year distributed—double taxation. Also, the plan may be subject to disqualification unless the error is corrected using EPCRS.

Annual Additions Limit
The annual additions limit determines the maximum that can be allocated to a participant’s account in each employer’s plan each year. All employee and employer contributions allocated to a participant’s account for 2022 cannot exceed the lesser of:

  • 100 percent of the participant’s compensation, or

  • $61,000, plus up to $6,500 for catch-up contributions if the participant is age 50 or older.

Correction: Distribute excess deferrals and after-tax contributions to the participant. A distribution of pretax deferrals and earnings is taxable in the year of distribution. Any associated matching contributions must be forfeited or held in a suspense account according to the plan document. Excess annual additions should be corrected as soon as possible under EPCRS.

Address Testing Issues
It’s important to review your plan’s testing results promptly. Most TPAs or recordkeepers will provide clear instructions for correcting testing failures, but you may first want to ensure that your service provider had accurate data (e.g., correct definition of compensation and accurate payroll data) to conduct the tests. Once you have confirmed that the data and tests were accurate, correct any failures as soon as possible to avoid additional tax or correction procedures.