Matching contributions to a 401(k) plan must be correctly determined and consistent with the provisions of the plan document. The document may provide that employer matching contributions may be restricted and not allocated to participants who complete fewer than 1000 "hours of service" in a year or are no longer employed by the company at year's end. It is important to determine when the match has been applied, consistent with the plan document, such as during every payroll period or at the end of the year.
The nondiscrimination requirements of the Internal Revenue Code for a 401(k) plan are satisfied by the plan passing an ADP and ACP test. The ACP test includes employer matching contributions and employee after-tax contributions. The test uses the terms "Highly and Non-Highly Compensated Employees (HCEs and NHCEs)". Generally, an HCE is an owner who controls at least 5% of the company or any other employee who earns more than $90,000 a year (adjusted annually by the I.R.S. for increases in the cost-of-living). All other employees are usually considered NHCEs.
ACP (and ADP) tests are not always required. If all participants of the 401(k) plan are NHCEs or all are HCEs, the test is automatically passed. However, extreme caution should be used when establishing such a plan since not always having all eligible employees as either HCEs or NHCEs may produce testing difficulties at that time.
The ACP test need not be applied if the plan satisfies certain safe-harbor requirements. The most common of these is that of a matching contribution of 100% of the first 3% plus 50% of the next 2% of employee compensation. Immediate vesting is required on these contributions. Alternatively, a contribution of 3% of employee compensation to all eligible NHCEs with immediate vesting may be made to satisfy the safe-harbor requirements.
If the above exceptions have not been met, ACP testing must be performed. The first step consists of classifying all eligible employees as HCEs or NHCEs. The next step is determining the "ACP ratio" for each participant; that is, the sum of the employer's matching contribution and other ACP contributions divided by the participant's annual compensation. A nondiscriminatory definition of compensation must be used for the test. In ACP testing, a critical decision must be made whether an employee is considered an NHCE based upon the current year or the prior one.
The average ACP percentage for "Highly-Compensated Participants (HCPs)" and "Non-Highly Compensated Participants (NHCPs)" is then calculated. The average percentage of the HCPs must not exceed the average percentage of the NHCPs by specified margins to satisfy the ACP test.
If the ACP test is not passed, several alternatives are available. Frequently,"excess aggregate contributions" are distributed back to one or more HCEs in accordance with IRS regulations. Elective deferral employee contributions or non-elective employer contributions can also be used to pass a failed ACP test.