The basics of the 401(k) coverage test

What’s the purpose of the 401(k) coverage test?

The IRS created the coverage test under Internal Revenue Code Section 410(b) to make sure 401(k) and other qualified retirement plans cover a fair cross-section of employees. To make this assessment, the test looks at the employees who are eligible to participate in the plan compared with those who aren’t.

How often must coverage testing be performed?

Coverage testing is usually performed annually as of the last day of the plan year (December 31 for calendar year plans) and considers all employees who worked at any point during the plan year. Alternative timeframes are available, but they’re rarely used, and specific criteria must be met.       

Who’s considered an employee?

For purposes of the 401(k) coverage test, a plan sponsor’s total workforce includes:

• Common-law employees
• Leased employees employed for a year or more
• Self-employed individuals
• Employees of certain related businesses (controlled group members)

If your business is related to or affiliated with another entity or has employees other than common-law employees, you should work closely with your third-party administrator (TPA) or ERISA consultant to make sure the right individuals are included in your coverage test.

Once you identify who’s an employee, you next need to determine which employees are benefiting from the 401(k) plan. Employees who are eligible to defer into the plan are deemed to be benefiting even if they’ve chosen not to make deferrals. The importance of this distinction will become clearer when we look at the types of coverage tests. 

Can any employees be excluded from the 401(k) coverage test? 

While all employees must be taken into account, you can generally exclude the following individuals from coverage testing:

• Employees who don’t meet the plan’s minimum age and service requirements, such as age 21 and 1 year of service
• Nonresident aliens with no U.S. income from the employer
• Employees subject to a good faith collective bargaining agreement
• Terminated employees who failed to meet the plan’s minimum service (500 hours or more) or last-day requirement before separating from service, if applicable  

Before excluding any employees from the coverage test, you should consider how this will affect your actual deferral percentage (ADP) and actual contribution percentage (ACP) nondiscrimination tests. Any employees excluded from coverage testing must also be excluded from these tests. You may not want to exclude employees who haven’t met the minimum age and service requirement if including them will improve your ADP and ACP test results.

How does a 401(k) plan pass the coverage test?

To pass the coverage test, a plan must satisfy either the ratio percentage or average benefit test. Many plan sponsors start with the ratio test because it’s easier to perform. The average benefit test is typically only used if a plan has trouble passing the ratio test. The following questions describe each method.

What is the ratio percentage test?

The ratio percentage test is a straight numerical test comparing the ratio of NHCEs benefiting from the plan with the ratio of HCEs benefiting from the same plan. To pass this test, the coverage ratio must be 70% or higher. 

Example

What’s the average benefit test?

The average benefit test is a more complex, two-part test.

Part 1: nondiscriminatory classification test

The first part of the average benefit test has two steps, and a plan must pass both of them to move on to part two.

Employee classifications

Plan sponsors must ensure the plan uses reasonable, objective classifications, such as job categories or geographic location, to identify which employees will benefit under the plan. Unreasonable classifications are open to interpretation, such as valued contributor.

Numerical nondiscrimination test

There are two ways a plan can pass this test. The first is to have a coverage ratio that’s greater than or equal to the safe harbor percentage, which is determined by the IRS based on the NHCE concentration percentage. The NHCE concentration percentage is determined by dividing the number of nonexcludable NHCEs by the number of all nonexcludable employees.

Under the second option, the plan must have a coverage ratio that’s greater than or equal to the unsafe harbor percentage, also set by the IRS, and pass a facts and circumstances test, which is a series of questions designed to make sure NHCEs are being treated fairly.

The higher the NHCE concentration, the lower the safe and unsafe harbor percentages will be. In essence, the more NHCEs covered by the plan, the easier it is to pass this test.

Part 2: average benefit percentage test

To pass the average benefit percentage test, the average benefit percentage for NHCEs must be at least 70% of the HCE average benefit percentage. 

As you can see, the average benefit test is quite complex. Plan sponsors should work closely with their TPA or ERISA consultant to make sure this test is performed correctly.

Do any plans automatically pass coverage testing?

In the following situations, a 401(k) plan is deemed to pass coverage testing so that neither the ratio percentage nor the average benefit test has to be performed:

• The plan doesn’t have any includable NHCEs.
• No HCEs benefited from the plan during the year.
• The plan benefits only union employees.
• The employer recently went through a merger or acquisition and takes advantage of the IRS transition rule.

What’s involved with correcting a failed coverage test?

If left uncorrected, a failed coverage test can result in plan disqualification, which means the participants’ vested account balances would become immediately taxable—an outcome no one wants. The corrective action varies, such as bringing more NHCEs into the plan or providing additional employer contributions to NHCEs.    

The plan’s document must be amended retroactively to expand the coverage group or permit an additional allocation. This amendment must be completed within 9½ months after the end of the plan year; otherwise, the plan sponsor will need to use the IRS Voluntary Correction Program to correct the test failure.

401(k) coverage test─positioning your plan for success     

Understanding the fundamentals of coverage testing is essential for fulfilling your fiduciary duty. Equally important is making sure you have accurate data, documented procedures, and a knowledgeable and trusted TPA or ERISA consultant. Having all three in place can help you feel more confident about the results and any steps you may need to take to keep your plan on track.