How do you test for fairness in a 401(k) plan? A code regulation spelled out by the Internal Revenue Service says that three important elements of a 401(k) plan - benefits, rights and features - must not discriminate in favor of highly compensated employees. Sounds simple, doesn't it?
How could a plan slip through the cracks of fairness in providing benefits, rights and features?
Let's say your company has just merged with another, and each company has come to the table with separate 401(k) plans. It's more expensive to keep two plans, so the merger chooses one. However, let's say you are grandfathered into the new plan with the benefits you had received all along. Meanwhile, the merger does not extend those benefits to your new colleagues from the other company. This plan must be tested, because every employee does not have access to its benefits.
A passing grade means the plan has met two requirements: effective communication and statistical proof.
As for definitions, the IRS defines a highly compensated employee as an employee who makes more than $80,000 a year, or owns 5 percent or more of a company.
On benefits, rights and features - just think dollars and cents.
Plan benefits may provide several different ways for participants to access their money, such as lump sums or annuities.
Rights and features run the gamut. They allow participants to choose where to invest their money; how much they want to invest; and when they can access that money (whether it be for a loan or a rollover into an IRA.) Participants also should have a fair shot at receiving matching contributions from their employer - but that's exactly where a plan most often slips up.
Here's an example. An employer says it will match 100 percent of the first seven percent that a participant defers into the 401(k). But the fact is, some participants do not even defer that much, while others defer much more. Therefore, an annual average percentage test on those deferrals may not meet the IRS requirement.
In those cases, the employer will have to return portions of highly compensated employees' 401(k) deferrals to pass the test. But if any employer matches associated with those returns are not forfeited completely, the plan may end up offering high-paid employees a higher rate than it offers to lower-paid employees.
So plan sponsors beware. If you tip the scale in favor of highly compensated employees, your 401(k) plan may be disqualified.
When you design your plan, keep a close eye on the availability of its benefits, rights and features. And if you do decide to exclude some participants from certain parts of the plan - follow the golden rule. Test the plan every year to make sure that you're being an equal opportunity 401(k) plan sponsor.