The Pitfalls of Failing a Discrimination Test in a Qualified Retirement Plan. The Plan Sponsor University (TPSU) is offering a series of the Top 10 Most Common Mistakes in 401k plans. This video addresses Mistake # 4 – the dangers associated with failing to pass a discrimination test, recognizing the failure, and subsequently not addressing the problem. The Discrimination Testing of a retirement plan is an annual mathematical check of the amount of compensation the Higher Paid Employees (HCEs) have deferred into the retirement plan, versus the amount that the Non-Highly Compensated Employees (NHCEs) have deferred into the retirement plan. The IRS wants to be sure that the plan is not just a tax-dodge for higher paid employees. The IRS wants to be certain that employees across all levels within an organization are benefitting from the retirement plan.
Ms. Esposito discusses the appropriate steps that a Plan Fiduciary would take to keep a tax-qualified retirement plan in compliance.
Full Transcript Below
Fred: Hi, this is Fred Barstein with 401KTV and we’re privileged to have Jewell Lim Esposito. Welcome, Jewell.
Jewell: Thanks, Fred.
Fred: Jewell is a renowned ERISA attorney with the law firm, partner with the law firm of Fischer Broyles and a well-known speaker and ERISA legal strategist.
Jewell: Mm-hmm (affirmative).
Fred: Okay if we ask you a few question today?
Jewell: Sure is.
Fred: So this is part of our series on the 10 biggest mistakes that 401K and 403(b) plan sponsors make according to advisors and we’re down to number four. So the fourth biggest mistake that you can make is failing discrimination testing and then doing nothing about it.
Fred: So before we get into it, what is discrimination testing and why is it required?
Jewell: Discrimination testing is a fancy term that the Internal Revenue Code uses to make sure that the retirement benefits that are flowing to employees are fair and by that, the IRS means that the benefits that flow to the highly compensated employees can’t way exceed the benefits that are flowing to the non-highly compensated employees.
Fred: And why do they do that?
Jewell: Basically the IRS wants to make sure that these are not set up just for the owners and management and the top people. These are plans that are supposed to be benefiting the entire demographic of the employer.
Fred: So in order for the highly compensated to put away as much as possible, they have to make sure that the less highly compensated are as well.
Jewell: That’s right.
Fred: So that seems fair.
Jewell: It does seem fair.
Fred: So what happens if a plan sponsor fails a testing, knows it, and doesn’t do anything about it?
Jewell: Well first of all, these tests are run at least annually. So every year, there’s an opportunity to see how plan is doing with [inaudible 00:02:07]. And so failing a test isn’t the biggest error. As you pointed out, it’s not correcting it. So what happens is if a plan sponsor sees that it has failed a test, then what it has to do is step and correct. And usually that might mean putting in extra money for the lower compensated people or it might mean giving money back to the highly compensated people.
Fred: And so how do highly compensated people feel where at the end of the year, they have to now give money back or pay a bigger tax bill, right? Is that a good news that they’re delivering?
Jewell: Well sometimes highly compensated people dislike the fact that they can’t put as much into retirement as they would like to because they are prohibited by theses IRS tests. There are designed strategies that allow an employer to allow the highly compensated employee to put in as much as possible and it just means seeking through designs strategies. For example, if an employer chooses to have what’s called a safe harbor plan, then under that design, the highly compensated employee can put in as much as they thought they could’ve put in this year. 2018, they can put in $18,500 and so now they can put in that money and not be limited in how much they can put in.
Fred: Well we won’t get into safe harbor today, but if you have any questions about safe harbor, go to your advisor or your TPA or your record keeper. It’s a pretty simple thing to do, but I think it’s an important thing. I know that we have a safe harbor plan for that.
Fred: So thanks for your time today.
Jewell: You’re welcome.
Fred: And thanks for watching our series on the 10 biggest mistakes that plan sponsors make according to advisors. We’re down to number four and we look to forward to seeing you for the top three coming up soon.
Latest posts by Fred Barstein (see all)
- 401kTV GENIE Awards – Announced for New York, Chicago and Los Angeles - May 15, 2019
- Performance-Based Asset Management Fees Resurrect - May 15, 2019
- 401k Matching Formula Motivates Seasoned Employees - May 12, 2019