What is IRC Section 401(a)(4)?
IRC Section 401(a)(4) addresses nondiscrimination requirements for qualified retirement plans. In simple terms, it ensures that the benefits, rights, and features of a retirement plan are not skewed to favor HCEs. This helps create an equitable system for all employees, preventing employers from designing plans that give unfair advantages to a select group.
The idea behind this provision is straightforward: highly compensated employees cannot receive significantly better benefits than their lower-compensated counterparts. If a retirement plan is found to discriminate in favor of HCEs, it risks losing its tax-qualified status, which means it could lose the tax benefits that both the employer and employees enjoy.
Why is IRC Section 401(a)(4) Important?
Compliance with IRC Section 401(a)(4) is important for several reasons:
- Ensures Fairness: It maintains equity between highly compensated employees and the rest of the workforce.
- Prevents Favoritism: It stops companies from designing retirement plans that disproportionately benefit the top earners.
- Maintains Tax Benefits: Compliance is critical for a plan to remain qualified for favorable tax treatment under the IRS code.
Key Requirements of IRC Section 401(a)(4)
To comply with Section 401(a)(4), retirement plans must meet the following core requirements:
- Nondiscriminatory Benefits: The plan must not provide disproportionate benefits to HCEs compared to NHCEs. It is essential that the benefits are allocated in a way that does not favor highly compensated employees too heavily.
- Testing for Nondiscrimination: Retirement plans must pass certain nondiscrimination tests, ensuring they meet the fairness criteria set out in the IRC. Some common tests include:
- The Average Benefit Test: This test compares the average benefits provided to NHCEs with those provided to HCEs.
- The Percentage Test: This test compares the percentage of compensation contributed to HCEs against the percentage of compensation contributed to NHCEs.
- Safe Harbor Provisions: IRC Section 401(a)(4) offers “safe harbor” provisions that allow employers to automatically meet nondiscrimination requirements. For example, the minimum allocation safe harbor ensures that the employer provides at least a minimum level of benefits for all employees. Similarly, composite testing methods help employers structure their plans in ways that ensure they pass nondiscrimination tests.
How Employers Can Ensure Compliance
To ensure compliance with IRC Section 401(a)(4), employers should:
- Understand the Rules: The first step is to thoroughly understand the rules surrounding nondiscrimination testing. This includes becoming familiar with both the 401(a)(4) Average Benefit Test and the 401(a)(4) Percentage Test.
- Review Plan Design: Employers should periodically review their plan design to ensure it doesn’t inadvertently favor HCEs. This could involve assessing whether certain features of the plan, such as contribution formulas, disproportionately benefit top earners.
- Work with a Retirement Plan Consultant: Many companies work with plan consultants or actuaries to design their retirement plans in compliance with IRC Section 401(a)(4). These professionals can help design plans that balance the needs of both HCEs and NHCEs.
- Use Safe Harbor Methods: Employers who want to simplify compliance can consider using safe harbor provisions, which are structured to automatically satisfy nondiscrimination requirements.
Testing for Compliance
There are two primary ways to test for compliance under IRC Section 401(a)(4):
- The Average Benefit Test: This test compares the benefits provided to NHCEs with those provided to HCEs. If the benefits for NHCEs are significantly lower than those for HCEs, the plan may fail this test.
- The Percentage Test: This test looks at the contribution rate for HCEs compared to NHCEs. If the percentage of compensation contributed to HCEs is substantially higher than that contributed to NHCEs, the plan may not pass the test.
If the plan fails either of these tests, corrective actions, such as adjusting the benefits or contributions, may be required.
What Happens if a Plan Fails the Nondiscrimination Test?
If a plan fails the nondiscrimination test under IRC Section 401(a)(4), the employer risks having their retirement plan disqualified. Disqualification means the plan could lose its tax advantages, such as tax-deferred growth for participants and tax deductions for employers. This can lead to severe consequences for both the employer and employees, including taxes and penalties.
Conclusion
IRC Section 401(a)(4) plays a crucial role in ensuring fairness in retirement plans. It helps prevent discrimination against lower-compensated employees while ensuring that all workers have access to meaningful retirement benefits. By understanding and complying with this section, employers can design equitable retirement plans that benefit all employees and avoid the risk of plan disqualification.
Regular testing and careful design are key to ensuring a balanced, compliant retirement plan for both HCEs and NHCEs. Contact TMG Pitchers to know more!
