Coverage testing analyzes whether an adequate proportion of the employees that the plan benefits are non-highly compensated employees (NHCEs), as qualified retirement plans cannot discriminate in favor of highly compensated employees (HCEs). Coverage testing is conducted for each type of contribution that is utilized (i.e. 401(k), matching, profit sharing).
There are two methods to test a plan for coverage:
- Ratio percentage test
- Average benefit test
1. Ratio Percentage Test
The ratio percentage test is generally calculated by dividing the percentage of NHCEs that are benefiting under the plan by the percentage of HCEs that are benefiting under the plan. In other words:
(# of Benefiting NHCEs ÷ Total # of Eligible NHCEs) ÷ (# of Benefiting HCEs ÷ Total # of Eligible HCEs)
In a 401(k) plan, a participant is considered to be benefiting if they are eligible to make elective deferrals at any point during the plan year, even if they do not elect to defer. Similarly, in the employer match portion of the plan, a participant is considered to be benefiting if they are eligible to receive the match, even if they did not elect to make a deferral that the employer could match.
If the above quotient is greater than or equal to 70 percent, then the ratio percentage test has passed and the plan is considered to benefit an acceptable amount of NHCEs. If this figure is less than 70 percent, then the ratio percentage test has failed. To correct this, the plan administrator can either increase the number of benefiting NHCE’s until the test passes or attempt to pass coverage testing using the average benefit test.
2. Average Benefit Test (a two-part test)
Part One: The Non-Discriminatory Classification Test
This test requires that the plan meet three requirements:
- That all plans of the employer, when combined, satisfy the average benefit percentage
- That the plan covers a non-discriminatory classification of employees*; and
- That either the ratio percentage (calculated as described above) is at least the safe harbor percentage, or the plan has both a ratio percentage of at least the un-safe harbor percentage, and the plan meets certain facts and circumstances requirements.
*A non-discriminatory classification is a classification determined on some business basis unrelated to the plan. Some examples are by location, job title or division.
Part Two: The Average Benefit Percentage Test
This test generally requires that the average benefit percentage for the NHCEs is at least 70% of the average benefit percentage for the HCEs.
The average benefit percentage for each group is determined by averaging the employee benefit allocation rate (EBAR) of each participant in the group.
The basic formula for an EBAR is:
Increase in Benefit ÷ (Compensation x Service)
If the average of the NHCEs’ EBARs is at least 70% of the average of the HCEs’ EBARs, then the plan passes the average benefit percentage test. If the plan also satisfies the non-discriminatory classification test, then the plan passes coverage testing.
Contact Pinnacle Plan Design
Pinnacle Plan Design is a third-party administrator (TPA) of employer-sponsored qualified retirement plans. We specialize in retirement plan design, administration and actuarial consulting. Pinnacle has offices in Tucson and Phoenix, Arizona (AZ) as well as Houston, Texas (TX), and we proudly serve clients nationwide.