The 410(b) coverage test is an annual IRS requirement that confirms your 401(k) plan does not disproportionately benefit highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). This article explains what the test is, when it applies to Gusto 401(k) plans, how it works, and what happens if your plan does not pass.
Coverage testing is a type of compliance test that certain 401(k) plans must complete each year. It confirms your plan does not disproportionately benefit highly compensated employees (HCEs) over non-highly compensated employees (NHCEs) in terms of who can participate.
The test calculates the percentage of eligible HCEs compared to eligible NHCEs who benefit under the plan. If your plan is part of a legally related group (LRG), all employees across the related entities must be included.
Companies that sponsor a 401(k) plan get significant tax breaks. In return, the Internal Revenue Service (IRS) requires the plan to pass several nondiscrimination tests — and the 410(b) coverage test is one of them. Generally, 410(b) testing passes if at least 70% of NHCE employees get the retirement benefit.
Whether your plan needs coverage testing depends on the plan design and whether any related entities have different retirement plan designs.
If every employee (other than certain non-resident aliens and union employees) who is at least age 21 and has done one year of service — including all related entities — is getting all plan benefits, 410(b) testing is not required.
Gusto 401(k) plans do not allow service requirements greater than one year or age requirements beyond 21, so most Gusto 401(k) plans do not require 410(b) testing. However, there are exceptions.
Many Gusto 401(k) plans have a last-day requirement for profit-sharing contributions. This means an employee who has met the plan's age and service requirements may still not get a profit-sharing contribution if they leave employment before December 31 of the applicable plan year.
When a profit-sharing contribution is calculated with a last-day requirement, Gusto Retirement will determine if the plan can pass coverage testing. If it cannot, the Gusto 401(k) plan document includes a fail-safe provision that requires the plan to waive the last-day requirement for the minimum number of eligible participants needed to pass. Gusto Retirement will automatically expand the group of NHCEs who are eligible for profit sharing, starting with employees who have done the most service in the plan year.
Coverage testing looks at all employees of the "employer" as defined by the IRS. This includes all entities that are controlled groups or affiliated service groups.
For example, if one entity in a controlled group offers a 401(k) plan with a matching contribution and another offers a 401(k) plan with a nonelective contribution, coverage testing will be required to make sure each plan can pass the 410(b) test for the benefit offered to only one group of employees. Since both plans offer elective deferrals, 410(b) testing is likely not required for that benefit.
If a plan fails 410(b), the plans typically need to be amended so that more NHCEs are eligible for the applicable benefit.
Note: Even if a plan passes coverage testing, additional nondiscrimination testing may still be required. For example, if all participants are eligible for matching contributions but the plan does not have a safe harbor design, ADP and ACP testing will be required to make sure the average deferral and matching contribution percentages among HCEs do not exceed the allowable limit based on the average of the NHCEs.
Eligible employees are those who have met the plan's minimum age and service eligibility requirements, including employees in any related entities.
Benefiting employees are those who actually get any applicable contributions.
Each plan contribution type is analyzed separately:
Elective deferrals — participants benefit from elective deferrals if they are eligible to contribute to the plan, even if they never do. Gusto 401(k) plans that are not part of an LRG will always pass 410(b) coverage for elective deferrals. However, if not all members of an LRG have the same plan design — or if some do not have a plan at all — 410(b) coverage testing will be needed. All employees of related entities who meet the minimum age and service requirements for elective deferrals are included as "eligible," while only employees who have the right to contribute are considered "benefiting." This type of testing may be available from Gusto Retirement on a fee-for-service basis.
Profit sharing — participants are benefiting employees in a profit-sharing plan if they get a profit-sharing contribution.
Matching contributions — in general, any participant eligible to contribute is typically considered benefiting from a matching contribution. Gusto 401(k) plans that are not part of an LRG will always pass 410(b) coverage for matching contributions. However, if not all members of an LRG have the same plan design — or if some do not have a plan at all — 410(b) coverage testing will be needed. This type of testing may be available from Gusto Retirement on a fee-for-service basis.
Allocation conditions are provisions where an eligible participant needs to meet additional requirements each year to get an employer contribution. These are typically based on service (for example, work 500 hours in the plan year) or employment (for example, be employed on the last day of the plan year). Gusto Retirement does not allow service-based allocation conditions on matching or profit-sharing contributions, or employment-based allocation conditions on matching contributions. Employment-based allocation conditions may be allowed on certain new comparability profit-sharing allocation formulas.
The ratio percentage test works in two steps.
Calculate the ratio of NHCEs and HCEs who are benefiting under the plan for each contribution source:
NHCEs who benefit / NHCEs who are eligible = NHCE ratio
HCEs who benefit / HCEs who are eligible = HCE ratio
Compare the NHCE benefiting ratio to the HCE benefiting ratio:
(NHCE ratio) / (HCE ratio) = ratio percentage
If the ratio percentage is 70% or higher, your plan passes the ratio coverage test and 410(b) coverage. If it is lower than 70%, the coverage test fails. The next step depends on your plan design:
Fail-safe provision — if the ratio percentage test fails because of a last-day allocation requirement for profit sharing, Gusto 401(k) plans include a fail-safe provision. The plan waives allocation requirements for the minimum number of eligible participants needed to pass the test. Gusto Retirement will automatically expand the group of NHCEs eligible for profit sharing by waiving the last-day allocation requirement, starting with eligible participants who have done the most service in the plan year.
Average benefits test — if the ratio percentage test does not pass because related entities do not offer the benefit, the average benefits test may be available to rescue the plan.
The average benefits test is more complex and consists of two parts. Both parts must pass for the overall test to pass.
To follow these steps:
The classification established by the employer must be "reasonable." This generally means it is based on objective business criteria that identify the category of employees who benefit under the plan. Since Gusto Retirement does not allow plans to exclude employees based on classification, this portion of the test will always pass for Gusto 401(k) plans that have operated according to their plan documents.
The test compares the ratio percentage obtained above to a table of safe and unsafe percentages that depend on the number of NHCEs compared to HCEs in the plan. If the plan's ratio percentage is greater than the plan's safe harbor percentage, the classification test passes.
This test is similar to the ratio percentage test in that it compares a ratio of HCEs to NHCEs — and must be at least 70% to pass. However, instead of comparing the number of benefiting participants, this test compares the actual benefit percentages received as a percentage of compensation.
All non-excludable employees are taken into account for this purpose, even if they are not benefiting under any plan.
Failing a coverage test can be costly. If your plan does not pass, you need to take corrective measures to bring the plan into compliance. You can do this by either extending coverage to more NHCEs or by modifying contributions to them.
A coverage failure must be corrected within 9½ months of the end of the plan year in which the failure occurred. If left uncorrected, your plan could face adverse consequences, including penalties, taxes, and even disqualification.
To avoid this, it is important that we have all the information needed to accurately complete the test. This is particularly important for entities that are part of a controlled group or affiliated service group.
Important: Gusto Retirement needs to be made aware of all plans of related entities and will need information about those plans and entities. When other entities have a 401(k) plan, Gusto Retirement can only complete coverage testing if all 401(k) plans in the controlled group are identified and administered by Gusto Retirement.