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DB/DC 401(a)(4) Testing Compensation Option Review

DB/DC combined tested retirement plans that illustrate compliance with the IRC 401(a)(4) nondiscrimination requirements by permissive aggregation (1.401(a)(4)-9) of DB and DC plans for running the General Test (1.401(a)(4)-2(c) and 1.401(a)(4)-3(c)) on employer-provided benefits have the option of showing participant nondiscrimination results as a percentage of Testing Compensation. This review is to summarize the testing compensation options. With testing options, regulation 1.401(a)(4)-9(b)(iv) does require that any option used must be consistently used in both the combined plans. There may be some differences in interpretations because 1.401(a)(4)-1(c)(2) provides reasonable interpretations that may be used. This review does not include compensation options for the 410(b) Average Benefits Percentage Test or the 401(a)(4) Gateway Test. Here is the DB/DC Testing Compensation review.

In general, there are two types of Testing Compensation: Average Annual Compensation (1.401(a)(4)-3(e)(2)) and Plan Year Compensation (1.401(a)(4)-12). Both types have associated options that do not apply to the other type but have similar general requirements regarding their associated options. These general requirements are:

Provided the general retirement benefits of the DB plan are tested using the General Test, it is not required to calculate participant benefits using any particular definition of compensation (1.401(a)(4)-3(e)(1)). DC allocations may require a specific definition of compensation, like safe harbor non-elective contributions (1.401(k)-3(b)(2)). If applicable, DB or DC top-heavy benefits do require specific compensation definitions (1.416-1 T-21).
Testing Compensation options apply for each plan year separately (1.401(a)(4)-1(c)(3)). Besides the Plan Year Compensation option to exclude compensation while not a participant, which should be reasonably consistent from year to year (1.401(a)(4)-12(4)), compensation options can be different each year.
For determining compensation, a compensation year is a 12-month period used for determining compensation and is generally the plan year; however, it can be any 12-month period ending in the plan year. (1.401(a)(4)-3(e)(2)(iii) and 1.401(a)(4)-12).
Compensation must use IRC 414(s) Compensation (1.401(a)(4)-3(e)(2)(i) and 1.401(a)(4)-12) and reflect the maximum 401(a)(17) compensation limit (1.401(a)(17)-1). The standard 414(s) compensation is IRC 415(c)(3) compensation with an option to include all deferred compensations (1.414(s)-1(c)): IRC 125, 402(e)(3), 402(h), 403(b), and 457(b) sections. Nonstandard 414(s) definitions are required to pass the 414(s) test.
The method and options used for calculating compensation must be consistently/uniformly calculated for all employees (1.401(a)(4)-3(e)(2)(iii) and 1.401(a)(4)-12(1)) in the test.

Given the above requirements, the general definition of Average Annual Compensation (1.401(a)(4)-3(e)) is the highest average compensation from an averaging period of at least three compensation years from their Compensation History. From their entire employment with the employer, the years considered for their Compensation History may start at any time in the past but must be continuous, be no shorter than the Averaging Period, and end in the current plan year. If an employee’s years of employment are less than the Averaging Period, then all their compensation years are averaged. The options for Average Annual Compensation are (1.401(a)(4)-3(e)):

Averaging Period. As included in the general definition, a minimum of 3 years, up to all their years of employment, may be averaged.
- Again, employees with fewer years than the Averaging Period are to have all their compensation years averaged.
Compensation History: As included in the general definition, it can begin at any time, only consider a specific number of prior years, or only consider years while a participant (1.401(a)(4)-3(e)(3) Example 4).
- For an employee, since Compensation History can’t be shorter than the Averaging Period and Averaging Period can’t be shorter than an employee’s years of employment, new employees can’t have their pre-entry compensation excluded from Average Annual Compensation.
- Together with the Averaging Period, it is possible that their average annual compensation may not use their current compensation in the high average because it was lower than in previous years.
Drop Out Years. Provided the plan’s benefit formula excludes years when an employee terminates, performs no service, or performs service less than a specified number of hours, Average Annual Compensation may have those years excluded. If an employer selects a specified number of hours for dropout years, then it can’t exceed three-quarters of the time that an employee in the same job category works on a full-time basis. If an employee normally works part-time, then this may be applied by reducing the specified number of hours by the ratio of this employee’s normal work schedule over a full-time schedule.
- This may apply to new hires/participants that do not have as many years as the Averaging Period, provided they are not benefiting from the year being dropped. See Drop Out Years below.
Non-consecutive periods for average. Provided the plan does not take into account consecutive years for compensation in providing benefits and permitted disparity isn’t considered in 401(a)(4) testing or the calculation of benefits, then the average compensation can use non-consecutive years.

The general definition of Plan Year Compensation is the compensation earned during the year. However, any 12-month period that ends within the plan year can be used. If the compensation year used is 12 months ending in the plan year, then for employees hired during the plan year, their compensation is either from the plan year or compensation earned while a participant, regardless of the consistency/uniformity requirement for the options used. Besides using 12 months ending in the plan year for plan year compensation, the other option is (1.401(a)(4)-12):

While Participant. Only include compensation earned while a participant during the year. If an employee ceases to be a participant, either due to termination of employment or being classified as an eligible participant, then compensation earned after can be excluded too.

Whereas the above general requirements are relatively straightforward, there are some gray areas to consider for DC/DB testing compensation.

Plan Using Permitted Disparity in Testing or Benefits. Regulation 1.401(a)(4)-12 for Section 414(s) compensation indicates that the underlying definition of compensation is not Section 414(s) compensation if the definition results in significant under-inclusion of compensation for employees. It is unclear what is a significant under-inclusion and how this may limit testing compensation options.
Net of Deferral and Roth. Regulation 1.414(s)-1(c)(4)(i) indicates that elective deferrals that are not includible in gross income can be excluded. However, Roth contributions are included in income; thus, some argue those can’t be used to reduce compensation. However, regulation 1.414(s)-1 was published on September 19, 1991. Congress didn’t introduce Roth until 1997 in the Taxpayer Relief Act. The 1.414(s)-1 regulation was written before Roth existed. In 2012 at an ASPPA conference, the IRS was asked if it was correct to use Roth to reduce compensation in Net of Deferrals, and their answer was Yes. Further, they said if only the pre-tax elective deferrals were used, that would not be a safe harbor definition because all elective deferrals are treated uniformly.
DB/DC Plans With Different Entry Dates. For participants that enter both plans during the testing year but with different entry dates, it is unclear how this impacts their While Participant Plan Year Compensation. 1.401(a)(4)-(9)(b)(2)(ii)(A) indicates that testing accrual rates are calculated for DB and DC plans separately and then combined for an aggregated result. This would imply separate DB and DC While Participant Plan Year Compensation would be used for that participant. However, 1.401(a)(4)-(9)(b)(2)(iv) indicates that accrual rates must be determined in a consistent manner and be applied consistently for the entire DB/DC plan. For a DB/DC combined tested plan, it may not be unreasonable to interpret While Participant Compensation to use the first entry date between the two plans to calculate consistent testing compensation for the entire DB/DC plan for that participant.

Depending on the demographics included in the 401(a)(4) test, different testing options may provide more favorable results. Review regulations to ensure compensation options are appropriate for each case. Also, audit the compensation provided by employers to ensure it meets the definition required by the plan for providing benefits and that it is eligible for being used in compliance testing.