Hi Choti!
Great question! This problem involves the ratio percentage test used to determine whether an employer's pension plan satisfies certain IRS nondiscrimination requirements.
The key is understanding that we are comparing the percentage of non-highly compensated employees (NHCEs) participating in the plan with the percentage of highly compensated employees (HCEs) participating.
Step 1: Identify the employee groups.
The employer has 1,000 employees:
Highly compensated employees (40%):
1,000 × 40% = 400 employees
Non-highly compensated employees (60%):
1,000 × 60% = 600 employees
Step 2: Understand the ratio percentage test.
Under IRC Section 410(b), a pension plan generally passes the ratio percentage test when:
Coverage Ratio = (% of NHCEs benefiting) ÷ (% of HCEs benefiting)
The resulting ratio must be at least 70%.
Scenario 1: 300 NHCEs participate, and ALL HCEs participate.
NHCE participation rate:
300 ÷ 600 = 50%
HCE participation rate:
400 ÷ 400 = 100%
Coverage ratio:
50% ÷ 100% = 50%
Answer: FAIL
The coverage ratio is only 50%, which is below the required 70%.
Scenario 2: 300 NHCEs participate, and only 50% of HCEs participate.
NHCE participation rate:
300 ÷ 600 = 50%
HCE participation rate:
200 ÷ 400 = 50%
Coverage ratio:
50% ÷ 50% = 100%
Answer: PASS
The coverage ratio is 100%, which exceeds the required 70%.
Final Answers:
Scenario 1: FAIL (50% coverage ratio)
Scenario 2: PASS (100% coverage ratio)
Key takeaway: The IRS ratio percentage test is designed to prevent qualified retirement plans from disproportionately benefiting highly compensated employees.
Interestingly, both scenarios include the same number of non-highly compensated employees (300). However, the second scenario passes because participation among highly compensated employees decreases, making coverage more balanced between the two groups.
One final distinction: Passing this ratio percentage test does not automatically mean the pension plan satisfies every IRS qualification or nondiscrimination requirement.
Hope this helps!
Michael
