What Is 401(k) Nondiscrimination Testing?
The Employee Retirement Income Security Act requires 401(k) plans to undergo annual nondiscrimination testing to ensure the plan benefits all employees, not just highly compensated employees (HCEs).
What specifically do nondiscrimination tests look for?
To determine whether the 401(k) plan is treating everyone fairly, nondiscrimination tests examine:
- Each participating employee's salary deferral amounts.
- How much the employer contributes to each participating employee's account.
- The amount of plan assets owned by HCEs.
Who is an HCE?
The IRS defines an HCE as an employee who:
- Owned more than 5% of the company at any time during the current or previous year; or
- Received more than $125,000 (for 2019) in compensation for the prior year or was placed (by the employer) in the top-paid group of employees. (The amount rises to $130,000 for 2020.)
What are the different types of nondiscrimination tests?
There are two standard nondiscrimination tests: Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP):
- The ADP test compares the average salary deferrals for non-highly compensated employees (NHCEs) with the average salary deferrals for HCEs.
- The ACP test compares the average employer contributions received by both HCEs and NHCEs.
To pass the ADP/ACP tests, the HCE salary deferrals and employer contributions cannot exceed the IRS' thresholds for both tests.
As noted earlier, the IRS also looks at the amount of plan assets belonging to HCEs. This is done via top-heavy testing. For the plan to pass the top-heavy test, the account balances for key employees cannot collectively exceed 60% of the total plan assets.
Who is a key employee?
The IRS defines a key employee as someone who meets at least one of the following criteria:
- An officer who earns more than $180,000 (for 2019).
- Someone who owns more than 5% of the business.
- An employee who owns over 1% of the business and earns more than $150,000 for the plan year.
These amounts may be adjusted annually.
What if the plan fails nondiscrimination testing?
If your plan fails the ADP/ACP tests, you must take corrective action, which can be done in several ways. The most common — and typically least expensive — solution is to refund the excess contributions to HCEs in the amount needed to pass the test.
If the plan is deemed top-heavy, you will need to bring the plan into balance by making the necessary allocations to non-key employees.
Can nondiscrimination testing be avoided?
Plan sponsors can bypass annual nondiscrimination tests by adopting a safe harbor 401(k) design. To qualify for a safe harbor plan, you must commit to making guaranteed matching contributions up to the IRS-defined limits.
Your safe harbor plan will automatically satisfy the ADP/ACP tests and is exempt from top- heavy rules so long as it meets the IRS' requirements. Note that small businesses with 401(k) plans tend to use a safe harbor design because it saves them from having to do compliance testing every year — and having to make corrections if the plan fails.
This is just an introduction to a complex, technical topic. So be sure to consult with a 401(k) plan expert for further details.