401k Nondiscrimination Testing Basics and Compliance Strategies

Nondiscrimination testing for 401k plans is a must, as it ensures that highly compensated employees (HCEs) aren't getting preferential treatment. The IRS requires regular testing to prevent this.

The ADP (Average Deferral Percentage) test is one such method, comparing the average deferral rate of HCEs to that of non-highly compensated employees (NHCEs). If HCEs are deferring more than a certain percentage, the plan may need to be adjusted.

The plan's safe harbor provisions can be used to avoid testing altogether, by making contributions to all eligible employees, regardless of their deferral rates. This can be done through a formula-based contribution or a fixed percentage of pay.

To pass the ADP test, the plan must have a higher average deferral rate among NHCEs than among HCEs. This ensures that HCEs aren't getting preferential treatment.

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The primary goal of 401(k) nondiscrimination testing is to ensure the plan doesn't disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs).

The IRS defines highly compensated employees as individuals who own more than 5% of the company at any time during the year or the preceding year, or receive compensation of more than $155,000 in 2023 or were in the top 20% of employees when ranked by compensation.

There are four major nondiscrimination tests most 401(k) plans must pass: the IRC § 410(b) Coverage Test, the Actual Deferral Percentage (ADP) Test, the Actual Contribution Percentage (ACP) Test, and 401(a)(4) General Nondiscrimination Testing.

The IRC § 410(b) Coverage Test aims to ensure the plan covers a sufficient number of NHCEs. If all employees are receiving a benefit, the plan passes the test.

The 410(b) test involves two options: the ratio percentage or the average benefit test. The ratio percentage test involves calculating the ratio of NHCEs who benefit from the plan to the ratio of HCEs who benefit. The plan passes the test if the ratio percentage is 70% or higher.

The average benefits test is more complex and consists of two parts. Most plan sponsors only use the average benefits test if the plan doesn’t pass the ratio percentage test.

Coverage testing compares how many HCEs are benefiting from the plan to how many NHCEs are benefiting. At least 70% of the NHCEs must also benefit from that contribution type.

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The coverage ratio is calculated by dividing the number of NHCEs benefiting from the plan by the total number of nonexcludable NHCEs. If the coverage ratio is less than 70%, the plan fails the ratio percentage test.

Here are the key points to remember:

A highly-compensated employee is anyone who meets specific requirements, including owning more than 5% of the interest in the business at any time during the year or preceding year.

These requirements also include certain family members of 5% owners, such as parents, children, and spouses. Highly-compensated employees must also have made more than $155,000 in 2024, up from $150,000 in 2023.

To qualify as a highly-compensated employee, an individual must have earned more than $155,000 in the prior year, regardless of their current compensation.

Here are some key characteristics of highly-compensated employees:

Newly hired employees who would traditionally qualify as highly-compensated employees but have not been with the company long enough to meet the $155,000 threshold will be considered non-highly compensated employees until the year after they exceed the threshold.

Highly-compensated employees often overlap with key employees, but it's essential to note that being a key employee doesn't necessarily mean someone is a highly-compensated employee.

Calculating deferrals and contributions is a crucial step in 401(k) nondiscrimination testing. You'll need to gather data on your employees' deferral rates and company contributions.

To calculate the Actual Deferral Percentage (ADP) test, you'll need to average the salary deferral percentages for Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). This involves dividing the amount each employee defers by their total W-2 income.

The ADP test compares the average deferral rate of HCEs to that of NHCEs. To pass the test, the HCE average rate can't exceed 125% of the NHCE average rate.

Here's a breakdown of the calculation steps:

The ADP test involves comparing the HCE deferral rate to the NHCE average deferral rate, which is 3% in this case. Since Jon's deferral rate is 10%, the plan fails the ADP test.

You can also calculate the Actual Contribution Percentage (ACP) test, which compares the average employer contributions received by HCEs and NHCEs. The ACP test is similar to the ADP test, but it takes into account company contributions.

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To pass the ACP test, the average contribution rate for HCEs can't exceed the greater of 125% of the NHCE average rate or the lesser of 2 times the NHCE average rate or 2% plus the NHCE average rate.

The ACP test involves dividing the company's contribution to an employee by their W-2 income. Here's an example:

In this example, the HCE average contribution rate is 3%, while the NHCE average contribution rate is 1.5%. Since the HCE average rate is less than 125% of the NHCE average rate, the plan passes the ACP test.

If your 401(k) plan fails nondiscrimination testing, you have a statutory correction period to take corrective action. This period typically lasts 2 ½ months after the end of the plan year being tested. Failing to correct the mistake within this time frame can result in a 10 percent excise tax on excess contributions.

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You may correct an ADP or ACP mistake through the Employee Plans Compliance Resolution System (EPCRS). If the employer distributes or recharacterizes excess contributions within 2 ½ months after the plan year of excess, the tax doesn't apply. However, if the corrective contributions are insufficient for the cash or deferred arrangement (CODA) to pass the ADP test, the tax applies to the remaining excess contributions.

To correct an ADP or ACP mistake, you can use one of two methods: Revenue Procedure 2021-30, Appendix A, Section .03, or the one-to-one method under Rev. Proc. 2021-30, Appendix B, Section 2.0. Both methods require the employer to make a qualified nonelective contribution to the plan for non-highly compensated employees (NHCEs).

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If your plan fails the ADP or ACP test, you must take corrective action described in your plan document during the statutory correction period to cause the tests to pass.

The plan has 2 ½ months after the end of the plan year being tested to correct excess contributions. If correction is not made before the end of the 12-month correction period, the plan’s cash or deferred arrangement (CODA) is no longer qualified and the entire plan may lose its tax-qualified status.

You can correct this mistake through EPCRS, but if the employer doesn't distribute/recharacterize excess contributions by 2 ½ months (six months for certain EACAs) after the plan year of excess, the employer is liable for a 10 percent excise tax on excess contributions.

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There are two different methods to correct ADP and ACP mistakes beyond the 12-month period, both requiring the employer to make a qualified nonelective contribution to the plan for NHCEs.

If the Plan provides for catch-up contributions, the refund may be recharacterized as a catch-up contribution (up to the catch-up limit) provided.

You have to take corrective action if your plan failed nondiscrimination testing, and there are several options for doing this, including making corrective distributions, QNECs, and QMACs.

Corrective distributions are when you refund the contributions from HCEs until the plan passes the test. HCEs will receive refunds in the order of deferral amount. Since 2008, these refunds have been taxable in the year they are made.

Making QNECs and QMACs are less popular options, as they tend to be more expensive and less convenient.

The IRS 401(k) Fix-It Guide has useful information on all kinds of situations you may encounter.

To correct a failing 401(k) plan, you must take steps to fix it, as there are major consequences if you don’t take corrective action.

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The plan has a statutory correction period, which is the period that you have to take necessary action for your plan to pass nondiscrimination testing.

You can correct a combined ADP and Top Heavy failure by refunding half of the HCE’s deferral or making appropriate top-heavy corrections of 3% for the same year the plan failed the ADP.

To correct a Top-Heavy failure, the plan will be considered top-heavy for the next plan year, and certain employer contributions will need to be made – up to 3% of non-key employees’ compensation for each year the plan is top-heavy.

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Annual testing is essential to ensure compliance with 401(k) nondiscrimination rules. Traditionally, NDTs are done on the last day of the plan year.

Occasional checks to your nondiscrimination status can help prevent unexpected paperwork and unhappy employees. Ideally, you are monitoring the situation throughout the year.

A mid-year assessment can help you catch potential issues before it's too late. This way, you can take preventative action to pass the test and avoid costly corrections.

A surprise assessment at a random point during the year can also be beneficial. If you fail the top-heavy test mid-year, you can limit HCE contributions until the plan passes.

A 401(k) plan is considered top-heavy if the account balances of key employees exceed 60% of total plan assets as of the last day of the prior plan year. Key employees are defined by the IRS as anyone who owns more than 5% of the business, or an employee owning more than 1% of the business whose compensation exceeds $150,000 for the plan year.

To determine if a plan is top-heavy, you need to gather key employee account balances and total plan assets. The key employee account balances are the account balances of key employees, including officers, 5% owners, and employees owning more than 1% of the business and making over $150,000.

If the total key employee account balances are greater than 60% of the total plan assets, the plan is top-heavy. For example, if a plan has total assets of $25,905 and the key employee has assets of $21,450, the plan is top-heavy.

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A plan fails the top-heavy test if the key employees own more than 60% of the total plan assets. The total value of account balances is determined by adding back distributions taken in the prior four years and subtracting unrelated rollover balances for both key and non-key employees.

Key employees are defined by the IRS as:

A plan is considered top-heavy if the account balances of key employees exceed 60% of total plan assets as of the last day of the prior plan year. If a plan is top-heavy, non-key employees must generally receive an employer contribution equal to 3% of their annual compensation.

Here are the steps to determine if a plan is top-heavy:

1. Gather key employee account balances

2. Determine the percentage of account balance contributed by key employees

3. Check the result: if the result is greater than 60%, the plan is top-heavy

A safe-harbor 401(k) plan can automatically satisfy the minimum contribution requirement when certain conditions are met. However, companies must still perform top-heavy testing annually based on the account balances on the last day of the prior plan year.

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Employer contributions play a significant role in 401(k) nondiscrimination testing, particularly in the Actual Contribution Percentage (ACP) test. This test evaluates the fairness of employer matching contributions and after-tax employee contributions.

Employer contributions can be either matching or nonelective. Matching contributions are made based on how much employees choose to defer, while nonelective contributions are made regardless of employee deferrals. Employer contributions are also subject to vesting schedules, which can impact the ACP test.

A 50% match up to 6% of an employee's deferral is a common employer contribution structure. This means that if an employee defers 6% of their income, the employer will match it with an additional 3% contribution. Employer contributions can make or break a plan's ability to pass the ACP test, as seen in the example where Winterfell Consulting's plan passed the ACP test due to a 50% match up to 6% of employee deferrals.

High participation rates can also impact the ACP test. Plans with automatic enrollment boast a 92% participation rate compared to 62% for plans with voluntary enrollment. This is because automatic enrollment removes the barrier of employees needing to opt-in to the plan, making it easier for them to participate and receive employer contributions.

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Here's a breakdown of the two types of employer contributions:

By understanding the impact of employer contributions on the ACP test, plan sponsors can take corrective action to ensure their plan passes the test and remains compliant with nondiscrimination regulations.

Employer contributions play a significant role in determining the fairness of a 401(k) plan.

The type of contribution a company makes can impact the Actual Contribution Percentage (ACP) test, which evaluates the fairness of employer matching contributions and after-tax employee contributions. Matching contributions, for instance, are made based on how much employees choose to defer, while nonelective contributions are made regardless of employee deferrals.

There are two types of employer contributions: matching contributions and nonelective contributions. Matching contributions benefit employees, as they receive additional money in their retirement nest egg, but they also benefit employers by keeping employees happier, qualifying as tax-deductible business expenses, and helping 401(k) plans avoid discrimination issues when structured correctly.

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A Safe Harbor Match can automatically pass the ACP test, and a Safe Harbor Nonelective contribution can also achieve this. These types of contributions are designed to ensure that employer contributions are made in a way that is fair to all employees.

Here are the two types of employer contributions:

The way a company contributes to its employees' 401(k) savings can have a big impact on whether the plan will pass nondiscrimination testing.

Employee participation is crucial for passing nondiscrimination tests, and it's not just about getting employees to join the plan. Automatic enrollment can help boost plan participation rates among non-highly compensated employees (NHCEs) to as high as 92%, compared to 62% for plans with voluntary enrollment.

A 2021 study found that 9 out of 10 employees who were automatically enrolled in a plan stayed in the plan, and 84% of employees said that auto-enrollment was key to saving earlier.

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Research in 2023 found that plans with automatic enrollment had a 94% participation rate, compared to a participation rate of 67% for plans with voluntary enrollment. This is likely because automatic enrollment makes it easy for employees to join the plan, without having to think about it.

To encourage employee participation, employers can also provide personalized education and effective, ongoing monitoring. This can include proactive, personalized communications, such as email, online tools, and even text messages, to make sure employees know about and are excited by the plan.

Here are some ways to increase employee participation:

By making it easy for employees to join the plan and providing them with the right tools and support, employers can increase employee participation and help their employees save for their future.

To avoid the costs of non-compliance, it's essential to know the deadlines for 401(k) nondiscrimination testing. Plans generally have 2.5 months after the plan year end to return excess contributions for failed ADP/ACP testing to avoid a 10% excise tax.

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Testing deadlines are typically tied to the end of the plan year, and failing to meet them can result in penalties and bureaucratic headaches. If the plan sponsor doesn't make the correction within 12 months, the plan can lose its qualified status.

Here are some key deadlines to keep in mind:

Failing to pass annual compliance tests can lead to significant headaches and expenses. This includes both for the company and potentially for employees, as mentioned in Example 2.

Failing a 401(k) nondiscrimination test means you'll need to take corrective action to avoid penalties and ensure the plan remains qualified. This can include returning excess contributions to highly-compensated employees (HCEs) or adjusting employer contributions to correct the imbalance, as explained in Example 4.

High participation rates in 401(k) plans can significantly impact nondiscrimination testing. Plans with automatic enrollment boast a 92% participation rate compared to 62% for plans with voluntary enrollment, as noted in Example 1.

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To avoid these compliance costs, it's essential to pass annual nondiscrimination tests. This requires understanding the specific tests applied and their applicability, which can vary depending on your plan design, as mentioned in Example 3.

Here are some key takeaways to help you stay compliant:

Deadlines are crucial for compliance, and it's essential to know them to avoid costly mistakes.

You have 2.5 months after the plan year end to return excess contributions for failed ADP/ACP testing.

The plan can distribute excess contributions any time within a 12-month period.

Missing the deadline can result in a 10% excise tax, so make sure to mark it on your calendar.

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A knowledgeable retirement advisor or 3(16) fiduciary can help your plan pass by using a different testing method, which might be just what you need if your plan is on the border.

You can also consider a Safe Harbor 401(k) plan, which includes an IRS-qualified employer contribution by default and is exempt from the 3 major NDTs, unless there's a profit-sharing component to the plan.

To qualify as a Safe Harbor plan, you can make one of three typical contributions: match 100% of employee contributions up to 4%, match 100% of contributions up to 3% plus 50% of the next 2%, or contribute 3% of every employee's compensation, regardless of whether they contribute to the plan.

This can be a great way to encourage employees to contribute to the plan and make your 401(k) a valuable recruitment and retention tool.

A Safe Harbor Plan is a type of 401(k) retirement plan that makes you exempt from most nondiscrimination tests, unless it has a profit-sharing component.

If you adopt a Safe Harbor Plan, you can skip most nondiscrimination tests, including ADP and ACP tests.

A Safe Harbor Plan includes an IRS-qualified employer contribution by default, which encourages employees to contribute to the plan.

You can choose from three typical contributions to qualify a plan as "safe harbor": the business matches 100% of employee contributions up to 4% of compensation, or up to 6% if the plan sponsor chooses; the business matches 100% of employee contributions up to 3% and 50% of the next 2%; or the business contributes 3% of every employee's compensation, regardless of whether they contribute to the plan.

By adopting a Safe Harbor Plan, you can avoid the costs of non-compliance and potential headaches for employees.

Passing nondiscrimination testing is essential, but with a Safe Harbor Plan, you can skip most annual tests by providing an employer contribution each year.

This can save you from unwelcome consequences for employees or require making employer contributions you may not have budgeted for.

A Safe Harbor Plan is a way to stay compliant with 401(k) plan administration, and it's highly advisable to consider it if you want to avoid the risks of non-compliance.

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A technically savvy 401(k) advisor can help your plan pass by using a testing method different from a typical nondiscrimination test.

If your plan is on the border, using a different testing method might be just what you need to squeeze past even if you've failed your standard test. After all, it never hurts to check.

You can avoid the costs of non-compliance by passing nondiscrimination testing, which is essential for your 401(k) plan's administration.

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Failing a 401(k) nondiscrimination test means headaches and expenses for the company and potentially for employees as well.

Conducting interim testing throughout the year can help you stay in front of any issues and address them early, reducing the risk of failure.

There is another way to stay compliant: a Safe Harbor 401(k) plan lets you skip most of the annual tests by simply providing an employer contribution each year.

A little planning can go a long way toward keeping your 401(k) plan compliant, and it's highly advisable to take this approach to avoid unwelcome consequences for employees or employer contributions you may not have budgeted for.