Tis the (Nondiscrimination Testing) Season!
During the festive holiday season, 401(k) nondiscrimination testing probably isn’t at the top of many retirement plan sponsors’ minds. But nondiscrimination testing is a critical function of operating a healthy retirement plan—not to mention an important mandate of ERISA.
Let’s take a look at what nondiscrimination testing is, some need-to-know terms and concepts, and how this important task affects your company’s retirement plan.
What is nondiscrimination testing?
ERISA requires a retirement plan to undergo annual calculations to ensure that the plan doesn’t disproportionately benefit a specific group of employees (highly compensated employees [HCEs]) and that plan participants haven’t exceeded IRS contribution limits. These calculations are referred to as nondiscrimination testing.
Is there a deadline to complete nondiscrimination testing?
Generally, the deadline is two and a half months following the plan’s year-end (March 15 for calendar year plans).
Who is responsible for performing nondiscrimination testing?
Your service provider (e.g., a third-party administrator or recordkeeper) will likely perform nondiscrimination testing as part of its contracted services.
Who is an HCE (and who is not)?
For 2018 tests, an HCE is classified as any employee who is either:
- A greater than 5 percent owner of the business at any time during the year for which the test is being conducted (Please note: Family members of a greater than 5 percent owner are attributed to own the same interest for purposes of nondiscrimination testing.), or
- Someone who earned more than $120,000 in compensation in the previous year (For example, when performing a 2018 test, HCE compensation would be determined by looking back to 2017 compensation to determine HCE status.) Conversely, a non-HCE (NHCE) is any eligible employee who does not fit into one of the two categories above. With that background in mind, let’s examine the different varieties of nondiscrimination tests.
The average deferral percentage (ADP) test
Although HCEs may freely (if they meet eligibility requirements) contribute to their retirement plan up to IRS-imposed limits (or plan-imposed limits, if applicable), the ADP test is applied to ensure that the HCEs do not contribute proportionately more than the NHCEs. The ADP test measures the average salary deferral (pretax and Roth but excluding catch-up contributions) percentage of the HCE group against the average salary deferral of the NHCE group. To pass, the average deferral percentage of the HCEs must not exceed the NHCE average deferral percentage by 1.25 percentage points or 2 percentage points, as illustrated in the table below:
| Maximum Annual NHCE Contribution Rate | Maximum Annual HCE Contribution Rate |
| Less than 2% | NHCE% × 2 |
| 2%-8% | NHCE% + 2 |
| More than 8% | NHCE% × 1.25 |
The average contribution percentage (ACP) test
The ACP test compares the employer matching contributions of HCEs with those of NHCEs. Also, if an employee (either an HCE or NHCE) contributes after-tax dollars, they would be factored into the ACP test. Once average rates are determined, the test is performed in the same manner as the ADP test.
What if the ADP or ACP test fails? A failing test is corrected with one of two methods. The first (and most common) method is to refund excess contributions to HCEs to the degree that it would lower the HCE average contribution percentage to a passing rate. The amounts are determined by a specific calculation and may or may not require each HCE to receive a refund. If a test fails and corrective action is required, timing is important. Corrective refund transactions must be completed by two and half months (March 15 for calendar year plans) after the plan year. If they are not, then a 10-percent excise tax (payable by the employer) may apply to the refunded amounts. Any pretax amounts refunded to an HCE would be taxable in the year in which they were distributed back to the HCE.
The second method is to make additional contributions to employee accounts in the NHCE group to the degree that it would raise the NHCE average contribution percentage rate to a passing level.
The top-heavy test
While both the ADP and ACP tests measure contribution averages, the top-heavy test measures overall balances of two distinct groups: key employees and nonkey employees. A key employee is:
- An officer of the company with gross compensation exceeding $175,000 (in 2018), or
- Employees of the company in the year for which the plan is being tested who:
- Own greater than 5 percent of the company (Please note: Family members of a greater than 5 percent owner are attributed to own the same interest for purposes of nondiscrimination testing.), or
- Own greater than 1 percent of the company (family attribution also applies) in the year for which the plan is being tested and had $150,000 or more in compensation
- Own greater than 5 percent of the company (Please note: Family members of a greater than 5 percent owner are attributed to own the same interest for purposes of nondiscrimination testing.), or
Once the key employee population is determined, their balances are aggregated and compared with the aggregate balances of nonkey employees. The balances of key employees cannot exceed 60 percent of the plan balance at the end of the plan year.
What if the top-heavy test fails? Generally, to correct a top-heavy test failure, the employer must make a minimum nonelective contribution to nonkey employees.
The safe harbor plan: A cure for testing headaches?
So, if your plan consistently fails nondiscrimination testing, is there anything you can do? Absolutely! A safe harbor plan eliminates the need for nondiscrimination testing. To qualify for safe harbor status, the employer must make a matching contribution, such as the following:
- Basic safe harbor match: The employer matches 100 percent of all employee contributions up to 3 percent of compensation, plus an additional match of 50 percent of their next 2 percent of compensation (for an effective 4-percent contribution).
- Enhanced match: A matching contribution must be as generous as the basic match at any level of employee deferral. A common formula is the employer matches at least 100 percent of all employee contributions, up to 4 percent of their compensation (not to exceed 6 percent of compensation).
- Safe harbor nonelective contribution: The employer contributes 3 percent of each employee’s compensation (regardless of whether the employees defer).
Sometimes, however, a drastic shift in plan design is not what’s needed to narrow the gap between HCE and NHCE contribution rates. Consider tweaking your plan by adding auto-enrollment or auto-escalation features—both will help most employees defer a higher percentage of their salary, raising the collective average of their contribution rate. Or, conduct a campaign to raise awareness of saving for retirement through a 401(k) plan. You’ll reap the benefits of improved worker morale, and your employees will take a positive step toward their future.
Additional tests to consider
The coverage test. To comply with IRC 410(b), this nondiscrimination test ensures that a sufficient number of NHCEs (70 percent at a minimum) are covered by the 401(k) plan, relative to the HCEs.
IRS statutory limits. The IRS imposes limitations on contributions to a retirement plan in one year. The annual additions test aggregates all an employee’s contributions (both elective deferrals and employer contributions) to ensure that they don’t exceed the 2018 combined defined contribution limit of $55,000 under IRC 415. The elective deferrals test verifies that an employee does not exceed the statutory elective deferral limit of $18,500 (for 2018) under IRC 402(g).
Administering a retirement plan takes a significant amount of time, care, and oversight. When it comes to nondiscrimination testing, some exceptions and nuances apply based on specialized scenarios beyond what is described above. So, where needed, tap into the expertise of service providers, such as your third-party administrator, recordkeeper, or plan advisor, for guidance.