Essentials of 401(k) Plan Nondiscrimination Testing

In the U.S., there are about 60 million active 401(k) plan participants, and nationwide plan assets represent about one-fifth of the entire American retirement market. Given the tax-preferred status, the IRS closely monitors plan compliance closely to ensure Atlanta and other Georgia employers do not favor certain employees over others. Nondiscrimination testing is required for most plans, and it’s also one of the harder compliance requirements for small and mid-size employers to achieve.

In many smaller plans, governance is typically not the sponsor’s primary job, so certain duties – like compliance with nondiscrimination rules – can easily be missed or misunderstood. A 401(k) that violates nondiscrimination rules risks hefty fees, penalties, and potentially losing its tax-preferred status. To help clients, prospects, and others, Wilson Lewis has provided a summary of the key details below.

What is Nondiscrimination Testing?

In any business, employees have different roles, responsibilities, and salaries. Nondiscrimination testing ensures equity amongst all participants by examining elective contribution rates, company contributions, and the percentage of plan assets that belong to highly compensated employees (HCEs). The test determines there is no discrimination that favors HCEs.  

It is required the test be performed annually and is typically conducted on the last day of the plan year. However, plan sponsors are encouraged to conduct an ad-hoc test mid-year to determine if potential issues exist. This mid-year exam will provide ample opportunity to take corrective steps without impacting the tax-favored status of HCEs.  

Highly Compensated Employees

Accurately identifying and defining highly compensated employees is a critical first step in meeting compliance requirements. The IRS stipulates that “compensation for purposes of HCE determinations must be based on Section 415(c) compensation, which may not be the plan’s definition of compensation.”

There are two tests to identify a highly compensated employee. An individual needs only pass one of these to qualify.

• A company owner with at least five percent interest at any point during the determination year or lookback year, regardless of compensation.
  • A spouse, child, parent, or grandparent of an owner-employee is also considered a highly compensated employee.
• Compensation, including wages and salaries, bonuses, tips, and fringe benefits, exceeds $130,000 in the lookback year if the year is 2020 or 2021. This amount increases to $135,000 for 2022.

If there are a disproportionate number of HCEs, a business owner may take the top-paid group election. This limits the number of highly compensated employees for plan purposes to the top 20 percent of all participants based on compensation.

In addition to highly compensated employees, plans must also correctly identify key employees.

Key employees:

• Receive more than $185,000 compensation in the determination year for 2021 ($200,000 in 2022),
• Have a five percent or more ownership stake in the company, or are directly related to someone who does, or
• Have one percent or more ownership stake in the company and earns more than $150,000 in compensation during the determination year.

Types of Nondiscrimination Tests

There are three main nondiscrimination tests: actual deferral percentage (ADP), actual contribution percentage (ACP), and top-heavy.

The ADP test determines the rate of salary deferrals, including pretax and Roth deferrals, of highly compensated employees, and compares it to contribution rates of non-highly compensated employees. This test measures engagement across all eligible plan participants.

To figure the allowable contribution rate, business owners must calculate the annual contribution rate for both highly compensated and non-highly compensated employees.

Highly compensated employees are not permitted to defer more than the following amounts.

New 401(k) plans without a lookback year can assume a 3% average for non-highly compensated employees. That means highly compensated employees could contribute up to 5% of compensation.

The ACP test uses the same calculations and contribution rates, except employer-match and after-tax contributions are included.

The third most common nondiscrimination test is the top-heavy test.

A plan is considered top-heavy if more than 60 percent of total plan assets on the last day of the lookback year are in key employee account balances. When a plan fails the top-heavy test, non-highly compensated employees must receive an employer contribution equal to three percent of their annual compensation. Employer-matching or profit-sharing contributions can offset this requirement.

401(k) plans must also pass a test to prove the plan covered enough non-highly compensated employees during the year. There are two ways to calculate this: using either a ratio percentage or the average benefit test.

Common Nondiscrimination Testing Failures

It’s often easier for large plans to stay in compliance because the pool of eligible and active participants is higher. For smaller plans, there are several factors that can impact compliance, like:

• Fewer eligible participants
• Low participation rate
• Incorrect definition of highly compensated employees
• Plan design

It’s most common for plans to fail the ADP and top-heavy tests. In a 2020 study, plans with automatic enrollment demonstrated a slightly higher deficiency rating with the ADP test than without automatic enrollment. It is important to note that safe harbor plans are automatically exempt from ADP and ACP tests but often fail the top-heavy requirement.

When plans fail the ADP test, the most common correction method is to refund excess contributions. Employees would then need to report the additional, untaxed compensation and potentially incur more tax liability for the year. Top-heavy test failures can be corrected with an amendment to the plan document, which would specify a minimum annual contribution limit for non-highly compensated employees.

Contact Us

Maintaining compliance with various plan rules and regulations can be a challenging task for many Atlanta businesses. The consequences of a compliance failure can be significant as is the case with nondiscrimination testing. If you have questions about the information outlined above or need assistance with your next retirement plan audit, Wilson Lewis can help. For additional information call 770-476-1004 or click here to contact us. We look forward to speaking with you soon.