Company 401(k) plans are created to benefit all employees, regardless of where they fall in the organizational hierarchy. In order to prevent 401(k) plans from favoring company executives, owners, and employees who are on the higher end of the pay scale, the IRS has enforced annual nondiscrimination testing. In this blog, we will discuss what nondiscrimination tests are and how to stay compliant with the IRS rules and specifications.
What is Non-Discrimination Testing?
The purpose of non-discrimination testing is to make certain that employees stay within a specific contribution range when comparing different groups of employees. These tests are required for employees who are considered Highly Compensated Employees (HCEs) to ensure they are not benefitting at an unreasonably higher rate when compared to those who are Non-Highly Compensated Employees (NHCEs). By setting clear contribution limits, the testing aims to make sure that all employees, regardless of compensation rate, have equal access to the company's benefits.
401(k) retirement plans provide significant tax benefits for employers which is why there are strict compliance regulations. In order for a company to continue receiving its tax benefits, it will need to pass all compliance tests set forth by the federal government.
The current IRS requirements are:
· 401(k) plans must meet certain minimum standards concerning coverage of employees
· The plan should not favor highly compensated employees
· Plan assets cannot favor owners, executives, or officers of the organization
· Plan contributions cannot exceed IRS limits
Since non-discrimination testing is based on where employees are classified, it is important to understand the criteria that go into each category.
Highly Compensated Employees are those who meet one or more of the following:
· The employee's annual compensation was $130,000 or more and, if the employer chooses, was in the top 20% of employees when ranked by compensation for the year plan prior.
· The employee-owned more than 5% of outstanding corporate stock, regardless of how much that person earned, holds voting power across corporate stock or the employee is related to an owner of the organization such as a spouse, children, parents, grandparents. In-laws, siblings, and grandchildren are exempt from the relationship rule.
· A key employee is someone who earns $185,000 or more in annual compensation based on the prior year of earnings
· The employee owns more than 5% of the company or is related to someone who does.
· If the employee owns more than 1% of the company and earns more than $150,000, they will be considered a key employee.
Non-highly compensated and non-key employees are those who do not meet the definitions above.
Two Key Non-Discrimination Tests
There are two key tests for 401(k) plans to ensure that a plan is compliant with established federal requirements and regulations. The types of testing will vary depending on your organization's specific plan design and benefits package.
1. Actual Deferral Percentage (ADP)
a. An ADP test compares the average deferral percentage that HCEs contribute from their salary to the average deferral percentage the NCHEs contribute.
b. The IRS requires that the disparity between the 2 groups is typically within a 2% range when comparing the average deferral rates for each group.
2. Actual Contribution Percentage (ACP)
a. ACP tests only apply to companies offering a traditional match. This test looks rate of matches received and compares the average percentage of matching contributions made for both HCEs and NHCEs.
b. The IRS requires that the disparity between the 2 groups is typically within a 2% range when comparing the average matching rate for each group.
401(k) administrators should ensure that their company's 401(k) does not discriminate in favor of the Highly Compensated Employee group by performing these non-discrimination tests on an annual basis. By performing these tests and staying vigilant throughout the year to adjust contributions as needed, you will proactively benefit all employees as they save for their retirement. If you have questions about your company's retirement plan, contact us today!