1. 401(k) Non-Discrimination Testing: Everything You Need to Know
2. Three Parts of Non-Discrimination Rules
3. Administering the Test
4. Ensuring Even Distribution
5. Methods for ADP/ACP Testing
6. Top Heavy Testing
7. Consequences of Discrimination

401(k) Non-Discrimination Testing: Everything You Need to Know

401(k) non-discrimination testing constitutes an important element of HR in any business these days. The Employee Retirement Income Security Act, or ERISA, requires a number of tests on an annual basis to ensure that your company's 401(k) plan isn't discriminatory by favoring those who make more money. It's vital that you understand how these tests work to ensure that your retirement benefits are fair and equitable for all of your employees.

In some non-discrimination tests related to 401(k) plans, employees will be divided between NHCEs, or non-highly compensated employees, and HCEs, or those who are highly compensated. The IRS defines an HCE as someone with more than a 5 percent interest stake in a business at any point during the current or prior fiscal year, regardless of their level of compensation.

Additionally, employees who received compensation that places them in the top 20 percent of earners in the company are also considered HCEs. This compensation is re-indexed every year, with the HCE and NHCE being mutually exclusive. This means that anyone who is not an HCE is considered an NHCE.

Three Parts of Non-Discrimination Rules

There are three parts to the non-discrimination rules, according to Robert Richter, VP of SunGard wealth and retirement. These three rules are as follows:

  • Broad coverage must be applied to all employees, comprising the 410(b) test.
  • If NHCEs are sufficiently covered, the plan must be thoroughly examined from all angles to be sure that it does not discriminate.
  • A test is administered to ensure that the plan's overall benefits that are accumulated among key employees are not top-heavy.

Administering the Test

The test to ensure non-discrimination is administered by examining the Actual Deferral Percentage (ADP) and the Actual Contribution Percentage (ACP). The ADP looks at the average salaries of HCE vs. NHCE employees, and the deferral percentages are used. This applies to both Roth and pre-tax deferrals. It ensures that all employees benefit from the plan. Since HCEs can only maximize deferrals if NHCEs do the same, this provides the incentive to encourage NHCE participation (usually through contributory matching by the company).

The ACP compares the matching percentage contributions as well as the after-tax contributions of NHCEs vs. HCEs. It includes both matching and voluntary contributions. This test examines the actual means by which the plan is used in a widespread manner and ensures that it isn't just used by HCEs. This is important because testing only works if employees across the range of income brackets use the plan.

Ensuring Even Distribution

The final test ensures that there isn't any top-heaviness to the plan and that overall benefits among key staff are evenly distributed. If over 60 percent of plan assets are going to key employees, the plan is considered to be "top heavy." This means that certain benefits have to be redistributed to non-key workers.

Key employees are not the same as HCEs. According to the IRS, a key staff member is anyone who, during the plan year:

  • Was both an officer and earned over $170,000 (re-indexed annually) -OR-
  • Had more than a 5 percent ownership stake or both owned more than 1 percent and earned over $150,000 per year.

Thus, while the first two tests examine overall coverage and ensure non-discrimination in terms of available benefits, the rules for even distribution are based on the total benefits accumulated. If more than 70 percent of NHCEs benefit at the same rate as NCEs, coverage is good. If the ratio is less than 70 percent, but the average NHCE benefit is 70 percent or greater when compared with HCE benefits, it still passes.

Methods for ADP/ACP Testing

There are two primary methods that can be used to test a 401(k) plan for fairness. Any plan to test for discrimination must satisfy one of these two methods but can use either current-year percentages or prior-year percentages when applied.

The first of these methods checks to ensure that the average HCE contribution is no more than 125 percent of the average contribution by NHCEs. For example, if the average of NHCE contributions to a plan is 3 percent, HCE average contributions cannot exceed 3.75 percent.

The second method states that average HCE contributions cannot be more than 2 percent plus the average NHCE contribution, or double the average NHCE contribution (whichever is lower). Thus, if NHCEs are contributing 3 percent on average, HCE contributions cannot exceed 5 percent (NHCE contribution + 2 percent), while if average NHCE contribution is only 1 percent, HCE average contributions can't exceed 2 percent (double the NHCE contribution, which would be lower than the 3 percent average +2).

Top Heavy Testing

The best method for testing whether your plan is top heavy is to group together all of your key employees and tabulate the total balance of their accounts. If this is greater than 60 percent of the entire plan balance, then you're top-heavy.

It's recommended that all testing be done annually before the 401(k) administrator checks the accounts. Given the severe consequences of discriminatory packages, however, companies should engage in regular, proactive tracking and monitoring of percentages grouped by employee classification.

Consequences of Discrimination

If your plan fails testing, you have until the end of the current plan year to bring it into retroactive compliance. This can be done by extending coverage to NHCEs or modifying the plan in other ways. If you fail to do so, your HCEs will have to report vested accrued benefits as income for tax purposes. Simple 401(k) plans aren't subject to ACP or ADP testing because they make mandatory vested deposits, but they may still be subject to testing related to the plan's top-heaviness. The end goal is to ensure company owners and HCEs aren't unfairly benefiting from their own plans at the expense of NHCEs.

If you need help with 401(k) non-discrimination testing, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.