For retirement plan employers, 401(k) nondiscrimination testing is one of the most critical functions of operating a healthy retirement plan—and it’s also an important mandate of ERISA. Here’s a look at some commonly asked questions and need-to-know terms and concepts, as well as how this important task affects your company’s retirement plan.
What Is Nondiscrimination Testing?
ERISA requires that retirement plans undergo annual calculations to ensure that they don’t disproportionately benefit a specific group of employees (i.e., highly compensated employees [HCEs]) and that employees 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. Although the test will be performed on your behalf, it is important to recognize that timely completion of the test is an employer’s fiduciary responsibility.
Who Is a Highly Compensated Employee/HCE (and Who Is Not)?
An HCE is classified as any employee who either:
What Types of Nondiscrimination Testing Are There?
There are a few kinds of nondiscrimination tests to be aware of:
What if the ADP or ACP test fails?
A failing test is corrected using one of two methods. The first (and most common) method is to refund excess contributions to HCEs in an amount that 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 within two-and-a-half months (March 15 for calendar-year plans) after the plan year. If they are not, 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 the overall balances of two distinct groups: key employees and non-key employees. A key employee is someone who, at any point in the plan year, can be characterized in at least one of the following categories:
Once the key employees are identified, their balances are aggregated and compared with the aggregate balances of non-key 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 non-key employees. Additional tests to consider:
The Safe-Harbor Plan: A Cure for Testing Headaches?
What if your plan consistently fails nondiscrimination testing? Is there anything you can do? The answer is yes! A safe-harbor plan eliminates the need for nondiscrimination testing. To qualify for safe-harbor status, the employer must make a matching contribution. Options for doing so include:
Sometimes, however, a drastic shift in plan design is not what’s needed to lessen 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. You’ll enjoy the benefits of improved worker morale, and your employees will take a positive step toward building their financial future.
Staying Ahead of the Game
Administering a retirement plan takes a significant amount of time, planning, 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. As your independent advisors we’re here to lead you through this process, so feel free to reach out to a member of our AFS with any questions or to learn more.