Under IRS regulations, 401k plans must pass certain nondiscrimination tests in order to avoid fees, required withdrawals, additional employer contributions, or the cancellation of a plan altogether. The purpose of the assessments is to ensure a company’s retirement plan doesn’t benefit top executives more than lower-level workers. 401k nondiscrimination testing follows the steps below.
HCEs and NHCEs
To evaluate 401k plans, the IRS divides workers into two categories: highly-compensated employees (HCEs) and non-highly-compensated employees (NHCEs). Under current guidelines, HCEs are defined as employees who earned at least $120,000 in the year prior to testing, or who owned at least 5% of the business during the preceding year or the testing year. A company can also add the requirement that a HCE be in the top 20% of the firm’s salary scale. Employees who don’t meet any of these standards are classified as NHCEs.
ADP and ACP tests
The first test a 401k plan must undergo is the actual deferral percentage (ADP) test. This analysis simply calculates what percentage each employee’s salary is being deferred. With figures for all employees, it’s possible to see how much HCEs in a company are saving versus NHCE rates.
Under the actual contribution percentage (ACP) test, an employee’s W-2 income is compared with the company’s 401k contribution for that employee. For example, an employee with W-2 income of $200,000 and $7,000 worth of employer contributions would have an ACP ratio of 3.5% ($7,000 / $200,000).
Uncle Sam doesn’t want ADP and ACP rates for highly-compensated employees to drastically exceed the same rates for non-highly-compensated employees. If the average ADP or ACP ratio for NHCEs is between 0% and 2%, the corresponding ratio for HCEs must be less than twice the NHCE ratio. If the ADP or ACP rate for NHCEs is more than 8%, the same measurement for higher earners in the company must be under 1.25 times the NHCE figure.
The top-heavy test
The third test is the top-heavy test. The analysis applies to key employees, who are defined as officers making more than $175,000 in the plan year; anyone who owns more than 5% of the business; or an employee who owns more than 1% and makes more than $150,000. The IRS requires that plan assets of key employees do not exceed 60% of total plan assets.
Rectifying failed tests
Plans that fail to meet any of the tests must either refund the contributions of highly-paid workers (along with the accompanying loss of tax deductions) or make qualified non-elective employer contributions (QNECs) to lower-level employees to raise their contribution levels. A company could do a combination of these to bring a 401k in line with IRS requirements.
Avoiding nondiscrimination testing
Instead of taking the above corrective measures, a company could avoid nondiscrimination testing by setting up a Safe Harbor 401k. With this type of retirement plan, contributions are immediately vested, and this mollifies the IRS enough so that it’s no longer interested in nondiscrimination testing.
Self-employed persons with no employees perhaps have it easiest: individual 401k's are not subject to testing.
If you need help maintaining compliance with federal regulations for your small business’s 401k, you can download Glass Jacobson’s guide on important topics for plan sponsors. If you need help educating the participants in your plan, check out our education tool 401kbuddy™. Our team also offers retirement plan advisory services if you need more oversight - just click the button below to contact us.