Providing a company 401(k) is a very generous gesture that demonstrates how much you care about your employees, so it can be both surprising and annoying when you are suddenly notified that you failed an IRS test for your retirement plan.
The government wants to encourage and incentivize businesses to offer 401(k)s, but needed to create some regulations around them to prevent abuse. Hence, every 401(k) plan is subject to annual IRS non-discrimination testing.
If you’d like more context on non-discrimination testing in general, here are some more general articles (we recommend starting with the first one!):
- Non-Discrimination Testing: The Basics of IRS 401(k) Compliance
- Non-Discrimination Testing Deadlines
- Non-Discrimination Testing for Startups
Why do good companies fail testing?
These tests, while well-intentioned, can be both confusing and inconvenient for employers who just want to offer a way to help employees invest in their futures. But don’t worry — the IRS knows that most employers are honest, and that mistakes happen. It is actually quite common for 401(k) plans to fail annual testing, so you’re not alone!
According to a study by retirement plan data publisher Judy Diamond Associates, almost 60,000 plans across the country failed their most recent nondiscrimination tests, resulting in $794 million in corrective refunds to employees! The vast majority of companies that fail non-discrimination testing have no idea until they receive notice from their Third Party Administrator or 401(k) plan provider.
There are a ton of reasons good companies might fail:
- Lack of awareness: The testing process can be confusing and opaque, and many employers are unaware of IRS regulations in the first place.
- Lots of jargon: The vocabulary used in testing is not very clear and no one takes the time to explain it, so companies frequently miscategorize HCE, NHCE, and key or non-key employees. The definition of “compensation” is also unclear, and many companies aren’t aware that commissions and bonuses count as well.
- Trying to hit a moving target: Contribution percentages are a moving target as employees change contribution rates throughout the year, or as new employees are added to or leave the 401(k) plan.
- Human behavior: Employers have little to no control over how much and when their employees decide to contribute into their individual 401(k) accounts. For example, some highly-compensated employees (HCEs) tend to max out 401(k) contributions at the end of the year, throwing carefully monitored balances awry.
- Inaccessible 401(k) data: Even for employers who meticulously track the contribution rates of individual employees, most retirement plans do not offer easy visibility and tracking into company-wide data.
We address many of these factors in our products and services, but it is fundamentally an informational problem — we have simple, straightforward definitions of NDT terms here.
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What to do when you think you are in danger of failing NDT
When you think you are in danger of failing, you should first calculate the average contribution percentages of HCEs and compare that to the average contribution rates of NHCEs. With Human Interest’s company administrator dashboard, this is easy to do. If the number seems off, you can either encourage participation from NHCEs or to reach out to the HCEs and communicate to them that they should scale back their contributions.
Human Interest tries to go above and beyond the services of traditional 401(k) plan providers by flagging your plan if the likelihood of compliance issues is high. However, while we help you take preemptive steps to address these challenges, there is still no guarantee. If you know in advance that you might have an issue with passing testing, here are our recommended preventative steps:
- Auto-enroll NHCEs into your 401(k) plan.
- Make the 401(k) experience easy: Human Interest’s dashboard is uncomplicated and easy for employees to use, making them more likely to monitor and adjust their contributions as needed.
- Educate NHCEs about the importance of contributing to a 401(k), not just for helping the company pass NDT, but for their own financial futures.
What to do when you have already failed (don’t worry!)
Never fear, you are not alone. And failure, while inconvenient, does not reflect poorly upon you or your company. You do NOT get on the IRS blacklist, you are not viewed as delinquent, and, if handled properly and in a timely manner, there are absolutely no long-standing penalties to either the company or the employees.
The IRS even has fix-it guides (that we link to below) that it publishes to specifically address this issue for the tens of thousands of companies that fail every year.
If you fail ACP or ADP (or both):
When you receive the annual testing results indicating that you have failed ACP/ADP, your Third Party Administrator or other compliance representative will often give you two corrective options:
- Refund HCEs: Refund the HCEs the amount that would bring the average contribution rates down to the acceptable level to pass testing, OR
- QNECs for NCHEs: Give all non-highly-compensated employees (NHCEs) a refund known as a Qualified Non-Elective Contribution (QNEC) that would effectively bring their contribution rates up to the minimum percent required to pass testing. Keep in mind this option is only available when the ADP/ACP test is based on current year testing. QNEC is not an option for prior year testing.
Most employers choose option 1, as option 2 can become quite expensive, depending on the results of the test. However, some recognize that option 2 is essentially bonus or extra match for employees who earn less, relatively, and for whom the money matters a lot more. QNECs, just like general 401(k) matches, are tax-deductible, and so some employers decide just to go this route as a nice gesture for their employees.
If you “fail” top-heavy testing
For companies deemed top-heavy (in which more than 60% of the total 401(k) plan assets are owned by key employees), you must properly contribute and allocate the required top-heavy minimum to the affected non-key employees, similar to the QNEC option above.
Human Interest will guide you through any of these corrective options, and we make it a priority to help you process these as soon as possible so that there will be no tax penalties incurred due to delays.
Tax penalties for failing non-discrimination testing
There are no tax penalties for either employers or employees just for failing NDT, so long as corrections are made in a timely manner.
Any corrective refunds (including both the money over-contributed, as well as any interest or investment gains) made to employees will be taxed as they would have normally been. There are no penalties or further actions required by the employer. Employees will receive an IRS Form 1099-R for the excess contributions to file by the next personal tax deadline.
If you miss the deadline for corrections (March 15th)
As we mentsioned before, plans fail testing all the time. It is important to make the required corrections on time, to avoid any penalties. Companies that do not make corrections by the IRS deadline of March 15 will be responsible for paying a 10% excise tax and filing a Form 5330.
After two years, SCP may only be used as long as the mistake can be classified as insignificant, whereas VCP may be used to correct both insignificant and significant mistakes. After that point, the company’s 401(k) is in danger of losing its tax-favored status — the employer and the employees will be required to pay taxes on the contributions they have made to the plan. If you work with any plan provider, they should hopefully make sure that it never gets to this point.
We have a very detailed post about NDT deadlines here.
Human Interest’s approach to NDT
We believe in financial literacy education and empowering employers and employees with the knowledge to do what is best for themselves and the company. To that end, we offer training about the IRS rules governing their 401(k). We’ve worked with companies to actively prevent failing NDT in advance, as well as helped companies who come to us after failing with a previous 401(k) provider.
Human Interest’s preventative measures:
- Categorizing HCEs, NHCEs, and key employees: To make sure that all employees are properly designated, we sync with payroll and automatically tag employees who meet certain criteria as HCEs and key employees, and send the employee census to the company for review and approval, so that information is accurate and timely.
- Regular notifications to employees: From within our dashboard, all HCEs and key employees are given notifications that they might be subject to certain contribution limits due to IRS regulations, so that there are no surprises when they are either capped by the employer or the refunds are made.
- Company-wide data tracking: As an employer, you are able to see the high-level information for the actions of your employees, so you can monitor the average contribution rates of HCEs and NHCEs and proactively reach out to either encourage members of the former group to contribute or discourage or limit the latter.
- Ease of use and approachability for employees: We also make it very easy to automatically enroll employees, and for them to sign up quickly and easily, which disproportionately impacts NHCEs and leads to higher participation rates among that cohort.
- Flexible plan design: We highly recommend choosing a Safe Harbor 401(k) plan, which will exempt you from 2 of the 3 NDT tests. Additionally, whether you a certain kind of vesting or want to include a Roth 401(k), we can help you set up a plan that suits your employees that is also compliant.
Human Interest’s corrective measures:
As with medicine, prevention is the easiest and most painless remedy. However, even if we are unable to address all issues preemptively, we conduct testing early enough to discover compliance failures by January or early February at the latest. We then communicate the results and solutions to clients quickly, and act to process refunds or corrective distributions to employees well before the March 15 corrections deadline.
IRS non-discrimination testing is required, and it protects workers by ensuring that 401(k) plans are fair and favorable to all employees. They are routine but can be unfortunately confusing and anxiety-inducing. Nobody likes to fail, but with some knowledge, coordination, and guidance from your plan provider, you can quickly correct the problem and your plan will remain in compliance so that you can continue to offer this great benefit to your employees!
If you’re looking for a great 401(k) for your employees, click here to request more information about Human Interest.
Many thanks to Connie D. Husley, QKA, ERPA, and Compliance Specialist, for her help in reviewing the content of this article.