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Non-Discrimination Testing: The Basics of IRS 401(k) Compliance

By Vijay Mirpuri

At Human Interest, we work on non-discrimination testing for small businesses every day. We monitor all of our clients’ accounts to notify them when they’re at risk of failing, and help set up plans that keep them from failing in the first place – all included. It can be tricky, and since we haven’t found a good resource that explains all of the components of non-discrimination testing in a straightforward, simple way, we’ve decided to make our own guide!

We delve into more detail for more onerous sub-topics here:

If you’re completely new to the world of NDT, we recommend starting off by reading the sections below to understand the basics. We hope you find it helpful! If you’re looking to set up a 401(k) you can feel confident about, reach out to our team and we’ll be happy to answer any other questions you have.

Why does non-discrimination testing exist for 401(k)s?

Because the U.S. government offers substantial tax benefits through 401(k) retirement savings plans, they want to make sure that 401(k) plans do not unfairly benefit company owners (key employees) and highly-compensated employees (HCEs) over non-highly compensated employees (NHCEs). To ensure that the 401(k) plan isn’t “discriminating” or favoring specific employees, the plan must pass a set of annual tests, and this responsibility falls on the company offering the 401(k) to its employees.

While most traditional, large companies have no issues passing, the tests were not designed with startups and SMBs in mind and can be confusing and difficult to navigate. Don’t be discouraged! You’re doing a great thing by making the effort to offer a 401(k) to your employees, and we’re here to make the compliance portion a little less intimidating. The IRS isn’t trying to scare you away from setting up a 401(k) — in fact, the government encourages employers to offer retirement benefits through tax credits and deductions!

Non-discrimination testing requires that employees of a certain status (highly compensated employees and key employees) stay within a specific contribution rate, as determined by the contribution rate of non-highly compensated employees. We’ll define these terms and then outline the various tests and approaches below!

Acronyms: NDT, SMB, HCE, NHCE, ADP, ACP

We’ll be using several acronyms as we provide a walkthrough of non-discrimination testing in this article! To ensure clarity, we’ve listed them out below. All of these are explained in further detail in later sections:

NDT = Non-discrimination testing

SMB = Small and medium sized business, typically any company with fewer than 100 employees

HCE = Highly compensated employee

NHCE = Non-highly compensated employee

ADP Test = Actual deferral percentage test

ACP Test = Actual contribution percentage test

Note: many of the compensation dollar amounts in the more detailed definitions below tend to be increased every few years by small increments by the IRS to account for inflation. For example, the $120,000 cap used to be $115,000 back in 2014.

HCE (Highly Compensated Employees) and NHCE (Non-Highly Compensated Employees)

An HCE is technically defined as an employee who meets either of the following qualifications, as outlined by the Internal Revenue Service:

  • Ownership: The employee owned more than 5% of the interest in the business at any time during the year OR the preceding year, regardless of how much compensation (defined by the IRS as including wages and salaries, bonuses, tips, and fringe benefits) that person earned or received. OR, the employee is related to an owner. “Related” is defined via family attribution (spouse, children, parents, and grandparents but NOT in-laws, siblings, or grandchildren).
  • Compensation: The employee’s annual compensation was $120,000 or more and, if the employer so chooses, was in the top 20% of employees when ranked by compensation in the previous year.

HCEs and NHCEs are mutually exclusive categories, so all other eligible employees who do not meet the above tests are considered NHCEs.

Detailed side note only relevant to very HCE-heavy companies: The optional top 20% distinction is called the “top paid election”. The “top paid group” is the top 20% in compensation of the entire participant group. This characterization is normally only used when there is a relatively large number of HCEs — this is a very specific use case, so if you have questions about this, let us know!

The HCE (and consequently, the NCHE) definition and count can be tricky because of the “any time during the year” and the “top 20% of employees when ranked by compensation” components. These two factors create moving targets so the categorization of who is and isn’t an HCE and your NHCE to HCE ratio may both change as the year progresses and raises are given, employees join/leave the company, etc. For this reason, most HCE categorizations are determined by prior year compensation, as described in detail below.

New, mid-year hires: Keep in mind that if an HCE joined your company this year, or if they were not at the company for the full year before, they could technically be NHCEs for the purposes of NDT, since they were not fully compensated (by your company) over $120,000/year. So you might have more NHCEs than you think!

Key Employees

On top of the HCE/NHCE distinction, someone is also considered a key employee if ANY of the qualifications below are met:

  • Compensation: Any officer whose annual compensation is $170,000 or more
  • Ownership OR relationship: Any employee who owns more than 5% of the company, or is directly related to someone who does
  • Ownership AND compensation: Any employee who owns more than 1% of the company and earns more than $150,000 An HCE may also happen to be a key employee, and an NHCE could also potentially be a key employee (< $120,000 in compensation/bottom 80% of compensation but is directly related to someone who owns > 5% of the company).

The Standard Approaches: ADP Test and ACP Test

If just reading the title of this section is exhausting you, we recommend skipping to the next section, “The Easy Approach: Safe Harbor Match.” Safe Harbor Match requires the company to match employee contributions (i.e. offer them automatic contributions) but exempts the company from the ADP and ACP tests, so it’s the recommended option if you have the capital to spare.

Actual Deferral Percentage (ADP) Test

There are two percentages you need to calculate:

1. Annual HCE Contribution Rate: Group the HCEs together and calculate their average annual employee contribution rate as a % of their total compensation.

2. Annual NHCE Contribution Rate: Group the non-HCEs together and calculate their average annual employee contribution rate as a % of their total compensation.

Annual NHCE Contribution Rate

Maximum Annual HCE Contribution Rate

2% or less

NHCE% x 2

2-8%

NHCE% + 2

more than 8%

NHCE% x 1.25

This table represents a causal relationship: the annual NHCE contribution rate dictates the maximum allowed contribution for the HCEs. For example, if the NHCEs contributed 1%, the HCEs, as an average, can only contribute 2% (or lower).

A note on calculating HCE salaries by prior year vs. current year: “Prior year” means that the average contribution rate for highly-compensated employees will be compared to the average contribution rate for the non-highly compensated employees from the prior calendar year instead of the current year. This is generally advantageous since you’ll know in advance what the HCE limit is (see the table in the ADP Test section above), rather than trying to manage against a moving target that changes throughout the year.

If you’re setting up a new 401(k), you won’t have a “prior year” to compare against — so the IRS allows you to assume 3% as the non highly-compensated employee average (the left-hand column in the ADP Test table). This means that for your first year of administering a 401(k), your highly-compensated employees will be able to contribute up to 5% of their compensation on average.

Actual Contribution Percentage (ACP) Test

This test applies only to companies offering 401(k) match. The calculations and breakdowns are the same as with ADP, but include employer match and after-tax contributions when calculating the average contribution rate.

A Third “Test”: The Top-Heavy Determination

This is not technically a non-discrimination test, but a determination that may result in required contributions to your participants, so we’re explaining it here. Group key employees together and calculate their total account balance from the prior year. In the first year of the plan (no assets in the prior year), the top heavy determination is done on the last day of the current year.

If the key employees’ total account balance exceeds 60% of the entire plan’s account balance, the plan is deemed to be top heavy and the employer may be required to make a contribution to participants (based on plan document specifications).

Action steps for the ADP, ACP, and top-heavy tests

To ensure that your company’s 401(k) plan is non-discriminatory and not deemed top-heavy, it is legally required that your 401(k) administrator perform testing annually. However, given that being determined top heavy may result in required contributions from your employees (this can be a huge headache), we strongly advocate for more proactive, regular monitoring and tracking of contribution percentages by cohort (and lucky for you, Human Interest can help your company with this!).

It’s important that throughout the year, employers encourage NHCEs to contribute to their 401(k) plans so that the ratio isn’t skewed too heavily to the HCEs. This is both a helpful thing to do from an NDT perspective and a good thing to do for your employees in terms of financial literacy.

Here are 3 tips to increase their contribution rates that can be done proactively before annual testing:

Here are some recommended resources for your employees who are reluctant to contribute, or are confused about 401(k)s altogether:

On the flip side (but for the same ratio-preserving reasons), you should notify your key employees and HCEs that there is a limit to how much they may be able to contribute. If communicated properly, they would understand that such a cap is necessary so that the company does not fail IRS compliance tests, especially if the alternative is not having a retirement benefit at all. This is a much better scenario for all involved than having to notify your HCEs and key employees after they’ve already contributed too much that they may need to be refunded.

The Easy Way: Safe Harbor Match

Safe harbor is the most popular match that companies do, because it automatically exempts you from the ADP and ACP tests. As long as you’re not doing a profit-sharing plan, your 401(k) will also be automatically exempt from the top-heavy test. If you’re not sure whether your plan has a profit-sharing feature, then you probably don’t have one.

Requirements of a safe harbor match:

  • Company matches 100% of all employee 401(k) contributions, up to 4% of their compensation, OR
  • Company matches 100% of all employee 401(k) contributions up to 3% of their compensation, plus a 50% match of the next 2% of their compensation

Pros of a safe harbor match:

  • Automatically pass ADP and ACP testing, satisfy top-heavy, and allow all employees to contribute the maximum allowable amounts to their 401(k).
  • Provide a tremendous incentive for employees to save for their future.
  • A matching 401(k) gives you an enormous advantage for recruiting and retaining talented employees, and is tax deductible.

Cons of a safe harbor match:

  • Under the Safe Harbor match, you need to commit to 1 year, and this needs to be renewed on an annual basis.
  • There is a termination fee charged by some 401(k) recordkeepers if you ever change your mind.
  • There are specific deadlines, so if you decide to offer safe harbor, it may take a few months to take effect. More detail here: Non-Discrimination Testing Deadlines.
  • It can be relatively expensive, depending on the salaries of your employees.

More information: Safe Harbor 401(k) Plans: Everything You Need to Know

What happens if I fail NDT? What can I do?

First off, we want to say that failing non-discrimination testing is quite common, and you shouldn’t be embarrassed or stressed out! If you take corrective measures quickly, it’s quite easy to resolve and avoid any negative, long-term consequences and penalties.

We have a full post about what to do when you don’t pass NDT here: Failing 401(k) Non-Discrimination Testing

Human Interest and NDT

You may be wondering why and how we know so much about NDT, and it’s because it’s part of what we do! Human Interest is an online 401(k) provider, and because we work with many small businesses, we’ve been through the NDT battle with multiple clients.

Our NDT experience:
  • We’ve helped companies set up completely new 401(k) plans and actively prevent any NDT issues.
  • We’ve helped companies decide which plan design is the best for their budgets, needs, and plausible testing scenarios.
  • We’ve helped companies who come to us after a poor experience with another 401(k) provider that caused them to fail NDT.
  • We’ve helped stressed out founders, CEOs, COOs, directors of HR, and business owners with questions and worries about NDT so that they can focus on their core business functions.

The ways in which we help clients with non-discrimination testing, with a combination of technology and friendly service!:

  • Give employers an easy-to-use dashboard in which they can look at high-level statistics on contribution rates for employees.
  • Communicate to employees the rules of IRS testing, both during training and also through notifications on our website.
  • Encourage contributions from all employees, especially non-highly compensated employees, through ease of use and financial literacy education.
  • Give employers the option to auto-enroll employees so that they opt out rather than opt in, which also improves participation rates.
  • Remit money quickly if the test is failed, so that there will be no tax penalties involved.

If you’ve made it this far and want more detail, here are the rest of the articles in our NDT series:

We hope you found this guide helpful. Let us know at [email protected] if there are any other NDT-related topics you’d like us to write about!

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.