Many small companies offer retirement benefit plans for their employees, but the IRS has several rules regarding how those benefits impact income taxes. One of the tools used to measure compliance is nondiscrimination testing.
Nondiscrimination Testing: The Basics
The IRS requires employers to run Nondiscrimination Testing (NDT) on certain retirement benefit plans in order to be compliant with ERISA and tax requirements. These tests assess the fairness of the retirement plans by ensuring that the benefits aren’t tailored to Highly Compensated Employees (HCEs) or key employees. The tests ensure that both the deferred wage and employer contribution mechanisms don’t unfairly benefit these individuals.
Nondiscrimination testing requires each 401(k) sponsor to pass two tests each year: the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. Sponsors can also choose between undergoing a Top-Heavy test or increasing employer contributions.
Two key factors determine if a 401(k) plan sponsor passes or fails:
- Employee participation: Highly compensated employees are far more likely to participate than employees who worry they can’t afford to make contributions. This imbalance of type of participating employees can make sponsors fail nondiscrimination tests.
- Employer contributions: Employers can make two types of contributions: matching contributions that match what employees have contributed to their accounts according to a pre-established formula, and nonelective contributions that are made regardless of an employee’s contributions. Having employer contributions can impact a plan’s likelihood of passing.
Cafeteria Plan NDT
Cafeteria Plan NDTs have three test components:
- Eligibility Test: This assesses whether the plan allows enough Non-Highly Compensated Employees (NHCEs) to become eligible and participate in the plan.
- Benefits Test: This portion assesses whether or not the plan gives the same benefits to both non-highly compensated employees and compensated employees.
- Utilization Test: This portion measures which employees are actively participating in the plan, not just if employees can participate in the plan. Self-insured benefits have separate nondiscrimination testing requirements. Small businesses are the most likely to fail this portion of the plan.
When Should NDT Be Performed?
Nondiscrimination testing should happen on an annual basis at the end of the plan year. Companies can also perform mid-year tests to correct any potential problems before the official tests. This is recommended because it’s much easier to fix in-progress problems than it is to adjust and retest after failing.
Actual Deferral & Actual Contribution Percentage Tests (ADP/ACP)
Both ADP and ACP tests assess the fairness of an employer’s 401(k) plan. ADP tests compare the salary deferrals between two employee groups: high compensated and non-highly compensated. It considers the deferral percentage or the percentage of an employee’s total salary that they contribute to the plan.
ACPs test the employer contributions percentages, not employee contributions. This test measures the employer contribution to employees as a percentage of the employee’s contribution to ensure highly compensated employees aren’t receiving unfairly high contributions.
If a plan sponsor fails either test, they have 12 months to correct the discrimination. Otherwise, they may incur pecuniary penalty fees from the IRS. They may also be subject to fiduciary liability and plan disqualification.
How ADP and ACP Tests Work
ADP tests compare the average percentage of money a highly compensated employee will contribute to an employer-sponsored plan to the average percentage of money non-highly compensated employees. The ADP taxes into consideration both pre-tax and Roth contributions, but not catch-up contributions for older employees. ACP tests follow the same general rules.
For the purposes of these tests, highly compensated employees are generally considered to be someone who has (or had in the last year) at least 5% company ownership, was paid at least $130,000, or was in the top 20% of paid employees. According to family attribution rules, being the spouse or child of someone with 5% ownership also makes that person a highly compensated employee. All other employees are considered non-highly compensated employees.
Applying the ADP/ACP Tests
As a general rule, the ADP and ACP tests require that highly compensated employees’ ADP doesn’t exceed non-highly compensated employees’ ADP by more than 2%. However, that threshold gets slightly more granular:
- If the NHCE percentage is 0-2%, the HCE percentage can’t be more than double
- If the NHCE percentage is 2-8%, the HCE percentage can’t be larger by more than 2%
- For NHCE percentages over 8%, the HCE percentage can’t be more than 125% that percentage
Correcting an ADP/ACP Test
If you fail ACP/ADP IRS compliance testing, you can resolve the problem. Employers often fix the problem by returning excess funds to highly-compensated employees (which are then taxed as regular income). Some employers also set caps or strict rules to decrease the likelihood of failing in the first place. These caps can be determined through mid-year testing, so highly-compensated employees can contribute as much as possible without causing a nondiscrimination testing failure.
Also, a Safe Harbor 401(k) plan can give companies access to a 401(k) plan without the NDT requirement.
What Is a Safe Harbor Plan?
A Safe Harbor 401(k) provides nonelective employer contributions. Due to those contributions, the plan is exempt from NDT requirements, and many financial experts recommend choosing Safe Harbor plans because of that exemption. The requirements for a 401(k) to qualify as a safe harbor plan are:
- Employer contributions of 100% on employee contributions up to 3% of the deferred salary and 50% on contributions between 3% and 5% of the employee’s salary
- Nonelective employer contributions of 3% of the employee’s salary
A top-heavy test is the third type of nondiscrimination test that sponsors may need to undergo. Sponsors fail the test if over 60% of a plan’s assets are held by “key employees.” Key employees, who are different from highly-compensated employees, are defined as employees that fit any of these three descriptions as of the year 2020:
- Makes over $175,000
- Owns (or is a qualifying family member under the attribution rules) 5% of the company
- Owns (or is a qualifying family member under the attribution rules) 1% of the company and makes over $150,000
Important Things to Know About Non-Discrimination Testing
NDT is required by the IRS for all plans that fall under Section 125 of the tax code. This testing ensures the plan is equally accessible to all employers and doesn’t unfairly favor highly-compensated employees. Testing should happen each year at the end of the plan year, but companies should also undergo mid-year testing to reduce the risk of failure.
If you want to learn more about how to manage NDT requirements, contact Human Interest today to learn more.
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