Nondiscrimination testing: 401(k) compliance

At Human Interest, we work on nondiscrimination testing (NDT) for small businesses. This means monitoring our clients’ accounts to notify them when they’re at risk of failing—and helping set up plans that keep them from failing in the first place. It can be tricky, and since we haven’t found a resource that explains all the components of NDT in a straightforward, simple way, we decided to make our own guide.

Completely new to the world of NDT? We recommend reading the sections below to understand the basics. We delve into more detail about how to perform NDT in our post about safe harbor 401(k) Plans.

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.

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

We’ll be using several acronyms in our walkthrough of nondiscrimination testing. To ensure clarity, we’ve listed them out below (all of these are explained in further detail in later sections):

• NDT: Nondiscrimination 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

What is nondiscrimination testing?

Nondiscrimination 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 NHCEs. (We’ll define these terms and outline the various tests and approaches in greater detail below.)

These tests measure the participation levels of HCEs and NHCEs in order to make sure plans are not overly utilized by HCEs. These tests follow federal regulations that have been established for every type of benefit plan, including retirement plans. The plan year in question is often called the “determination year.” 

While the tests focus on participation levels across all employee types within an organization, multiple factors can play a role in that participation—and whether a company passes or fails the nondiscrimination tests.

Why does nondiscrimination testing exist for 401(k) plans?

Because the U.S. government offers substantial tax benefits through 401(k) retirement savings plans, they want to make sure that plans do not unfairly benefit company owners (Key employees) and HCEs over NHCEs. To ensure a 401(k) plan isn’t “discriminating” or favoring specific employees, it must pass a set of annual tests. 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. But don’t be discouraged—you’re doing a great thing by offering a 401(k) to your employees. We’re here to help make the compliance portion a little less intimidating. Know that 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 (see articles for employer 401(k) contribution tax and 401(k) cost for employers).

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: When determining who is an HCE due to ownership, we must evaluate two time periods: the plan year being tested (the determination year) and the preceding year (the lookback year). If an employee owned more than 5% of the interest in the business at any time during the determination year OR the lookback year, regardless of how much compensation that person earned or received, that person is an HCE. Employees related to an HCE based on ownership will also be treated as HCEs (“related” is defined via family attribution—spouse, children, parents, and grandparents—but NOT in-laws, siblings, or grandchildren).

• Compensation: Compensation is defined by the IRS includes wages and salaries, bonuses, tips, and fringe benefits. When determining who is an HCE due to compensation, we’re only considering compensation in the lookback year. An employee will be an HCE based on compensation if the employee’s annual compensation in the lookback year was $150,000 or more (if the preceding year is 2023), and $155,000 or more (if the preceding year is 2024). The plan may limit the number of HCEs based on compensation by electing in the plan document to use the “top paid group election” as explained further below. HCEs and NHCEs are mutually exclusive categories, so all other eligible employees who do not meet the above tests are considered NHCEs.

Example: If NDT is being run for the 2021 plan year (the determination year), we will look for HCEs based on compensation paid in 2020—and we will look for HCEs based on ownership in both 2020 and 2021.

New, mid-year hires: Keep in mind that a highly paid employee will not be an HCE based on compensation in the first year they are hired because they do not have compensation in the lookback year. So, you might have more NHCEs than you think

Note for HCE-heavy companies: An optional top 20% distinction is called the “top paid group 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 plan document must include the top paid group election specifically before it can be used.  

Key employees

Separate from HCE and NHCE distinctions, someone is considered a Key employee if ANY of the qualifications below are met for the determination year (the year being tested for top heavy status):

• Compensation: Any officer whose annual compensation is $220,000 or more (for the 2024 determination year; $215,000 for the 2023 determination year).

• 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 $155,000 (not indexed). 

The standard approaches: ADP test and ACP test

The ADP and ACP tests apply to “traditional” 401(k) plans (i.e. non-safe harbor plans).  

Actual deferral percentage (ADP) test

This test compares the average percentage of the salary that participating HCEs defer to the average percentage that NHCEs defer. This percentage reveals how relatively engaged in the plan each employee type is at a glance. This test doesn’t reveal the total number or percentage of employees who are making deferrals. Instead, it measures the level of engagement.

There are two percentages you need to calculate:

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

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

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 deferral rate for HCEs in the current year (i.e. the plan year being tested) will be compared to the average deferral rate for the NHCEs from the prior calendar year. This is generally advantageous since you’ll know the HCE limit in advance (see the table in the ADP Test section above), rather than trying to manage against a moving target that changes throughout the year. However, the impact of any increase in participation due to education campaigns will not be recognized until the next year. 

If you’re setting up a new 401(k) that uses prior year testing, 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). 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 if you choose to use the prior year’s testing election.  

A plan may also elect to use the “current year” testing method. This method compares the HCE average deferral rate for the current year with the NHCE average deferral rate for the current year. A plan can be amended to switch from prior year testing to current year testing at any time. However, once the amendment is approved, the plan must generally use the current year method for five consecutive years before switching back to the prior year method. 

Actual contribution percentage (ACP) test

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

A third “test”: The top-heavy determination

While not technically a nondiscrimination test, this determination may result in required contributions to your participants—so we’re explaining it here. The top-heavy test looks to see if Key employees hold more than 60% of the total plan assets by comparing the account balance of Key employees to non-key employees using data from the last day of the prior 12 month testing period. For 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 Key and non-key balances, the plan is top-heavy. If a plan is top-heavy, the employer must generally make a minimum contribution of 3% of each non-key participant’s compensation. Any employer contribution made for the year (e.g. match, profit sharing, safe harbor contributions) can be used to offset any top-heavy minimum contribution owed to a participant.

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

To ensure that your company’s 401(k) plan is neither discriminatory nor top-heavy, it’s legally required that your 401(k) administrator performs testing annually. We strongly advocate for proactive, regular monitoring and tracking of contribution percentages. Staying vigilant through the year can help your company make employee withholding adjustments as needed without the risk of failing the tests or having to make major adjustments near the end of the plan year.

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. (Note: As discussed earlier, the benefit of increased NHCE enrollment will be delayed for plans using prior year testing.).

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

1. Auto-enroll employees into your 401(k) plan: This is shown to increase overall participation rates. In fact, some data shows that, among new hires, automatic enrollment increases participation rates in defined contribution plans to 91%.

2. Make the 401(k) experience easy: Human Interest’s dashboard is uncomplicated and easy for employees to use, making them more likely to sign up and adjust their contributions as needed.

3. 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.

On the flip side (but for the same ratio-preserving reasons), you should notify your HCEs that there’s a limit to how much they may be able to contribute (read 401(k) contribution limits). If communicated properly, they should understand that such a cap is necessary so the business 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 after they’ve already contributed too much that they may need to be refunded. 

If your plan is suspected to be top-heavy, you may also wish to exclude Key employees or ask them not to contribute for the current plan year so the employer can avoid the 3% top-heavy minimum contribution, if required. 

The easy way: Safe harbor design

Using a safe harbor plan design automatically exempts the plan from the ADP and ACP tests (in most cases). As long as you’re not contributing any additional contributions in a plan year, your 401(k) may be automatically exempt from the top-heavy test.

Pros of a safe harbor design:

• Helps businesses automatically pass ADP and ACP testing, may satisfy top-heavy testing requirements

• Provides a tremendous incentive for employees to save for their future and allows all employees to contribute the maximum allowable amounts to their 401(k).

• Includes a mandatory, tax-deductible employer contribution to a 401(k), which can also provide an advantage for recruiting and retaining talented employees

Cons of a safe harbor design:

• Under the safe harbor design, you need to commit to one year (which needs to be renewed on an annual basis).

• Termination fees may be charged by some 401(k) recordkeepers if you ever change your mind (although Human Interest never charges transaction fees)

• There are specific deadlines. If you decide to offer a safe harbor contribution, you may be limited to starting it at a specific time.

• It can be relatively expensive, depending on the salaries of your employees.

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

First off, we want to say that failing nondiscrimination 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 you should avoid any negative long-term consequences and penalties.

Human Interest and NDT

Human Interest is an online 401(k) provider, and because we work with many small businesses, we’ve helped multiple clients address and resolve NDT issues. Here are some ways in which we can help clients with nondiscrimination testing:

• Provide employers an easy-to-use dashboard in which they can look at high-level statistics on contribution rates for employees.

• Communicate to your 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.

• Advise employers on the option to auto-enroll employees so that they opt-out rather than opt-in, which also improves participation rates.

• Make required refunds to HCES, if required so that there will be no tax penalties to the employer involved.

Human Interest can help your business uncover which plan design is best for your budgets, needs, and plausible testing scenarios. And if you've failed testing with a previous provider, we can help uncover the root of the issue. By guiding you along the 401(k) setup process, we can help your business avoid any NDT issues—so you can focus on core business functions.