LAST REVIEWED Sep 18 2019 13 MIN READ
By Joyce Yan Zhang
The IRS designed non-discrimination testing with a typical company in mind. Most companies are pyramidal in structure, with a few executives, a small handful of senior managers, and a large base of employees. In many other contexts, most startups would be considered “small and medium businesses”, but because of factors like equity, salary, and number of employees, there are some unique factors to keep in mind as you dive into non-discrimination testing as a part of your startup HR tasks. If you’d like more context on non-discrimination testing in general or are unfamiliar with terms like HCE, NHCE, and safe harbor, here are some more general articles (we recommend starting with the first one!):
Average companies vs. startups
The average American makes less than $45,000 a year, with median salaries around $29,000. The IRS definition of a Highly-Compensated Employee (HCE) is one who earns more than $120,000 in total compensation in the previous year, or owns more than 5% equity in the company, or is directly related to an HCE. At $120,000 annual income, an individual would be earning in the 94th percentile of all Americans. Sources: 1, 2 Venture-backed startups are not structured like typical companies. They tend to be smaller in size, with a large percent of company owners and HCEs — a reverse pyramid in many cases. Startups are an odd mix of highly compensated employees coexisting with a lack of spare company capital, because venture funding is typically reserved for “growth expenditures”. Because they are often not yet profitable, startups often cannot match 401(k) contributions because of budget constraints, and therefore do not qualify for Safe Harbor, which would exempt them from testing and is a relatively easy option for larger companies. Given these complications, startups are far more likely to run into issues with non-discrimination testing than more traditional companies, and will unfortunately often give up trying to offer a retirement benefit to their employees.
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We were lucky to have been part of the Y Combinator Summer 2015 batch. YC and many fellow portfolio companies are clients of ours, so we have become experts in helping early-stage startups’ 401(k) plans stay compliant. We follow a few simple best practices to help these clients pass non-discrimination testing even without a safe harbor 401(k) match:
Educate employees about the IRS regulations and how it might affect them.
Encourage participation through offering the option for auto-enrollment and giving employees an easy-to-use online dashboard for their 401(k).
Work with the company to design a plan that best fits the needs of the company, including setting prior year testing and discretionary matching.
Educate employees and set expectations for HCEs
Contribution caps: No employee likes being told at the end of the year that their 401(k) contributions have to be retroactively adjusted and their savings and taxes will be affected. However, if communicated properly, many HCEs and key employees would understand in advance that they are capped and that it is required so that the company does not fail IRS compliance tests, especially if the alternative is not having a retirement benefit at all. Most companies that do not offer a match will proactively set a cap for HCEs and key employees, and communicate that contribution percentage to those employees as a company policy. Accurate censuses: Company plan administrators must complete employee censuses, to properly designate all employees who are HCE or key employees as such. However, the employees themselves are often unaware of their own designation, which is why it is important to educate them about their status and what it might mean for their contribution rates. Grumbling: While some employees might grumble that they are capped in how much they can contribute, you should point out that having a company-sponsored retirement plan and access to the fund selection and investment advising of a 401(k) provider like Human Interest is a big perk, and even limited contributions are better than no contributions. Furthermore, employees can also open an IRA and contribute concurrently to a company 401(k) to maximize their retirement savings. Auto-enrollment & UX: It has become best practice to automatically enroll employees in 401(k) plans, as opting out (as opposed to opting in) leads to much higher rates of participation. And without tedious paperwork and a fast online signup, employees are much more likely to participate. Providing educational materials financial/investment best practices will also help: Money Management for Startup Employees Human Interest automatically notifies HCE and key employees within their employee dashboards that their contributions are subject to limits, to ensure that the company stays compliant with IRS regulations.
401(k) plan design for startups
We work with company administrators to design custom plans. Many startups want to attract and retain great talent, especially in a competitive hiring market. They also want to incentivize and reward hard work to early employees as they help build a company. To that end, they usually like to offer bonuses, but, because they are still running on venture capital, startups have to be very deliberate with how they spend it. One attractive option is to use a discretionary 401(k) match as a bonus for employees, if the company grows to a certain ARR or hits their growth targets. A 401(k) match is tax-deductible and untaxed for employers, and employees do not pay taxes on them until they withdraw, as with other 401(k) contributions.
Prior year testing and compensation limits: no data
Another nuance of non-discrimination testing is that startups can begin their plans by designating testing as “prior year” testing, which means that the average contribution rate for HCEs will be compared to the average contribution rate for the NHCE employees from the prior year (instead of the current year). This is generally advantageous since the companies will know in advance what the limit is, rather than trying to manage against a moving target that changes throughout the year. A startup, by definition, is a very young company and as they set up their first 401(k) plan, they will probably not have a “prior year” to compare against — so the IRS allows you to assume 3% as the NHCE average, which means that the HCEs will be able to contribute up to 5% of their compensation on average. Startups also often have employees who have been with the company for less than a year, and HCE status is calculated by compensation of the previous year at the company. So if an employee joined the company in the current year and had no previous year compensation with the company, or only worked for the company part-time and earned less than $120,000 during that time, he/she would count as an NHCE. This is true even if the employee’s annual salary is listed as higher than $120,000. However, this employee would later become an HCE, so it is important to keep the employee census up to date and accurate.
High startup salaries and calculating NDT ratios
The IRS issues annual compensation limits that can be used in testing and contribution calculations each year. For 2016, the limit is $265,000. Only a small fraction of individuals in the US earn anywhere close to this amount annually, and yet quite a few salespeople and engineers in Silicon Valley startups are able to command these salaries. What this limit means is that, for testing purposes, the denominator cannot exceed $265,000. So an individual who earns $1 million a year and reached the maximum $18,500 contribution did not contribute 1.8%, but rather 6.8%. Therefore, when calculating the average HCE compensations, the 6.8% number must be incorporated into the average, making it even more difficult to stay in compliance of non-discrimination testing. We have some example calculations and more detail about the testing restrictions here: Failing Non-Discrimination Testing: How to Correct It (or Prevent Failing Altogether!) Other than safe harbor matching, there is no foolproof way to pass non-discrimination testing, and startups have a trickier time than most because of high average salaries and/or large salary discrepancies.
A typical startup example case
One client in particular has almost 40 employees, with only 3 of those non-HCEs. They were unable to budget for matching and therefore could not go the Safe Harbor route, and the solution in their case is just to proactively communicate to the HCEs that they might be limited in their contribution levels and to encourage the non-HCEs to contribute as much as possible. We have systems that monitor the contributions on an ongoing basis and can restrict contributions of HCEs if they go over a certain amount. Many startups know how important it is to invest in people and provide quality employee benefits on par with much more established companies. However, most startups do not want to become HR/compliance experts — it’s just not a worthwhile area of focus when you are in a hyper-growth state of mind! We make it possible for startups to provide 401(k) plans by easing the complication and pain of compliance testing, freeing up time so that they can focus their time and energy on growth, and providing innovative solutions to their customers. We hope you found this guide helpful! We’d love to hear your experiences (or questions about) having a startup 401(k) — feel free to leave a comment below. Human Interest works with startups like Joyable and Buffer to help their employees save with a great, scalable 401(k). Click here to learn more. Many thanks to Connie D. Husley, QKA, ERPA, and Compliance Specialist, for her help in reviewing the content of this article.
Joyce Yan Zhang
Joyce Zhang previously worked for the Federal Reserve & US Department of Labor. She holds an MBA from Stanford, MPA from Princeton, and BA from Harvard.