Failing 401(k) nondiscrimination compliance testing


By Vijay Mirpuri

An employer-provided retirement plan such as a 401(k) can help demonstrate that you care about your employees. In some cases, employers may even benefit from tax advantages provided by these plans. However, to ensure 401(k) plans aren't favoring specific employees such as highly-compensated employees (HCEs) or key employees, they must pass certain annual nondiscrimination tests (or NDT for short) based on the plan’s features.

Failing NDT is actually fairly common. However, by taking corrective measures, businesses can avoid any long-term consequences and penalties.

So why do plans fail nondiscrimination testing?

NDT can be confusing and inconvenient for employers offering a qualified plan. A majority of plans that fail NDT may have no idea until they receive notice from their plan service provider. Ultimately, there are numerous reasons plans may 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: Vocabulary used in testing can be unclear, so plan sponsors frequently confuse terms (for example, HCE, NHCE, and Key employees*). The definition of “compensation” used for testing can also be unclear.

  • 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 to a 401(k). For example, some HCEs tend to max out 401(k) contributions at the end of the year, throwing carefully monitored balances awry.

*Looking to add to your retirement vernacular? The Human Interest Retirement Glossary includes simple, straightforward definitions of NDT terms.

What tests are included in NDT?

There are several nondiscrimination tests that a qualified plan may be subject to, including ADP testing, which compares average deferral rates of HCEs to non-highly compensated employees (NHCEs). ADP is the most common, followed by ACP testing, which compares the average matching rates of HCEs to NHCEs. Another common NDT is the top heavy test, which ensures that key employees do not hold the majority of plan assets. A plan with assets of 60% or more that belong to a key employee is considered to be “top heavy”, which may require additional employer contributions to the plan.

What to do when you think you are in danger of failing the ADP test

First, it’s important to know whether your plan uses “current year” or “prior year” testing (click here for more information on NDT basics). The “current year” testing method compares HCE average deferral rates for the current year with NHCE average deferral rates for the current year. On the other hand, the “prior year” testing method compares average deferral rates for HCEs in the current year (i.e. the plan year being tested) against average deferral rates for NHCEs from the prior calendar year.

For plans using the “current year” method, it’s possible to make changes that will have some immediate impact on the test results. If sample testing indicates the tests will fail, you can encourage participation from NHCEs by either: 

  • Matching contributions (or increasing current matching contributions), or 

  • Communicating to HCEs that they may want to scale back their contributions to avoid possible refunds for the year

What to do when you have already failed (don’t worry!)

Never fear, you aren’t alone. While inconvenient, failure doesn’t reflect poorly upon a plan or its sponsor. You do NOT get on the IRS blacklist and you aren’t viewed as delinquent. If handled properly and in a timely manner, there are absolutely no long-standing penalties to the plan sponsor or the employees required to receive a refund. The IRS even has fix-it guides that address specific NDT tests (we’ll link out to those below) for the numerous plans that fail every year.

If you fail ACP or ADP (or both):

When you receive the annual testing results indicating that you’ve failed an ACP or ADP test, your plan service provider will explain the two corrective options:

  1. Refund HCEs: Refund the HCEs the amount that would bring the average contribution rates down to the acceptable level to pass testing, or

  2. QNECs for NCHEs: Give all NHCEs an additional contribution known as a qualified non-elective contribution (QNEC) that would effectively bring their contribution rates up to the minimum percentage required to pass testing. (This option is only available when the ADP/ACP test is based on current 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 the latter is an extra contribution for employees who earn less, relatively speaking. QNECs, just like other employer contributions, are tax-deductible, which provides an incentive for some companies to choose this option instead of refunding contributions to HCE’s.

Learn more: IRS 401(k) plan fix-it guide for ADP and ACP tests

If you “fail” top-heavy testing

Some qualified plans are deemed to be top-heavy and must contribute and allocate a required top-heavy minimum contribution to the affected non-key employees, similar to the QNEC option above. The actual amount due depends on the plan type and contributions made to the plan for the year it is considered to be top-heavy.

Human Interest will guide you through any of these corrective options and makes it a priority to help you process these as soon as possible so that there will be no tax penalties incurred due to delays.

Learn more: IRS 401(k) plan fix-it guide for top-heavy failure

Tax penalties for failing nondiscrimination 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 refunds as well as any interest or investment gains) made to employees will be taxed in the year distributed. There are no penalties or further actions required by the employer. Employees will receive an IRS Form 1099-R for any refunds to file by the next personal tax deadline.

If you miss the deadline for corrections (March 15)*

While it’s not uncommon for plans to fail testing, it’s important to make required corrections on time to avoid any penalties. Companies that do not make corrections by the IRS deadline of March 15 (for calendar year plans) must pay a 10% excise tax and file a Form 5330. If the March 15 deadline is missed, refunds must still be made by December 31.

Plans that miss the December 31 deadline must use a self-correction program (SCP) or voluntary correction program (VCP) under the IRS Employee Plans Compliance Resolution System (EPCRS). Failing to correct the issue can lead to plan disqualification—and the 10% penalty for missing the March 15 deadline still applies. EPCRS guidelines specify how corrections must be made and require employers to make a QNEC contribution to the plan, as well as make refunds in some cases: 

  • If error is considered significant, the SCP is available only if the issue is corrected within three years of the year of failure (the plan year in which testing was conducted). 

  • If error is considered insignificant, it can be corrected at any time using the SCP. 

*Plans using Eligible Automatic Contribution Arrangements that meet certain requirements have six months to make refunds before the 10% penalty applies.

Learn more about NDT deadlines here.

Human Interest’s approach to NDT

At Human Interest, we believe in financial literacy education and empowering employers and employees with the knowledge to do what is best for themselves and the company. We’ve worked with companies to take preventative action against failing NDT and assisted companies who come to us after failing NDT in prior years to make plan document adjustments in the hopes that future years will not fail the NDT. Human Interest’s preventative measures include:

  • Categorizing HCEs, NHCEs, and key employees: To make sure 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: All HCEs and key employees are given notifications within our dashboard that they might be subject to IRS contribution limits. This helps reduce surprises if contributions need to be capped or refunds need to be 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 the latter.

  • 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.

  • Flexible plan design: We highly recommend choosing a safe harbor 401(k) plan, which may exempt you from several of the NDT’s.

  • Auto-enroll NHCEs into your 401(k) plan: We make it very easy to automatically enroll employees, which helps increase NHCE participation and drive participation rates for better NDT results. Higher NHCE averages reduce your chances for a refund.

As with medicine, prevention is the easiest and most painless remedy. Human Interest strives to communicate the results and solutions to clients quickly—and acts to process refunds or corrective distributions to employees well before the March 15 corrections deadline. 

IRS nondiscrimination testing is required and protects employees by ensuring that 401(k) plans are fair to all. Nobody likes to fail, but with some knowledge, coordination, and guidance from your plan service 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! Looking for a great 401(k) for your employees? Click here to request more information about Human Interest.

Vijay Mirpuri

Article By

Vijay Mirpuri

Vijay Mirpuri, QPA (Qualified Pensions Administrator), is a former 401(k) Compliance Manager at Human Interest.

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