How midyear nondiscrimination testing can help your 401(k) plan

LAST REVIEWED Aug 04 2022 16 MIN READ

By Wendy Baker, J.D. + Independent Freelance Contributor*

Key Takeaways

  • Midyear nondiscrimination testing (NDT) can help assess if your 401(k) plan is at risk of failing key annual tests

  • While it doesn't guarantee your plan will pass NDT, it can help alert you if your plan is at risk

  • Ultimately, midyear testing can help small businesses take corrective steps to avoid NDT failure

Midyear nondiscrimination testing (NDT) can help assess if your plan is at risk of failing the annual tests that traditional 401(k) plans must pass. Not all providers offer midyear testing, but Human Interest does. Passing midyear testing is not a guarantee that your plan will fail or pass NDT at the end of the year. But it can alert you to existing issues and give you time to assess your options. 

Generally speaking, larger companies have less of an issue passing NDT simply due to the size of eligible employees. Smaller companies may have a more difficult time passing testing. If NDT fails, employers must decide if the plan will: 

  • Make refunds of elective deferrals to certain highly compensated employees (HCEs), or 

  • Make additional, unexpected, contributions to the plan for non-highly compensated employees (NHCEs). 

Midyear testing can help small businesses take corrective steps to avoid NDT failure—and help you better prepare for an upcoming failure and its implications.

Let’s review: What’s 401(k) nondiscrimination testing?

We have a complete guide to NDT—but for the purposes of understanding midyear testing, we’ll review key details. NDT consists of several different tests completed annually on traditional 401(k) retirement plans to assess the fairness of the plan, specifically by ensuring that HCEs or key employees (including business owners) are not unfairly benefitting from the plan. 

An HCE is defined by the IRS as an individual who either:

  • Owned more than 5% interest in the business (directly or as part of family ownership) at any time during the current or the preceding year, regardless of how much compensation they earned or received, or

  • Received compensation for the preceding year from the business of more than $130,000, if the preceding year is 2020 or 2021 ($135,000 if the preceding year is 2022) and, if the employer chooses in the plan document, was in the top 20% of employees when ranked by compensation.

To ensure a plan is fair, NDT measures plan participation levels of HCEs and NHCEs. HCEs and key employee contributions must stay within a specific rate, as determined by the contribution rate of NHCEs. The higher the average salary deferral of NHCEs to the plan, the higher the HCEs’ salary deferral can be. This ensures HCEs aren’t disproportionately benefiting from a plan. 

What does midyear nondiscrimination testing do, exactly?

A midyear compliance test reviews a plan’s year-to-date information to determine the likelihood a plan may pass or fail compliance testing at year-end. (Remember, midyear outcomes do not guarantee year-end results!) This testing looks at your eligible employees’ average deferral and matching contributions, comparing those of HCEs and NHCEs. 

At Human Interest, we compare compensation and contribution records from a company’s payroll provider between the dates of January 1 through June 30 of the current year to project the income and contributions by participants for the full year. There are numerous end of year compliance tests, but Human Interest only runs one  of them midyear: the actual deferral percentage (ADP) test.

Actual deferral percentage (ADP) test

The ADP test compares the average deferrals of participating HCEs compared to those of participating NHCEs. The test first determines each participant's actual deferral percentage by dividing their total deferrals for the applicable year (not including catch-up contributions) by their compensation for that same year. The actual deferral rates are averaged for NHCE and HCE groups so the two can be compared. These are the NHCE ADP and the HCE ADP. 

When making these comparisons, the prior plan year NHCE ADP will be compared to the current plan year HCE ADP, unless current year testing is elected in the plan document. 

There are two ways to pass the ADP test: 

  1. The “1.25” test says if the HCE ADP is not more than 125% of the NHCE ADP, the test passes. 

  2. The “2 plus, 2 times” test says if the HCE ADP is not more than 2 percentage points greater than the NHCE ADP, and the HCE ADP is not more than 2 times the NHCE ADP, the test passes.

Plans aren’t required to pass both tests—and the greater of the two test results will be applied. A simplified way to explain these tests is in the following chart*:

*Click here for more information on calculating ADP tests.

What to do if you’re at risk of failing nondiscrimination testing

As we’ve reviewed, it’s not uncommon for businesses—especially small ones—to be at risk of failing NDT. Common causes of changes in testing results include:

  • Incorrect labeling of HCEs. (This can be avoided by reviewing your employee data throughout the year for accuracy. If your payroll provider can give the data directly to your plan’s recordkeeper, even better.)

  • An increase in HCE participation after midyear testing.

  • A decrease in NHCE participation after midyear testing.

  • Termination of NHCEs after midyear test results that impacts employee demographics. The number of NHCE terminations that would result in a significant change to employee demographics is specific to each company.

While results are based on partial-year data, midyear testing can project where your plan is headed with respect to NDT—and gives your business an opportunity to consider its options, should your plan be at risk of failing. For example, it can help you decide which correction method to use if the final NDT test(s) fails and how you’ll fund any employer contributions, should you make a contribution rather than a refund to HCEs. 

Midyear testing results may also cause your business to consider making plan design changes that may help all employees save more for retirement (explained later in this article). If a midyear test suggests the likelihood of failing, there are a few things you can do to potentially  increase the NHCE ADP for the year.

Consider amending the plan to be a 3% nonelective safe harbor plan 

If the midyear testing indicates that a plan is at high risk of failing NDT for the current year, the plan sponsor may want to change plan designs so NDT isn’t an issue. If the plan is amended for the current year to be a safe harbor nonelective contribution design plan, the plan will pass  NDT for the year. 

To take advantage of this opportunity, the amendment must be done by December 1 (for calendar year plans). The plan sponsor will be required to make a 3% nonelective contribution to all eligible employees (regardless of deferrals), based on the employee's compensation for the full year. This contribution is typically made after the end of the plan year. If you don’t act by December 1, you can still amend the plan to a safe harbor nonelective design (and through the end of the next plan year), but you’ll be required to make a 4% nonelective contribution for the full plan year instead of a 3% one.   

Communicate with employees about participation 

If your plan is using a current year testing method, you may be able to increase NHCE contributions (and the NHCE ADP) by encouraging NHCEs to contribute to the plan. Reminding employees that a 401(k) plan is available—and providing updates on how to enroll—can send a message that your business cares about its employee’s retirement savings and is providing a valuable benefit.

You may also want to consider telling HCEs that there’s a chance they won’t be able to contribute up to the full IRS limit for the plan year. If this happens, some HCEs will receive refunds. In response, HCEs may choose to reduce their deferral rate for the remainder of the year or wait to see if they’re actually refunded. Only the business can decide if it’s better to give HCEs a heads-up of this nature or to wait for them to be surprised if a refund actually occurs. 

It's important to note that failing NDT is fairly common. However, by taking corrective measures, your business can avoid long-term consequences and penalties. Learn more about failing 401(k) compliance testing.   

Plan design options that may help NDT issues

Since NDT takes into account all eligible employees—and employee turnover and plan participation fluctuate throughout the year—your plan risks failing every year. The good news is that there are changes your business can make to your retirement plan to help reduce (or even eliminate) NDT failure issues.

Adding auto-enrollment to your plan

Help increase plan participation among NHCEs by adding auto-enrollment, an automatic contribution arrangement that allows employers to enroll eligible employees in the plan at a default deferral rate. This requires employees to opt-out of making contributions, rather than opting in. Some data indicate that auto-enrollment may increase plan participation. In fact, plans with an auto-enrollment plan design have participation rates nearly 50% higher compared to plans using an opt-in approach, according to 2021 research from Vanguard. Plus, those same employees also saved an average of 57% more than those in voluntary plan designs.

You may also add “auto-escalation” plan features to encourage plan participants to increase their savings via automatic contribution increases, usually made annually. Like auto-enroll, participants must opt-out (rather than opt-in) to this feature. Auto-escalation may assist employees with meeting their retirement goals. In fact, 2022 research from Vanguard on plans it administers, found that even modest increases in participant deferral rates (1-3% percentage points) could empower 20% of participants to realize a 75% retirement replacement ratio.

Adding a safe harbor contribution

Want to automatically pass key NDTs while providing an opportunity for all your employees to maximize their savings? A safe harbor 401(k) plan ensures all eligible employees receive an employer contribution. If properly designed, employers get a “pass” on the ADP and ACP (actual contribution percentage) tests. This means that all plan participants—owners, HCEs, and NHCEs alike—can max out contributions.Any 401(k) plan can be designed to include a safe harbor contribution, but there are some rules to follow. 

At Human Interest, there are three types of safe harbor options you may select. All employers should realize this fixed, mandatory contribution is generally required to be immediately 100% vested. Additionally, safe harbor plans have strict deadlines. Depending on what safe harbor feature is right for your plan, you may have to wait until the start of a new plan year to add it.

Combined with auto-enrollment, a safe harbor plan design can help empower all your employees to save for the future. Click here for a more detailed overview of safe harbor contributions—including plan design options, deadlines, and more.

Midyear testing results: Now what?

Keep in mind that, even with midyear testing, things can happen in the second half of the year that may change your annual testing results. Unexpected life events, for example, can cause NHCEs to lower their deferrals or stop altogether. Unless the deferral average of your HCE and NHCE groups stays exactly the same for the next six months, testing results will shift.

If plans do fail NDT, Plan Sponsors and plan providers must work to make corrections before IRS deadlines. If you've failed testing with a previous provider, Human Interest can help uncover the root of the issue. 

Here are some ways Human Interest can help with nondiscrimination testing:

  • Provide employers with an easy-to-use dashboard that provides 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 they opt-out rather than opt-in, which improves participation rates.

  • Make required refunds to HCEs, so there will be no tax penalties to the employer.

Want to learn more about midyear compliance testing? Interested in adding a safe harbor contribution? Contact us to discuss your plan design options today.

*Amy Johnson is an independent contractor commissioned by Human Interest to help contribute to this article.

Wendy Baker is Senior Legal Counsel at Human Interest, bringing over 25 years of experience exclusively in the ERISA space, spanning defined contribution plan recordkeeping and administration. She has a J.D. from Case Western Reserve University, is a member of the North Carolina and Ohio Bars, the American Bar Association, and industry groups.