401(k) Nondiscrimination testing

Nondiscrimination testing is a critical safeguard in the 401(k) retirement system, ensuring retirement benefits are distributed fairly within an organization. When employers offer 401(k) plans, they commit to maintaining a retirement program that serves their entire workforce, not just their highest-paid employees.

The foundation of fair retirement benefits

Nondiscrimination testing represents the Internal Revenue Service's (IRS) method of verifying that 401(k) plans provide proportional benefits to all employees.

These tests examine how much highly-compensated employees (HCEs) contribute compared to non-highly compensated employees (NHCEs). The IRS defines HCEs as employees who earned more than $135,000 in the previous year (as of 2024) or own more than 5% of the business (either directly or through family attribution).

The testing process: A closer look

The annual testing procedure involves several key examinations. The actual deferral percentage (ADP) test compares the average percentage of salary that HCEs defer to the plan against the average percentage deferred by NHCEs. The actual contribution percentage (ACP) test evaluates employer-matching contributions and after-tax contributions.

Maintaining compliance and corrective actions

When a plan fails nondiscrimination testing, employers must take specific steps to rectify the imbalance. Common correction methods include making additional qualified nonelective contributions (QNECs) to NHCEs or refunding excess contributions to HCEs. These corrections must occur within IRS-mandated timeframes to maintain the plan's tax-qualified status.

Some employers opt for a proactive approach by implementing safe harbor provisions. A safe harbor 401(k) plan automatically passes certain nondiscrimination tests by providing minimum employer contributions to all eligible employees. While this approach requires additional employer investment, it offers predictability and reduces administrative burden.

The impact on plan design and management

Successful nondiscrimination testing often begins with thoughtful plan design. Automatic enrollment can significantly increase participation rates among NHCEs. When new employees must actively opt out rather than opt in, participation typically rises across all income levels.

Regular monitoring throughout the year helps identify potential testing issues before they become problems. This might involve tracking contribution patterns, participation rates, and compensation levels. Many employers also provide targeted education programs to encourage broader plan participation.

Creating a sustainable retirement program

Understanding nondiscrimination testing helps employers create more effective and compliant retirement programs. While the rules may seem complex, they serve an essential purpose: ensuring that 401(k) plans fulfill their intended role as a broad-based retirement savings vehicle for all employees.

For those considering implementing or modifying a 401(k) plan, working with experienced retirement plan professionals can help navigate these requirements effectively. They can assist in designing a plan that not only meets testing requirements but also serves the retirement needs of your entire workforce.

Remember, successful nondiscrimination testing represents more than just regulatory compliance – it indicates a retirement plan that truly serves its fundamental purpose of helping all employees prepare for a secure retirement future. Regular monitoring, thoughtful plan design, and proactive management can help ensure your plan meets these important requirements while providing valuable benefits to your entire workforce.