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The ins & outs of annual nondiscrimination testing for 401(k) plans

Retirement plans use nondiscrimination testing to ensure fairness. Let's demystify the various forms of testing and ensure you can avoid financial penalties for your employees.

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Jan 17, 2024
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Last updated on May 08, 2023

Retirement plans are designed to make later-in-life financial security accessible to the workforce. Like many other financial services, there are checks and balances in place to ensure fairness in these plans. 

Annual nondiscrimination testing (NDT) is mandatory for all 401(k) plans, per the Internal Revenue Service (IRS), to make sure every qualified plan in the United States provides proportionate benefits for each of their eligible employees.

What is nondiscrimination testing?

NDT requires that businesses with a 401(k) plan assess their plan annually to determine that highly compensated employees (HCEs) are not being unfairly favored. 

According to the IRS, an HCE is an individual who either:

  • Owned more than 5% interest in the business (directly or as part of attributed 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 $150,000, if the preceding year is 2023 ($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.

This testing is usually performed by a third-party administrator or recordkeeper who will then analyze the results and report to the plan sponsor whether or not they’ve passed the required tests. Plans are subjected to several different types of testing, though not all plans need all tests.

Types of nondiscrimination testing

There are several NDT types, but not all are necessary for every plan. Testing types are determined based on what type of plan a business offers and what features the plan has.

Many plans will undergo actual contribution percentage (ACP) testing, actual deferral percentage (ADP) testing, coverage testing, and top-heavy testing.

ACP & ADP testing

ACP testing and ADP testing determine if HCEs are benefiting disproportionately from the plan. 

The ACP test measures the average percentage of employer matching contributions and after-tax contributions made on behalf of HCEs and NHCEs comparatively. Similarly, the ADP test compares the average percentages of deferral contributions made on behalf of HCEs vs. NHCEs. 

Both tests use the same methodology. Here’s a breakdown of what a passing ACP and  ADP test would look like:

Annual NHCE contribution rate

Maximum annual HCE contribution rate

Less than 2%

NHCE % x 2

Between 2-8%

NHCE % + 2

More than 8%

NHCE % x 1.25

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, on average, can only contribute 2% (or lower).

Top-heavy testing

Top-heavy testing determines what percentage of the value of plan assets are owned by key employees, who are defined as:

  • An officer who makes more than $215,000 for 2023 or $200,000 for 2022; 
  • Owns 5% of more of the business (actually or via attribution); or
  • Owns more than 1% of the business (actually or via attribution) and makes more than $150,000.

If key employees own more than 60% of the value of plan assets, the plan is deemed to unfairly benefit key employees. The IRS requires a minimum employer nonelective contribution—an employer contribution, usually equal to 3% of compensation, made to an employee’s retirement account even if the employee isn’t making contributions—to be funded.

What are the benefits of midyear testing?

Midyear testing is essentially a trial run of the annual ADP and ACP testing that takes  place sometime during the plan year. During midyear testing, a plan’s year-to-date information regarding average deferral and matching contributions is reviewed on a pass-fail basis. 

While the results of midyear testing don’t guarantee year-end results, they can provide a great bit of insight that can benefit a company in many ways.

Identify and address issues early

There are a lot of ways a plan can fail NDT, so it’s not uncommon. Fortunately, midyear testing can shed light on where a plan is failing. Most commonly, you’ll see:

  • HCE over-participation: If HCEs are contributing a disproportionate amount to the plan or have too much employer matching when compared to NHCEs, a plan may fail.
  • Low NHCE participation. If your NHCEs are not participating in the plan, your HCEs will not be able to contribute to the plan as much as they may like. Encouraging participation through automatic enrollment or by offering an employer match can help bring up NHCE deferral averages so your HCEs may maximize their deferrals during the year

Avoid financial penalties

Plan sponsors and participants benefit greatly from the qualified status of a 401(k) plan. If a plan is found to be discriminatory during annual testing, corrections must be made to keep the plan in compliance with the Employee Retirement Income Security Act (ERISA). Failure to make the appropriate corrections in a timely manner could potentially result in plan disqualification.  

Disqualification means immediate taxation of all contributions made to the plan and compound earnings. Depending on the size of the plan, this could be detrimental to the company itself and could impact the retirement savings of participants.

Additionally, the plan sponsor may be subject to fines from the IRS. 

How to reduce your chances of failing

While there are many ways to fail NDT, there are just as many steps you can take to prevent that from happening.

Add a safe harbor contribution to your plan

Safe harbor 401(k) plans were specifically designed to automatically pass certain nondiscrimination tests to safeguard plan sponsors from repercussions, while maximizing saving potential for participants.

A plan automatically passes ACP and ADP testing with the following safe harbor requirements:

  • Employers make a contribution on behalf of employees that’s either a non-elective contribution of at least 3% of compensation or a 100% match of the first 3% of compensation deferred by each employee plus 50% of the next 2% of deferred compensation.
  • Employer contributions must become 100% immediately vested.
  • Employer provides annual plan notices–including annual contribution limits, availability of safe harbor contributions, and other plan features–to every employee at least 30 days before the start of each plan year.

Redesign your plan with auto-enrollment

According to research from Vanguard, plans with auto-enrollment have participation rates nearly 50% higher compared to plans using the traditional opt-in approach.

Why? Because auto-enrollment allows employers to enroll eligible employees in the plan at a default deferral rate just for meeting eligibility requirements. There’s little to no footwork needed on the end of the employee.

Not only does auto-enrollment get more of the workforce into saving for retirement, it can also:

  • Help businesses pass coverage testing by increasing participation in the plan. 
  • Assist in hiring and retaining top talent. A study by Human Interest found that businesses of all sizes have at least a 70% lower turnover rate (when compared to the average turnover rates from the U.S. Bureau of Labor Statistics) when they offer a retirement plan.
  • Open doors for businesses to take advantage of tax credits. Under the SECURE Act, small businesses that choose auto-enrollment when starting a new 401(k) plan can receive a tax credit of $500 per year for the first three years.

Work with a 401(k) expert

Helping businesses stay compliant is the bread and butter of a third-party administrator’s role. It’s their job to make sure your plan is good to go throughout the year and to help prevent surprises when coming up on annual NDT.

Experts, like 401(k) recordkeepers and third-party administrators, can keep your plan compliant and help you pass NDT by:

  • Providing midyear compliance testing. Doing a rehearsal in the middle of the plan year can highlight big and small issues that can be corrected before the end of year.
  • Guiding failed businesses through remedial action. If a business fails annual NDT, a third-party administrator will be able to create an efficient roap map back to compliance.
  • Educating plan sponsors. It’s likely that businesses aren’t aware of all the ways they can become noncompliant. Recordkeepers and third-party administrators can provide comprehensive instruction on how compliance testing works and how they can pass before the situation becomes dire.

To learn more about starting an affordable, compliant retirement plan, consider Human Interest, a fully bundled 401(k) provider that provides recordkeeping services and more.

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