The Ultimate Guide to 401(k) Nondiscrimination Testing

401(k) nondiscrimination testing—What is it, and why is it important? What happens if you don’t pass your tests, and how can you ensure that you pass?

Whether you’ve been tasked with 401(k) administration, you’ve just started a new 401(k) for your company, or you’re dealing with failed testing for your existing 401(k), there’s a lot of ground to cover when understanding and dealing with nondiscrimination testing.

401(k) plans were designed to help all Americans, from the bottom to the top of the corporate ladder, fund their own retirement. In order to promote fairness in the retirement savings process, The Employee Retirement Income Security Act (ERISA) established 401(k) nondiscrimination tests. ERISA is enforced by the Department of Labor (DoL) and the Internal Revenue Service (IRS). 

The idea behind non-discrimination rules is that 401(k) benefits should be broadly shared. That is, lower paid employees should have similar access to the plan as highly paid employees. And, those lower paid employees should be contributing to the plan as well.

That’s why 401(k) discrimination testing seeks to answer one big question: Does your company’s 401(k) plan benefit all your employees—even at the lower levels—or does it favor owners and executives who make more money? 

Nondiscrimination tests are designed to make sure everyone has a fair chance at saving for their future. For testing purposes, workers are classified either as highly compensated employees or non-highly compensated employees.

Nondiscrimination tests take a magnifying glass to three key numbers:

• How much income is deferred by employees
• How much the company contributes to employee accounts
• What percentage of assets in the plan belong to highly compensated employees and key employees

That’s why there are three key annual nondiscrimination tests to pass each year:

• The Actual Deferral Percentage (ADP) test
• The Actual Contribution Percentage (ACP) test
• The Top-Heavy test

These tests verify that deferred wages and employer matching contributions don’t discriminate in favor of highly compensated employees.

In this article, we’ll give a broad overview of how 401(k) nondiscrimination testing works. Let’s dive in.

401(k) Discrimination Testing: The Basics

What is 401(k) nondiscrimination testing?

Every year, ERISA requires employers to complete nondiscrimination tests to evaluate whether a retirement plan offers equitable benefits to highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). This is done through 401(k) nondiscrimination testing, also known as 401(k) compliance testing.

The types of testing will differ depending on your company’s specific benefits package. If you fail to meet the IRS’ standards, it can mean fines, penalties, and other bureaucratic headaches.

What is the purpose of nondiscrimination testing?

In short: Employers must prove their retirement plans aren’t discriminating in favor of higher-income employees. Nondiscrimination testing confirms that your company’s 401(k) gives HCEs and NHCEs equal opportunity to enjoy the significant tax benefits of a 401(k) retirement plan.

HCEs are subject to an ownership test or a compensation test to calculate whether they own more than a certain percentage of the company sponsoring the package, or whether they exceed a specific income level. NHCEs might participate in a minimum coverage test, compensation ratio test, ADP/ACP test, or a top-heavy determination test.

All these tests will confirm whether NHCEs are given an equitable chance at saving for retirement. They’re used to determine whether a benefits plan is biased toward HCEs. In one example, a compensation ratio test would determine whether your company’s retirement plan includes overtime pay for HCEs, but not for NHCEs. Such an exclusion could be discriminatory.

What happens if a 401(k) plan fails to pass nondiscrimination tests?

It’s every employer’s responsibility to pass these nondiscrimination tests.

But let’s say you don’t pass a nondiscrimination test. What happens next?

You must take the appropriate remedial actions, or your plan can lose its qualified status. That means that all the tax benefits related to your 401(k) plan would go away, and you and all of your employees could be left with a hefty tax bill.

What are some of the common struggles with nondiscrimination test distribution?

Nondiscrimination tests were designed to assess the workforce of traditional large companies. That’s why small businesses and startups, as well as certain medium-sized businesses, have a harder time passing their nondiscrimination tests.

Small and medium-sized companies, like family-owned businesses, generally have more HCEs and key employees. When your workforce has a higher proportion of HCEs, NHCE contributions must be higher. To add to the challenge, smaller companies usually don’t have the resources to provide employees with services to boost employee participation and contribution rates, like financial advising and retirement education.

Startups also face unique problems with implementing 401(k)s and passing nondiscrimination tests. New companies are generally have a high number of HCEs in proportion to NHCEs, and since they may be operating “lean and mean” for some period of time, they might not be able to sidestep nondiscrimination testing with a Safe Harbor plan.

How to perform non-discrimination testing

401(k) nondiscrimination testing is usually performed by a third-party administrator. Employers should still understand the basics of how this testing works, especially when assessing your company’s plan and developing NHCE plan participation and contribution strategies.

HCEs vs. NHCEs vs. Key Employees

When the IRS looks at your 401(k) plan, they’ll place employees in three major groups.

Highly compensated employees (HCEs) are individuals who:

• Owned more than 5 percent of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
• For the preceding year, received compensation from the business of more than $125,000 (if the preceding year is 2019—and $130,000 if the preceding year is 2020),
• Or, if the employer so chooses, was in the top 20% of employees when ranked by compensation*

*Companies with a large proportion of HCEs have the option to use the “Top Paid Election,” in which the top paid group are the top 20 percent when ranked by compensation. This isn’t the standard, but it can be useful when your company has a high number of HCES in comparison to NHCEs.

Non-highly compensated employees (NHCEs) are individuals who:

• Don’t meet the above HCE requirements
• Are newly hired employees who would traditionally qualify as HCEs, but haven’t been with the company long enough to be paid the required $120,000+ a year (they will count as HCEs in the year that they exceed the threshold)

Key employees are the final important category. There are several ways that both highly and non-highly compensated employees can qualify as “key.”

• Any company officer (CEO, CFO, COO, etc.) making more than $170,000.
• Any employee who owns more than 5 percent of the company, or is related to the employee.
• Any employee who owns more than 1 percent of the company AND earns over $150,000.

It’s plain to see why HCEs are often key employees. However, if they are the parent, child or spouse of an employee who owns more than 5 percent of the company, NHCEs can also be key employees even if they don’t meet the compensation requirements.

A note about prior year compensation

Take note of one important nuance regarding HCE and NHCE categorization: Calculations can be based on prior year compensation. Up-to-date employment fluctuation and retirement reporting creates administrative challenges, so if your company’s Plan Document allows it, you can use the prior year’s information.

If your calculations are based on prior year compensation, you’ll also be comparing average contribution rates from the prior calendar year. You’ll know your HCE contribution limits beforehand, which reduces the possibility of having to refund HCE contributions later down the line.

If you’re just started a 401(k), you can’t use “prior year” information, so the IRS allows you to use 3 percent as the NHCE average deferral percentage. Your HCEs will have a maximum contribution of 5 percent.

The potential downside of prior year testing is that the beneficial results of increasing participation rates are not realized until the following year.

Additionally, a plan that uses the prior year testing method for the ACP test will face an automatic failure if it resumes a matching contribution after going for a year without one. This is because the NHCE average for the year when no match is made is 0 percent; therefore, the maximum match the HCEs can receive in the following year is 0 percent.

The testing method can be changed via a plan amendment adopted no later than the last day of the year being tested (e.g., no later than December 31, 2020, for the 2020 ADP/ACP test). A plan can switch from current year to prior year once every five years.

ADP vs. ACP vs. Top Heavy Tests

Actual Deferral Percentage (ADP) test

Our first nondiscrimination test is the Actual Deferral Percentage (ADP) test, which compares the average salary deferral percentages of HCEs to that of NHCEs.

Step 1: Calculate Annual HCE deferral rate.

Gather your HCE contribution rates, then average them.

Deferral Rate = Salary Deferral ÷ Total Compensation

Step 2: Calculate Annual NHCE deferral rate.

Again, gather your NHCE contribution rates, then average them.

Deferral Rate = Salary Deferral ÷ Total Compensation

Step 3: Compare and assess.

The annual maximum HCE deferral rate is based on the contribution rates of your NHCEs. Make sure the percentages fall within the acceptable ranges.

Actual Contribution Percentage (ACP) test

The actual contribution percentage (ACP) test is just the ADP test, but created to include employer match contributions and any after-tax contributions employees make.

Step 1: Calculate Annual HCE deferral rate.

Gather your HCE contribution rates, then average them.

Deferral Rate = Salary Deferrals + Employer Contributions + After Tax Contributions ÷ Total Compensation

Step 2: Calculate Annual NHCE deferral rate.

Again, gather your NHCE contribution rates, then average them.

Deferral Rate = Salary Deferrals + Employer Contributions + After Tax Contributions ÷ Total Compensation

Step 3: Compare and assess.

Make sure the percentages fall within the acceptable ranges.

What happens if my plan fails the ADP/ACP test?

You can correct a failure by either:

• Refunding amounts to the HCEs,
• Providing additional company contributions to NHCEs, or
• Some combination of the two

As long as the correction is made on a timely basis, there are no penalties.

Top-Heavy Test

Unfortunately, there isn’t a fun acronym for this test. 

The good news is, determining if a plan is top-heavy is actually quite simple: If the sum of all key employee account balances is greater than 60% of the total retirement account plan balance, the plan is top-heavy.

Step 1: Gather Key Employee account balances.

Add up the sum of account balances of the Key Employee participants in your plan.  

Step 2: Determine the percentage of account balance contributed by Key Employees.

Divide the total Key Employee account balance by the total account plan balance.

Step 3: Check and assess.

Your plan won’t pass the Top Heavy Test if the quotient is greater than 60 percent.

How often do I need to perform nondiscrimination tests?

As previously mentioned, using data from the prior year can help you determine HCE contribution maximums ahead of time. Monitor your nondiscrimination status throughout the year to prevent administrative headaches during annual testing season.

Annual nondiscrimination testing happens on the last day of the plan year (or the beginning of the next). We’d recommend doing a mid-year assessment, which can help you take preventative action early on—and avoid a potentially costly correction. For instance, if you fail the Top Heavy Test in June, you can limit HCE contributions until the plan passes. You could also prohibit HCEs from contributing in the next plan year. If you don’t do either of these things, you’ll have to make a 3 percent nonelective contribution to all eligible participants.

Important Yearly Nondiscrimination Test Deadlines

It’s important to stay on top of important testing deadlines not only to manage your own administrative workload, but also to help your employees optimize their retirement accounts.

Safe Harbor 401(k) Plan

If you want to skip the hassle of ADP and ACP tests entirely, consider a Safe Harbor 401(k). Safe Harbor plans are structured so you can automatically pass or avoid the ADP and ACP tests altogether (unless there’s a profit-sharing component to the plan).

Safe Harbor plans with a matching contribution encourage your employees to contribute to the plan, which helps you recruit and retain great employees.

Plans can allocate contributions in one of three ways:

1. 1Basic. The employer matches 100 percent of the first 3 percent of compensation, plus 50 percent of the next 2 percent of compensation.
2. 2Enhanced. The matches 100 percent of employee retirement plan contributions up to 4 percent (can be up to 6 percent, if the plan sponsor chooses).
3. 3Non-elective. The employer contributes 3 percent of compensation to all eligible employees, regardless of whether the employee actively contributes to their 401(k) plan.

My 401(k) plan failed nondiscrimination testing. What should I do?

If your plan administrator tells you that your plan has failed nondiscrimination testing, there are several possible causes. No matter the cause, you’ll need to act to fix the issues before your plan loses its qualified status.

Though there are general deadlines, you should refer to your 401(k)’s plan documents for specific information about your statutory correction period. The statutory correction period lays out the exact time frame that you have to take necessary corrective actions in order to pass nondiscrimination testing.

What to do when your 401(k) fails nondiscrimination test strategies

Step 1:  Check again, using a different test method

Reach out to a knowledgeable 401(k) Advisor to help your plan pass by using a testing method that’s different from a typical nondiscrimination test. If your plan is right on the cusp of pass/fail, your plan might get the green light even if you’ve failed your standard test.

If this go-around doesn’t work, it’s time to take corrective action. Even if you did pass with this little trick, you don’t want to deal with failing your nondiscrimination test again, so take precautionary measures to make sure you pass next year.

Step 2: Take corrective action immediately

If your 401(k) plan failed nondiscrimination testing, you have three options for taking corrective action:

1. Make corrective distributions. A corrective distribution happens when the company returns a portion of contributions from HCEs until the plan passes the test. These refunds are taxable in the year they are made.
2. Make QNECs. You can make a qualified non-elective contribution (QNEC) by contributing on behalf of all eligible employees—regardless of how much they contributed to the retirement plan. QNECs are generally used to pass the ADP test.
3. Make QMACs. You can make a qualified matching contribution (QMAC) by making matching contributions based on a percentage of the employee’s elective deferral. QMACs are generally used to pass the ACP test, but can also be used to pass the ADP test.

QNECs and QMACs are less popular, as they tend to be more costly and less convenient to employers.

Step 3: Fix your plan, and encourage participation and contribution

Your best chance for improving your nondiscrimination tests is by encouraging your NHCEs to contribute to their 401(k) plans. This helps balance the proportion of HCE and NHCE contributions, helps your employees get on solid financial footing, and could help boost employee retention.

We Can Help with Nondiscrimination Test Solutions

Passing nondiscrimination testing is essential!

If you need help with nondiscrimination testing, or if you’d like to learn more about our 401(k) Advisor services, please fill out the form below and we’ll get back to you shortly. We look forward to hearing from you.

DISCLAIMER: Advisory Services offered through Prosperity Financial Group, Inc., an Independent Registered Investment Advisor. Securities offered through Fortune Financial Services, Inc. Member FINRA/SIPC. Prosperity Financial Group, Inc. and Fortune Financial Services, Inc. are separate entities.