401(k) Nondiscrimination Testing: The Plan Sponsor’s Guide
401(k) plans are popular because they offer incredibly valuable benefits for both an organization and its employees. But, these plans also come with very specific requirements for those who sponsor them. And one of the most important requirements is nondiscrimination testing.
To maintain a qualified status under IRS rules, 401(k) plans must adhere to various nondiscrimination tests designed to ensure fairness and compliance. Understanding these tests helps business owners avoid penalties and guarantees plan benefits are equitably distributed.
Below, we’ve answered some frequently asked questions about 401(k) nondiscrimination testing.
What Is the Purpose of 401(k) Nondiscrimination Testing?
The primary goal of 401(k) nondiscrimination testing is to ensure the plan does not disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs).
The IRS defines highly compensated employees as individuals who:
- Own more than 5% of the company at any time during the year or the preceding year, or
- Received compensation of more than $155,000 in 2023 or were in the top 20% of employees when ranked by compensation.
401(k) nondiscrimination testing helps maintain plan compliance with IRS regulations, thereby avoiding penalties and ensuring the plan’s benefits are fair and accessible to all eligible employees.
Do All 401(k) Plans Need Nondiscrimination Testing?
Yes, all 401(k) plans must undergo some form of nondiscrimination testing.
The specific tests applied and their applicability can vary depending on your specific plan. For example, plans that use a safe harbor plan design are automatically exempt from certain tests.
What are the Major 401(k) Nondiscrimination Tests?
There are four major nondiscrimination tests most 401(k) plans must pass: the IRC § 410(b) Coverage Test, the Actual Deferral Percentage (ADP) Test, the Actual Contribution Percentage (ACP) Test and 401(a)(4) General Nondiscrimination Testing.
Actual Deferral Percentage (ADP) Test
The ADP test ensures the deferrals made by HCEs are not disproportionately higher than those made by NHCEs.
The test compares the average salary deferral percentages for HCEs to the average salary deferral percentages for NHCEs. This involves comparing the average deferrals of HCEs to that of NHCEs.
To pass the ADP test, the average contribution rate for HCEs for the current year can’t exceed the greater of:
- 125% of the NHCE average rate, or
- The lesser of:
- 200% of the NHCE average rate, or
- The NHCE average rate plus 2%.
Actual Contribution Percentage (ACP) Test
The ACP test evaluates the fairness of employer matching contributions and after-tax employee contributions. It works the same way as the ADP test, but instead of looking at employee deferrals, it examines the related matching contributions.
IRC §410(b) Coverage Test
The 410(b) test aims to ensure that the plan covers a sufficient number of NHCEs.
If all employees are receiving a benefit, the plan passes the test.
If the 410(b) test is required, employers have two options: the ratio percentage or the average benefit test.
- The ratio percentage test involves calculating the ratio of NHCEs who benefit from the plan to the ratio of HCEs who benefit. The plan passes the test if the ratio percentage is 70% or higher.
- The average benefits test is more complex and consists of two parts.
- The first part involves:
- Ensuring the plan uses reasonable, objective classifications to identify which employees will benefit under the plan, and
- Having a coverage ratio greater than or equal to a safe harbor percentage determined by the IRS.
- If the plan passes both of these tests, it moves on to the second step, where the average benefit percentage for NHCEs must be at least 70% of the HCE average benefit percentage.
- The first part involves:
Most plan sponsors only use the average benefits test if the plan doesn’t pass the ratio percentage test. It’s important to note that some plan documents may be written in a way which limits the availability of both testing options.
401(a)(4) General Nondiscrimination Testing
The purpose of 401(a)(4) general nondiscrimination testing is to evaluate contributions and benefits to ensure the plan doesn’t discriminate in favor of HCEs. The contributions of NHCEs are compared to those of HCEs to determine whether contributions provided to HCEs are proportional to those provided to NHCEs.
The methods used to determine whether the plan passed this test can be complex and may require the services of an actuary.
What Happens if Our 401(k) Plan Fails a Nondiscrimination Test?
Failing a 401(k) nondiscrimination test requires immediate corrective action to avoid penalties and ensure the plan maintains its qualified status. Solutions could include returning excess contributions to HCEs or adjusting employer contributions to correct the imbalance.
What are the Deadlines for 401(k) Nondiscrimination Testing?
Testing deadlines are typically tied to the end of the plan year. Plans generally have 2.5 months after the plan year end to return excess contributions for failed ADP/ACP testing to avoid a 10% excise tax.
The plan can distribute excess contributions any time within a 12-month period. If the plan sponsor doesn’t make the correction within 12 months, the plan can lose its qualified status.
What is the Top-Heavy Test?
A plan is top-heavy when the owners and most highly paid employees (i.e., key employees) own more than 60% of the value of the plan assets.
Companies must perform this test annually based on the account balances on the last day of the prior plan year. If the top-heavy ratio exceeds 60%, the employer must pay a minimum 3% benefit to the accounts of non-key employees.
There’s no need to perform top-heavy testing on a safe-harbor 401(k) that receives only elective deferrals and safe-harbor minimum contributions.
How Should We Correct Test Failures?
There are a few common fixes for plans that fail 401(k) nondiscrimination testing, such as:
- Depositing Qualified Nonelective Contributions (QNECs)
- Depositing Qualified Matching Contributions (QMACs)
- Issuing refunds
- Implementing retroactive plan amendments
- Depositing additional employer contributions
What’s Expected of My Company in the 401(k) Nondiscrimination Testing Process?
A third-party administrator typically completes nondiscrimination testing. However, plan sponsors still have some responsibilities. Companies should be prepared to participate in nondiscrimination testing by:
- Collecting accurate and comprehensive data for all eligible employees
- Ensuring the integrity and compliance of the data
- Coordinating closely with your third-party administrator
- Understanding all requirements and deadlines associated with the testing process
Should We Engage a Third-Party Administrator?
Engaging a competent, professional third-party administrator is always a good idea. Your third-party administrator can provide expertise in conducting and reviewing the results of nondiscrimination tests and guidance in navigating the complexities of compliance.
Learn More About 401(k) Nondiscrimination Testing
If you have any questions about 401(k) nondiscrimination testing or want to discuss your options after a failed test, contact Warren Averett Benefit Consultants.
