While nondiscrimination testing might sound like a culture-building exercise, it’s actually a much more specific set of 401(k) testings conducted by the IRS to assess the financial equity of a company.
The truth is that there’s a lot that goes into 401(k) nondiscrimination testing, and sifting through pages and pages of legal documents and government guidelines could seem like a huge burden, especially when you’re already so busy with the day-to-day operations of your business. It is still, however, a necessary and important task that companies need to invest time in.
Below is everything you need to know about nondiscrimination testing and how to create a more equitable financial structure at work.
What are nondiscrimination tests?
401(k) nondiscrimination tests assess, primarily, two things:
- Does your company's 401(k) plan benefit everyone in the company equitably?
- Are owners and executives benefiting from their 401(k) plan at a disproportionate rate relative to other employees in the company?
Nondiscriminatory tests look at the difference between highly compensated employees (HCEs), those who own a large percentage of the business or receive a high enough income to place them in the HCE bracket, and non-highly compensated employees (NHCEs). Nondiscriminatory tests ensure that all the 401(k) plans are financially equitable by looking at the difference of income between HCEs and NCHEs, how much the company contributes to their accounts, and the percentage of assets that belong to NCHEs.
Key employees are another important category, and they include company officers who make more than $170,00, any employee who owns more than 5% of the company, or any member of the company who earns more than 1% of the company and makes more than $150,000.
By comparing the income, benefits, and 401(k) plans across all the payment brackets, the IRS can assess whether individuals in each category receive equitable benefits and if companies are discriminating against NCHEs.
The tests come in two forms, the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test, which are given annually by the IRS.
The final test, the Top-Heavy test, is different from the ADP and ACP in that it focuses primarily on key employees.
According to the 401(k) ADP and ACP guide, you can calculate your ADP and ACP numbers by:
“The ADP test is met if the ADP for the eligible HCEs doesn't exceed the greater of:
- 125% of the ADP for the group of NHCEs, or
- the lesser of:
- 200% of the ADP for the group of NHCEs, or
- the ADP for the NHCEs plus 2%.
The ACP test is met if the ACP for the eligible HCEs doesn't exceed the greater of:
- 125% of the ACP for the group of NHCEs, or
- the lesser of:
- 200% of the ACP for the group of NHCEs, or
- the ACP for the NHCEs plus 2%.”
While this might sound complicated, it’s essential that companies take a hard look at how all of their employees, officers, and executives are receiving their benefits. The good news is that the IRS has several ways in which companies can self-correct and ensure they are in line with these regulations for the future.
Below we’ll look at a few ways companies can increase their chances of passing the test.
Employee participation in 401k plans
One way to increase the chance of failing a nondiscrimination test is to have a low 401(k) employee participation percentage. Participation in a 401(k) plan is optional, and some employees may not see the value or choose to participate in a plan.
Low employee participation, coupled with much higher participation from key employees and HCEs, can increase your chance of failing a nondiscrimination test. It’s incumbent on the 401(k) plan sponsor, typically the employer, to encourage participation from their employees.
How employers contribute to their employees’ 401(k) plans can also affect the determination of their nondiscrimination test. Contributions can be made in one of two ways:
- Nonelective contributions, which are contributions made from the employer to the employee, regardless of whether an employee defers their income to their plan
- Matching contributes, which refer to contributions that are measured by how much an employees defers their income to their 401(k) plan
When structured appropriately, matching benefits are a win-win for everyone. Employees benefit from their employer’s matching contribution, and employers can enjoy some financial perks from contributing to their employees’ plans. If employers don’t take advantage of or enjoy a disproportionate amount of benefits, these structures often help companies demonstrate 401(k) nondiscrimination.
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