Introduction to Nondiscrimination Testing: How to Stay Compliant
Because 401(k) plans provide significant tax benefits for Employers, 401(k) plans are subject to complex compliance tests that demonstrate the plan does discriminate in favor of owners and / or highly compensated employees. Plans must pass all compliance tests in order to retain their tax-qualified status.
How to pass the tests? This article will introduce the different tests and what they mean to your plan. B&Co can review and test your plan on an annual basis to ensure your plan meets the required compliance tests. We can also review and suggest plan design provisions that help you meet these requirements.
What are the IRS requirements?
- 401(k) plans must meet certain minimum standards concerning coverage of employees
- The plan cannot discriminate in favor of highly compensated employees
- The plan assets cannot be skewed towards the owners and officers of the company.
- Plan contributions cannot exceed IRS limits (e.g. deferrals limited to $19,000 for 2019)
What are the tests that verify plan compliance?
- Coverage Testing: compares who benefits under the plan
- ADP / ACP Testing: compares average rates of employee/employer match contributions
- Top-Heavy Testing: compares the account balances of key employees and owners to non-key employees
- Limits Testing: ensures no employee exceeds the limit on 401(k) deferrals ($19,000 if under 50 years old for 2019). Also ensures other required limits are followed.
Additional tests may be required depending on your plan design.
How are employees categorized for testing?
Many of the tests compare highly compensated employees (HCEs) and key employees to non-highly compensated employees (NHCEs), but what do these terms mean? Employees are categorized based on ownership, compensation and officer status. Each of these types are defined below for plan years ending December 31, 2018.
A highly compensated employee (HCE) is an employee who meets one or more of the following criteria:
- Prior (Lookback) Year Compensation– earned over $120,000 in 2017; some plans may limit this to the top 20% of earners in 2017 (known as the top paid group election); or
- Ownership in Current or Prior Year – owns over 5% of (1) outstanding corporate stock, (2) voting power across corporate stock, or (3) capital or profits of an entity not considered a corporation
A Key employee is an employee who meets one or more of the following criteria during the plan year:
- Ownership over 5%: owns over 5% of (1) outstanding corporate stock, (2) voting power across corporate stock, or (3) capital or profits of an entity not considered a corporation.
- Ownership over 1%: owns over1% of the stock, voting power, capital, or profits, and earned over $150,000 during current year.
- Officer: an officer of the employer who earned over $175,000 during current year; this may be limited to the lesser of 50 officers, or the greater of 3 or 10% of the employee count.
Non-highly compensated employees (NHCEs) and non-key employees are those that do not meet the definitions above.
A Closer Look at Some Tests
Coverage Tests review the ratio of HCEs eligible for and benefitting from the plan against the ratio of NHCEs eligible for and benefitting from the plan. Typically, the ratio of NHCEs benefitting to HCEs benefitting must be over 70%, or further testing is required.
Non-Discrimination Tests. These tests are performed across three sections of a 401(k) plan: the employee contributions, matching and after-tax contributions, and non-elective (employer, non-matching profit sharing) contributions.
- The Actual Deferral Percentage (ADP) Testand the Actual Contribution Percentage (ACP) Test look at the average deferral (traditional + Roth deferral) and average contribution (employer matching + after-tax deferral) rates between HCEs and NHCEs. The IRS limits the disparity between the two groups based on the average rate of the NHCE group.
If a plan fails the ADP and/or ACP test, the employer may have several correction options, which include refunds to HCE and/or contributions to NHCEs. Beasley & Company can assist with determining these options.
- The General Test is required to demonstrate an allocation of profit sharing (non-elective) contributions is non-discriminatory. Many profit sharing contributions are allocated on a basis that are automatically non-discriminatory. The general test is required for contribution formulas that do not automatically satisfy non-discrimination.
Top Heavy Test analyzes the accrued benefits between two groups: Key employees and non-Key employees. Top-heavy determination is an important annual determination that may result in required contributions to plan participants.
A plan is considered top-heavy when the total value (account balance with adjustments related to rollovers, terminated accounts, and a five-year lookback of distributions) of the Key employees’ plan accounts is greater than 60% of the total value (also adjusted as noted above) of the plan assets, as of the end of the plan year.
If the plan is considered top-heavy based on the determination period, typically as of December 31 of the prior year, non-Key employees are due up to 3% in employer contributions if any Key employee makes or receives contributions for the year (including deferral contributions and forfeiture allocations).
If you have questions about your company’s retirement plan and required testing, please contact us at email@example.com or at (918) 742-1123.