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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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.
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:
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.
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 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 determines what percentage of the value of plan assets are owned by key employees, who are defined as:
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.
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.
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:
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.
While there are many ways to fail NDT, there are just as many steps you can take to prevent that from happening.
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:
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:
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:
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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