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Everything You Wanted to Know About 401(k) Discrimination Testing (But Were Afraid to Ask)

In the complex world of retirement and benefits administration, there are many rules and regulations that can fly under your radar as a business owner. For something like discrimination testing, though, you may be aware of them, but unsure about the specifics. If you have questions about them, we’re here to help clear the air.

What is a discrimination test?

The federal government issues nondiscrimination tests to evaluate the benefit plans of Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). How can you know the difference? The IRS designates an HCE as anyone who meets one of the following criteria:

Owned more than 5% of the interest in the company at any time during the year or the preceding year, or a linear family member (I.e. a spouse, a child, or parent) of a 5% owner. Or

Received more than $125,000 in 2020 or $130,000 in 2021, and, if the employer chooses, was in the top 20% of employees when ranked by compensation.

Testing ensures that businesses comply with federal requirements: to confirm that the NHCEs are not being excluded from the benefit plans. Tests will also make sure 401(k) plans aren’t designed to favor HCEs. For example, a compensation ratio test will determine if an organization excludes overtime pay for NHCEs, but not HCEs: such exclusions could be considered discriminatory.

Why is testing necessary?

Retirement plans like 401(k)s offer valued tax benefits for both employers and employees. This is because the government wants employers to help employees retire comfortably and they offer tax incentives to help make this happen. However, it came to happen that some retirement plans were set up and administered so that business owners and HCEs were benefitting from the plans and while NHCEs were included on the plan, they didn’t really benefit from the plan. To help make sure everyone benefitted from saving for retirement, the government designed compliance tests for the plans.

How are these tests done?

Basically, coverage tests look at the percentage of eligible HCEs who are benefitting from the plan compared with the percentage of eligible NHCEs who benefit. If the ratio obtained by dividing the average percentage of NHCEs benefitting from the plan by the average percentage of HCEs benefits. If the result is greater than 70%, the plan passes. If the ratio is below 70%, then the test looks at the average benefit of the NHCEs compared with the average benefit of the HCEs to see if that ratio is 70% or greater.

What types of tests are there?

There are a few different tests to be aware of. Let’s take a quick look at two of the more common ones:

Actual Deferral Percentage (ADP) Tests ensure the employee salary deferrals made to the plan do not disproportionately benefit HCEs.

Actual Contribution Percentage (ACP) Testing ensures the matching and voluntary contributions made to the plan do not disproportionately benefit HCEs.

In both cases, should the plan fail testing, the most common correction method is to distribute excess contributions to HCEs in the amount necessary to make the plan pass testing.

When it comes to retirement plans, making sure your plan passes the government’s nondiscrimination tests is among the top priorities for plan sponsors and administrators. If you need help maintaining your plan’s compliance, the Associated Pension team is trained in and equipped with the knowledge and expertise needed to maintain your retirement plans.