401(k) Plan Nondiscrimination Testing: Requirements, Failures, and Remedies
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Many Los Angeles and Dallas businesses provide employees access to a retirement plan as part of the overall benefits package. The most common plan types are a traditional 401(k) and safe harbor 401(k), which are employer-sponsored defined contribution accounts under Subsection 401(k) of the Internal Revenue Code (IRC).
In order to retain the qualified plan status under the Internal Revenue Service (IRS) rules, these types of plans must comply with certain nondiscrimination tests established by the Employee Retirement Income Security Act of 1974 (ERISA). These tests are designed to maintain plan fairness and evaluate whether the plan favors officers, owners, directors, or highly compensated employees (HCE) over non-highly compensated employees (NHCE). Given the importance of the test, understanding common failures and resolutions can help plan sponsors avoid noncompliance. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key requirements.
Nondiscrimination Test Requirements
Plans must maintain certain minimum requirements and conduct nondiscrimination testing each year to ensure that employee participation, deferred wages, and employer contributions do not favor the HCE over the NHCE. The following are commonly prescribed tests performed annually:
- IRC §401(m) Actual Deferral Percentage (ADP) Test: Ensures that the ratio of total salary deferrals over annual compensation of the HCE does not exceed the maximum allowable threshold of the same ratio for the NHCE.
- IRC §401(m) Actual Contribution Percentage (ACP) Test: Ensures that the ratio of total employer matching contributions over annual compensation of the HCE does not exceed the maximum allowable threshold of the same ratio for the NHCE.
- IRC §416(c) Top-Heavy Test: Ensures that the HCE account balances do not exceed 60% of total plan assets for the year.
- IRC §402(g) Elective Deferral Limit: Employee deferrals are limited to the lesser of the dollar limit in effect for the year or 100% of the participant’s compensation.
- IRC §415(c) Annual Additional Limit: Total employee and employer contributions are limited to the lesser of the dollar limit in effect for the year or 100% of the participant’s compensation.
Nondiscrimination Test Failures
Employee Fiduciary conducted a survey of more than 3,200 401(k) plans to determine the failure rate of nondiscrimination testing. The results were summarized by plan type.
* Excluding safe harbor plans, which pass automatically.
Nondiscrimination Test Remedies
Safe harbor 401(k) plans are popular because the plan automatically passes the ADP and ACP tests in exchange for required employer contributions. Plans with an automatic enrollment provision have also proven to improve the ADP, ACP, and top-heavy tests. Often businesses have NHCEs who are unaware of the plan and their eligibility to participate. Educating the NHCE about the plan and campaigning for participation is another way to avoid failing the requirements noted above. Small businesses are prone to fail the top-heavy test as the composition of the employee census is predominately the owners.
The most common way to remediate a failed ADP or ACP test is to timely refund the HCE excess contributions. Failure to do so may result in a 10% excise tax on excess contributions.
We’re here to help
Nondiscrimination testing is an important component of compliance with ERISA guidelines. Although most companies do not experience issues, it is important to be aware of how such testing ensures proper plan operation. If you have questions about the information outlined above or need assistance with your 401(k) plan audit, JLK Rosenberger can help. For additional information, call us at 818-334-8631 or click here to contact us. We look forward to speaking with you soon.