though nondiscrimination testing is likely performed by a plan’s recordkeeper
or third-party administrator (TPA), plan sponsors need to understand the basics of
the tests, including the types of contributions that are tested, the methods
used and the consequences of failing.
Employee Retirement Income Security Act (ERISA) requires several tests each
year to prove 401(k) plans do not discriminate in favor of employees with
some of the tests, employees are divided between non-highly compensated
employees (NHCEs) and highly compensated employees (HCEs). The Internal Revenue
Service (IRS) defines "highly compensated employee" as an individual who:
more than 5% of the interest in the business at any time during the year or the
preceding year, regardless of how much compensation that person earned or received,
the preceding year, received compensation from the business of more than
$115,000 (if the preceding year is 2013 or 2014; $120,000 if the preceding year
is 2015), and, if the employer so chooses, was in the top 20% of employees when
ranked by compensation.
compensation used for determining whether an employee is an HCE is indexed each
Richter, vice president with SunGard’s wealth and retirement unit, breaks the
nondiscrimination rules into three parts. First, he says, there are rules
to ensure there is broad coverage of employees; those compose the 410(b)
once you have a sufficient number of NHCEs covered, you look at the benefits,
rights and features of the plan to ensure they are nondiscriminatory. This is tested
by the ADP and ACP tests.
ADP stands for actual
deferral percentage, explains Robert Kaplan, national retirement consultant for
Voya Retirement Solutions. This test compares the average of salary deferral
percentages for HCEs with the average of salary deferral percentages for NHCEs.
The ADP test applies to pre-tax and Roth elective deferrals. Kaplan says the
purpose of this test is to ensure that all participants, both HCEs and NHCEs, are
benefitting from the plan.
adds that, if an HCE wants to maximize his deferrals, then NHCEs will
also need to make deferrals. So, it is an incentive for the employer to
encourage participation by NHCEs. The most common incentive is to provide for
ACP, or actual contribution percentage test, compares the average of the
percentage of matching contributions and after-tax employee contributions for
HCEs versus NHCEs. Matching contributions and voluntary employee after-tax
contributions (different from Roth elective deferrals) are included in this
test. The purpose of the ACP is to ensure that the actual usage of the plan
feature is widespread and not used merely by the HCEs. “Plans subject to testing
only work if employees across the entire income spectrum participate,” Kaplan
explains: “For example, if I give the HCEs $50,000 and all NHCEs $1, I will
pass coverage, but the actual benefits will be discriminatory. Similarly, if I
establish a 401(k) plan and let all NHCEs participate, I will pass the coverage
tests. However, if the rate of deferrals of the NHCEs isn’t sufficient, then
the HCEs will be limited in the amount they can defer.”
there is a test to ensure the 401(k) plan is not top-heavy; this looks at overall
benefits that have been accumulated by key employees. Generally, if more than
60% of the overall assets in the plan are attributable to key employees
(different from HCEs), then the plan is top-heavy and certain minimum benefits
may need to be provided to the non-key employees. Defined by the IRS, a key
employee is any former or deceased employee who at any time during the plan
year was an officer making more than $170,000 (this is indexed each year); was an
owner of more than 5% of the business; or was an owner of more than 1% of the
business and making more than $150,000 for the plan year.
the first two—coverage and nondiscrimination of benefits—are annual tests
looking only at contributions for a specific year, whereas the top-heavy rules
are a test based on total accumulated benefits,” Richter says.
the coverage test looks at the percentage of eligible HCEs who are benefitting
from the plan and compares that with the percentage of eligible NHCEs who are
benefitting from the plan. If the ratio obtained by dividing the average
percentage of NHCEs benefitting from the plan by the average percentage of HCEs
benefitting from the plan is greater than 70%, the plan passes the coverage
test. If the ratio of the two falls 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.
There are two methods
for performing the ADP and ACP tests in which the average of the applicable
ratios of the HCEs is compared with the average of the ratios of the NHCEs. A
plan needs to satisfy one of the two tests and may generally use either the
prior-year or current-year percentage for the NHCEs in applying the tests.
first method provides that the ratio of the contribution average of HCEs to
that of the NHCEs may be no more than 125%. For example, if the average NHCE contribution
is 3%, then the average HCE contribution may be no more than 3.75%.
the second method, the average contribution for the HCEs may not exceed the
lesser of the average contribution of the NHCEs plus 2% or the average
contribution of the NHCEs times two. For example, if the average contribution for
the NHCEs is 3%, then the average contribution for the HCEs may not exceed 5%
(the average contribution of the NHCEs plus 2%). If the average contribution
for the NHCEs is 1%, then the average contribution for the HCEs may not exceed 2% (because 1% times two is less than 1% plus 2%).
the 410(b) coverage test is failed, plan sponsors must bring the plan into
retroactive compliance by the end of the plan year, either by extending
coverage to a broader group of NHCEs or by modifying contribution allocations
or benefit accruals. According to information on the Employee Benefit Research Institute website, if the sponsor fails to bring the plan into compliance—i.e., leaving the failed coverage test uncorrected—HCEs will have to report as income their vested
accrued benefit that was not previously reported as income on their income tax returns.
the ADP and ACP tests, Kaplan says, “If the plan fails either test the employer
must take corrective action in the 12-month period following the close of the
plan year in which the oversight occurred.”
IRS explains two methods for correcting a failed ADP or ACP test:
the amount necessary to raise the ADP or ACP of the NHCEs to the percentage
needed to pass the tests, and make a qualified nonelective contribution (QNEC)
to all eligible NHCEs in that amount, and
excess contributions, adjusted for earnings, to the HCEs. If any excess
matching contributions are not 100% vested for the participant, the applicable
percentage must be forfeited. Kaplan notes that, for calendar year plans, distributions
must be done by March 15 (2.5 months following the plan year) to avoid excise
a plan is found to be top-heavy in a plan year, the plan sponsor must make a minimum contribution to the non-key employees. The contribution
is generally 3% of compensation.
notes that SIMPLE 401(k) and safe harbor 401(k) plans are not subject to either
the ADP or ACP tests because, in lieu of testing, they deposit mandatory fully
prefers increased benefits for NHCEs or non-key employees. That is why there
are provisions in the law to give employers an exemption from the ADP and ACP
tests and the top heavy rules,” Richter adds. “Specifically, safe harbor 401(k)
plans can be designed to avoid these tests. That is the carrot. The cost is
that safe harbor plans require certain minimum contributions for NHCEs.”