401(k) Nondiscrimination Tests Explained

By PLANSPONSOR staff | December 01, 2014
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Richter 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 matching contributions.

The 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 adds.

Richter 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.”

Finally, 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.

“So 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.


Basically, 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.