What is a 401(k) Nondiscrimination Test?

A 401(k) is a special kind of plan, and it comes with special rules. Among those are nondiscrimination rules, which are designed to make sure your retirement plan benefits all your employees.

To give everyone an opportunity to save for the future, a 401(k) plan can’t favor highly compensated employees or key employers, such as owners. Nondiscrimination tests make sure everything is fair by looking at how much of their income is deferred by employees, how much the company contributes to employee accounts, and what percentage of assets in the plan belong to the highly compensated employees and key employees.

According to the IRS 401(k) overview, the government wants to make sure that deferred wages and employer matching contributions do not overly benefit these two groups:

• Those who own more than 5% of the company, either directly or by family attribution, at any time.
• Those who received more than $125,000 in compensation. You can limit this to the top 20% of employees, ranked by compensation, in your governing plan document.

The government imposes two tests. Let’s start by seeing what each discrimination test measures, how to apply them and what it means if your plan fails.

• The Actual Deferral Percentage test: The IRS says that this test compares the average salary deferrals of highly compensated employees with that of non-highly compensated employees. Each employee’s deferral percentage is the percentage of compensation that’s been deferred to the 401(k) plan. The ADP is calculated by dividing the amount an employee defers by the total W-2 income. The test measures how much income each group contributes to their respective 401(k) plans.
• The Actual Contribution Percentage test: Itꞌs similar to the ADP test, but it compares the average employer contributions received by the two groups — highly compensated versus non-highly compensated — rather than how much they defer. The ACP is calculated by dividing the company’s contribution to an employee by the W-2 income.

Both tests look at the most recent full plan year. If your plan fails either one of the above tests by failing to meet certain ratios, you must take steps to fix it. There are major consequences if you don’t take corrective action. So here are a few fixes recommended by the IRS, any one of which can solve the problem:

• Refund highly compensated employees’ contributions to bring the average contribution rates down to the passing level.
• Make qualified nonelective employer contributions to all non-highly compensated employees to pass the test.
• A combination of the above two corrective actions.

Ultimately, the results of discrimination testing depend on which employees participate by deferring income to their 401(k) accounts, how much they defer and how much a company contributes. It’s a good idea to understand the basics and deadlines because the consequences for late testing or correction can be severe — including IRS penalties, missed tax deductions and even plan disqualification.

Correcting a failure can have unwelcome tax consequences for employees and require you to make contributions you haven’t budgeted for. To address any risk early, it’s advisable to conduct plan testing throughout the year.

Another alternative is to offer special kinds of 401(k) plans: safe harbor or SIMPLE. They are not appropriate for all companies, but if they’re right for you, a big advantage is that they don’t require nondiscrimination testing.

This is just a summary of a complex legal and financial issue. In fact, there are many other rules 401(k) plans have to follow. Your best bet is to work with qualified professionals from Day One, and keep on top of 401(k) status: A little planning can go a long way to keeping your 401(k) compliant.