Non discrimination testing

What Is Non-Discrimination Testing?

Non-discrimination testing refers to a set of annual compliance requirements for certain employer-sponsored retirement plans, most notably 401(k) plans. These tests, falling under the broader category of Employee Benefits and Retirement Planning, ensure that a plan does not disproportionately favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs) regarding contributions and benefits. The primary goal of non-discrimination testing is to uphold fairness and equity in tax-advantaged retirement savings vehicles, ensuring that the benefits of deferred taxation are broadly accessible across an employer's workforce. Without passing these crucial tests, a plan risks losing its tax-qualified plan status with the Internal Revenue Service (IRS).

History and Origin

The framework for non-discrimination testing largely stems from the passage of the Employee Retirement Income Security Act (ERISA) in 1974. ERISA established comprehensive regulations for private industry employee benefit plans, including pension and welfare plans, to protect participants and their beneficiaries. This landmark legislation sought to prevent abuses and ensure the security of retirement funds. Subsequent amendments and regulations issued by the Internal Revenue Service (IRS) further refined the rules, particularly with the introduction of the 401(k) plan in 1978. The specific non-discrimination tests, such as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, were developed to enforce the equitable distribution of benefits within these defined contribution plans. The IRS continues to provide guidance and resources, including a "Fix-It Guide" for plans that fail these tests, underscoring their ongoing importance in regulatory compliance.¹³

Key Takeaways

• Non-discrimination testing ensures that employer-sponsored retirement plans do not disproportionately favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs).
• The two primary tests for 401(k) plans are the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test.
• Failing non-discrimination tests can result in corrective actions, such as refunding excess contributions to HCEs or making additional contributions to NHCEs.
• Compliance with these tests is essential for a retirement plan to maintain its tax-qualified status under IRS regulations.
• Safe harbor plans are specifically designed to automatically satisfy certain non-discrimination requirements, alleviating the need for annual testing.

Formula and Calculation

The most common non-discrimination tests for 401(k) plans are the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. These tests compare the average contribution rates of HCEs to those of NHCEs.

Actual Deferral Percentage (ADP) Test:
This test evaluates employee elective deferrals (pre-tax and Roth).
The calculation involves determining the average deferral percentage for both groups:

To pass the ADP test, the ADP of the HCE group generally cannot exceed the greater of:

1. 125% of the NHCE ADP.
2. The lesser of: 200% of the NHCE ADP, or the NHCE ADP plus 2 percentage points.¹²

Actual Contribution Percentage (ACP) Test:
This test evaluates employer matching contributions and after-tax employee contributions.
The calculation involves determining the average contribution percentage for both groups:

Similar to the ADP test, to pass the ACP test, the ACP of the HCE group generally cannot exceed the greater of:

1. 125% of the NHCE ACP.
2. The lesser of: 200% of the NHCE ACP, or the NHCE ACP plus 2 percentage points.¹¹

Interpreting the Non-Discrimination Testing

Interpreting the results of non-discrimination testing is critical for plan sponsors. A passing test indicates that the plan's contribution patterns align with IRS requirements, ensuring the tax-deferred status of the plan remains intact. Conversely, a failed test signals that the plan disproportionately benefits HCEs, requiring corrective action.

A failed non-discrimination test doesn't immediately disqualify a plan. Instead, it triggers a mandatory correction period. The plan administrator must take steps to correct the failure, typically within 2.5 months of the plan year-end to avoid a 10% excise tax. If corrections are not made within 12 months, the plan's tax-qualified status could be jeopardized.¹⁰,⁹ Common corrective actions include distributing excess contributions (and any attributable earnings) to HCEs, or making additional Qualified Nonelective Contributions (QNECs) to NHCEs to raise their average contribution percentage.⁸ The specific interpretation of whether a plan passes or fails directly dictates the necessary steps to maintain compliance and avoid penalties from the IRS or the Department of Labor (DOL).

Hypothetical Example

Consider "Tech Innovations Inc." with a 401(k) plan. In a given year, the NHCEs collectively contributed 3% of their eligible compensation to their 401(k)s.

ADP Test Scenario:

• NHCE Average Deferral Percentage (ADP_NHCE): 3%

To pass the ADP test, the HCEs' average deferral percentage (ADP_HCE) must not exceed the greater of:

1. 125% of ADP_NHCE = 1.25 * 3% = 3.75%
2. The lesser of:
   • 200% of ADP_NHCE = 2.00 * 3% = 6%
   • ADP_NHCE + 2% = 3% + 2% = 5%
     The lesser of these two is 5%.

So, the HCEs' average deferral percentage must not exceed the greater of 3.75% or 5%, which is 5%.
If the HCEs at Tech Innovations Inc. had an average deferral percentage of 5.5%, the plan would fail the ADP test. To correct this, the plan might need to refund some of the elective deferrals to the HCEs to bring their average down to 5% or less, or Tech Innovations Inc. could make additional Qualified Nonelective Contributions (QNECs) to the NHCEs to increase their average, thereby allowing the HCEs to retain more of their contributions.

Practical Applications

Non-discrimination testing is a fundamental component of administering qualified defined contribution plans like 401(k)s in the United States. Its primary application is to ensure that employers comply with tax laws designed to prevent retirement plans from disproportionately benefiting highly compensated individuals.

• Plan Design and Administration: Employers and their plan administrators must design and operate their 401(k) plans with non-discrimination testing in mind. This includes carefully monitoring contribution rates for both Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs).
• Correction of Failures: If a plan fails the Actual Deferral Percentage (ADP) test or Actual Contribution Percentage (ACP) test, specific corrective actions are required. These can include refunding excess contributions to HCEs, which are then taxable to them, or making additional employer contributions (such as Qualified Nonelective Contributions, or QNECs) to NHCEs.⁷,⁶ The IRS provides detailed guidance on these correction methods to help plans regain compliance.⁵
• Adoption of Safe Harbor Provisions: Many employers choose to adopt safe harbor plan designs, which involve specific employer contribution requirements (e.g., a mandatory matching contribution or a non-elective contribution for all eligible employees). By meeting these requirements, plans are generally deemed to satisfy the ADP and ACP non-discrimination tests, thereby simplifying plan administration and avoiding potential failures.⁴
• Regulatory Scrutiny: Both the IRS and the Department of Labor (DOL) oversee compliance with non-discrimination rules. The DOL, for instance, has clarified its stance on fiduciary responsibilities related to plan administration, reinforcing the importance of proper oversight, including non-discrimination compliance.³

Limitations and Criticisms

While non-discrimination testing is intended to promote equitable access to tax-advantaged retirement benefits, it has faced criticisms and presents certain limitations. One significant critique is the administrative burden and complexity it imposes on plan sponsors, particularly smaller businesses. The detailed calculations and potential need for corrective actions can be time-consuming and costly.²

Some research suggests that strict non-discrimination rules, while well-intentioned, may not always achieve their stated goal of increasing coverage for low-wage workers. A study examining the effects of non-discrimination rules on pension participation found that stricter standards did not necessarily increase coverage rates for low-wage workers and, in some cases, might even have been counterproductive by increasing administrative costs for employers, potentially leading to reduced overall plan coverage.¹ This unintended consequence could stem from employers being deterred by the complexity and potential for penalties, opting not to offer plans or to offer less generous ones if they anticipate difficulties in passing the non-discrimination testing.

Furthermore, the need for Highly Compensated Employee (HCE) refunds can be a source of frustration for these employees, who may have made significant elective deferrals in good faith, only to have a portion returned due to the plan's overall participation patterns. This can sometimes disincentivize higher earners from maximizing their retirement savings within the employer-sponsored plan.

Non-Discrimination Testing vs. Compliance Testing

While "non-discrimination testing" is a specific type of regulatory assessment, it is often discussed interchangeably with the broader term "compliance testing." The key distinction lies in their scope.

Non-Discrimination Testing specifically refers to the set of tests, like the Actual Deferral Percentage (ADP) test and Actual Contribution Percentage (ACP) test, designed to ensure that a retirement plan does not disproportionately favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs). Its focus is on the equitable distribution of benefits and contributions.

Compliance Testing, on the other hand, is a more encompassing term that includes non-discrimination testing but also extends to a wide array of other regulatory checks for a retirement plan. This includes, but is not limited to, ensuring adherence to annual contribution limits, vesting schedules, eligibility requirements, top-heavy rules, and timely filing of government forms (such as Form 5500). All of these tests are crucial for a plan to maintain its tax-qualified plan status with the IRS and Department of Labor. Therefore, while non-discrimination testing is a vital part of compliance testing, it is not the entirety of it; a plan can pass all non-discrimination tests but still fail other compliance requirements.

FAQs

What is the main purpose of non-discrimination testing?

The main purpose is to ensure that employer-sponsored retirement plans, such as 401(k) planss, do not unfairly benefit Highly Compensated Employees (HCEs) at the expense of Non-Highly Compensated Employees (NHCEs). This helps maintain the plan's tax-qualified status.

What happens if a retirement plan fails non-discrimination testing?

If a plan fails non-discrimination testing, the employer must take corrective actions, typically by either refunding excess contributions to the Highly Compensated Employees (HCEs) or making additional contributions (called Qualified Nonelective Contributions (QNECs)) to the Non-Highly Compensated Employees (NHCEs). Failure to correct these issues can result in penalties and even the disqualification of the plan.

Can a plan avoid non-discrimination testing?

Yes, some plans can avoid annual non-discrimination testing by adopting a safe harbor plan design. This involves the employer making specific, mandatory contributions to employees' accounts, which automatically satisfies certain non-discrimination requirements.

Who is considered a Highly Compensated Employee (HCE) for testing purposes?

For non-discrimination testing, a Highly Compensated Employee (HCE) is generally defined by the IRS as an individual who meets one of two criteria in the prior year (or current year, if elected): they own more than 5% of the employer, or they received compensation above a certain threshold (which is adjusted annually for inflation).

Is non-discrimination testing only for 401(k) plans?

While non-discrimination testing is most commonly associated with 401(k) plans and their elective deferrals and matching contributions, similar non-discrimination rules apply to other types of qualified retirement plans and certain welfare benefit plans to ensure equitable benefits for all eligible employees.