Nondiscrimination testing is a crucial aspect of Employee Benefits & Retirement Planning, ensuring that employer-sponsored benefit plans, particularly qualified plans like a 401(k), do not disproportionately favor highly compensated employees (HCEs) or key employees over the rest of the workforce. These tests are mandated by the Internal Revenue Service (IRS) to maintain the tax-advantaged status of such plans. The core principle behind nondiscrimination testing is to promote equitable access to and benefits from retirement and other welfare plans for all eligible participants, including both Highly Compensated Employees (HCE) and Non-Highly Compensated Employees (NHCE).
What Is Nondiscrimination Testing?
Nondiscrimination testing refers to a series of regulatory evaluations that employer-sponsored benefit plans must undergo annually to demonstrate that they do not favor higher-earning or ownership-level employees. These tests are a fundamental component of tax compliance for plans offering tax benefits, such as those under the Employee Retirement Income Security Act (ERISA). The primary goal of nondiscrimination testing is to ensure that the valuable tax deductions and deferred tax growth offered by these plans are broadly accessible and utilized across an employer's entire eligible employee base, rather than being concentrated among a select few.
History and Origin
The concept of nondiscrimination in employee benefit plans is deeply rooted in U.S. tax and labor law, largely solidified with the enactment of the Employee Retirement Income Security Act (ERISA) of 1974. Prior to ERISA, many employees faced significant risks of losing their promised retirement benefits due to insufficient funding, mismanagement, or discriminatory eligibility requirements in pension plans. A notable event that highlighted these issues was the Studebaker pension fund default in 1963, which left numerous workers without their promised pensions.30
ERISA was signed into law by President Gerald Ford on September 2, 1974, establishing minimum standards for voluntarily established pension and health plans in private industry.28, 29 This landmark legislation aimed to protect the interests of plan participants and their beneficiaries by setting forth requirements for disclosure, fiduciary responsibilities, vesting, and funding. Within this framework, nondiscrimination rules were instituted to prevent qualified retirement plans from being designed or operated in a way that disproportionately favored company owners, executives, or higher-paid employees. These rules ensure that all eligible employees receive similar benefits, investment options, and tax advantages. The IRS, as a primary regulator, continues to enforce these rules, which have evolved through various amendments to ERISA over the decades.27
Key Takeaways
- Nondiscrimination testing ensures that employer-sponsored benefit plans do not unfairly favor highly compensated or key employees.
- These tests are mandatory for plans to maintain their tax-advantaged status under IRS regulations.
- Key tests include the Actual Deferral Percentage (ADP) test, Actual Contribution Percentage (ACP) test, and Top-Heavy test.
- Failure to pass nondiscrimination testing can lead to financial penalties for the employer and adverse tax consequences for employees.
- Safe harbor plans offer an alternative design that can automatically satisfy certain nondiscrimination testing requirements.
Formula and Calculation
Nondiscrimination testing involves specific calculations to compare the participation and contribution rates of Highly Compensated Employees (HCE) against those of Non-Highly Compensated Employees (NHCE). While the precise formulas can be complex and vary by test, the fundamental approach involves calculating average contribution or benefit percentages for each group and comparing them against IRS-defined thresholds.
Two common tests for 401(k) plans are the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test.
The Actual Deferral Percentage (ADP) test compares the average deferral rates of HCEs to those of NHCEs. An individual's deferral percentage is their elective deferrals divided by their compensation.26
The plan passes if:
- The HCE average ADP is not more than the NHCE average ADP plus 2 percentage points; or
- The HCE average ADP is not more than 2 times the NHCE average ADP.25
The Actual Contribution Percentage (ACP) test similarly compares the average percentage of employer matching contributions and employee after-tax contributions for HCEs and NHCEs.24
Both tests typically allow for a maximum spread between the two groups' average percentages. The specific allowable spread depends on the NHCEs' average contribution rate.
Another common test, not strictly a nondiscrimination test but a compliance requirement, is the Top-Heavy Test. This test determines if more than 60% of a plan's assets are held by "key employees." If a plan is deemed top-heavy, the employer may be required to make minimum contributions to non-key employees.22, 23 These calculations are critical for maintaining the plan's tax-advantaged status.
Interpreting Nondiscrimination Testing
Interpreting the results of nondiscrimination testing is crucial for plan sponsors to ensure their employee benefits remain compliant. The tests essentially measure whether the benefits or contributions are skewed towards HCEs.
If a plan passes its nondiscrimination tests (such as ADP, ACP, and Coverage tests), it means the plan is operating in compliance with IRS regulations, and its tax-qualified status is secure. This implies that the distribution of contributions and benefits is considered fair and does not unduly favor higher-paid individuals.
However, if a plan fails a test, it indicates that HCEs are participating or benefiting disproportionately compared to NHCEs. For example, in an ADP test failure, it means that HCEs are deferring a higher percentage of their salary into the 401(k) than permitted relative to NHCEs.21 Such a failure necessitates corrective action. The employer must either increase contributions for NHCEs or reduce the contributions for HCEs.20 These corrections ensure that the plan continues to adhere to the principle of broad-based benefit distribution, a cornerstone of pension plans and other employer-sponsored retirement vehicles.
Hypothetical Example
Consider "Tech Innovations Inc.," a growing tech company with 100 employees, 10 of whom are Highly Compensated Employees (HCE) and 90 are Non-Highly Compensated Employees (NHCE). Tech Innovations offers a 401(k) plan with an employer matching contribution.
At the end of the plan year, Tech Innovations performs its Actual Deferral Percentage (ADP) Test and Actual Contribution Percentage (ACP) Test.
ADP Test Example:
- The average deferral rate for the 90 NHCEs is calculated to be 3% of their compensation.
- According to IRS rules, if the NHCE average is between 2% and 8%, the HCE average cannot exceed the NHCE average by more than 2 percentage points. So, the HCE average cannot exceed 5% (3% + 2%).
- Upon calculation, the average deferral rate for Tech Innovations' 10 HCEs is found to be 6%.
Result: The plan fails the ADP test because the HCE average deferral rate (6%) exceeds the permissible limit of 5%.
Correction: To correct this failure, Tech Innovations must reduce the contributions of the HCEs to bring their average down to 5%. This typically involves issuing taxable refunds of excess deferrals to the HCEs. Alternatively, the company could make additional contributions (Qualified Nonelective Contributions or Qualified Matching Contributions) to the NHCEs' accounts to raise their average deferral percentage, thereby allowing the HCEs to maintain a higher deferral rate. The choice of correction method often depends on the company's financial planning and desired employee retention strategies.
Practical Applications
Nondiscrimination testing is a critical regulatory hurdle for various employer-sponsored benefits. Its most common application is within retirement plans, specifically defined contribution plans such as 401(k)s, 403(b)s, and profit-sharing plans. For these plans, annual tests like the Actual Deferral Percentage (ADP) test, Actual Contribution Percentage (ACP) test, and the Minimum Coverage Test (IRC Section 410(b)) ensure that eligibility and contributions do not discriminate against Non-Highly Compensated Employees (NHCE).18, 19
Beyond retirement savings, nondiscrimination rules also apply to other employee welfare benefits, including certain health savings accounts (HSAs), flexible spending accounts (FSAs), and group-term life insurance plans. The IRS mandates these tests to ensure that the tax advantages associated with these benefits are not predominantly utilized by Highly Compensated Employees (HCE) or key employees.16, 17
For employers, understanding and proactively managing nondiscrimination testing is essential for maintaining a plan's qualified status and avoiding severe financial penalties, including lost tax deductions and plan disqualification.15 The Internal Revenue Service provides comprehensive guidance on these requirements, emphasizing that contributions or benefits provided under a plan must not discriminate in favor of highly compensated employees.14 Many businesses engage third-party administrators to navigate the complexities of these tests and ensure ongoing compliance.
Limitations and Criticisms
Despite their vital role in promoting fairness, nondiscrimination testing rules come with inherent limitations and criticisms, primarily centered on their complexity and potential for unintended consequences. The tests are often described as intricate, requiring specialized knowledge and sometimes leading to significant administrative burdens for plan sponsors.12, 13 This complexity can be particularly challenging for small businesses and startups, which may struggle to navigate the detailed requirements without professional assistance.11
One major criticism is that despite complying with the mathematical aspects of the tests, some plan designs might still indirectly favor HCEs by limiting benefits for NHCEs through indirect means, such as requiring long service periods for vesting that lower-paid employees may not meet before leaving employment.10 While employers aim to ensure compliance, a significant number of plans do fail their nondiscrimination tests annually, leading to necessary corrective actions such as returning excess contributions to HCEs or making additional contributions to NHCEs.9
Furthermore, the focus of nondiscrimination testing is primarily on the statistical distribution of benefits, rather than the underlying intent or broader economic fairness. Critics argue that while the rules prevent explicit discrimination, they do not necessarily guarantee that all employees receive truly equitable access or benefits, especially given varying employee demographics and financial circumstances. The U.S. Department of Labor, for instance, has intervened in cases where pay practices, while perhaps not violating specific plan tests, led to broader pay discrimination across different employee groups.8 The ongoing evolution of these rules, including changes introduced by legislation like SECURE 2.0, aims to simplify aspects, but the overall landscape of compliance remains challenging.7
Nondiscrimination Testing vs. Qualified Plan
Nondiscrimination testing and a qualified plan are closely related but represent different concepts in the realm of retirement planning.
A qualified plan is an employer-sponsored retirement plan that meets specific requirements set forth by ERISA and the Internal Revenue Code (IRC). These plans receive favorable tax treatment, such as tax-deductible contributions for employers and tax-deferred growth for employees, in exchange for adhering to strict rules designed to protect participants. Examples include 401(k)s, defined benefit plans, and profit-sharing plans. To be "qualified," a plan must comply with a range of regulations, including reporting, disclosure, vesting schedules, and funding standards.
Nondiscrimination testing, on the other hand, is one of the specific requirements that a qualified plan must satisfy annually to maintain its qualified status. It is the process by which a plan demonstrates that it does not disproportionately favor Highly Compensated Employees (HCE) over other employees in terms of participation, contributions, or benefits. Without passing these annual tests, a plan risks losing its qualified status, which can result in significant tax penalties for both the employer and plan participants. Thus, a qualified plan is the type of plan that offers tax advantages, while nondiscrimination testing is the process required to ensure it continues to be eligible for those advantages by operating fairly.
FAQs
What happens if a plan fails nondiscrimination testing?
If a plan fails nondiscrimination testing, the employer must take corrective action to avoid penalties. Common corrections include issuing taxable refunds of excess contributions to Highly Compensated Employees (HCE) or making additional contributions to Non-Highly Compensated Employees (NHCE) to bring the averages into compliance. Failure to correct in a timely manner can lead to IRS penalties, loss of tax deductions for the employer, and even disqualification of the entire plan, resulting in current taxation of all plan assets.6
Are all employer-sponsored plans subject to nondiscrimination testing?
Not all employer-sponsored plans are subject to the same nondiscrimination testing requirements. Generally, plans that receive favorable tax treatment, such as qualified retirement plans (e.g., 401(k) plans, defined benefit plans), are subject to these rules. Government plans and individual retirement accounts (IRAs) are typically exempt from ERISA's nondiscrimination rules. Some welfare plans, like Flexible Spending Accounts (FSA), also have specific nondiscrimination requirements.5
What is a "Highly Compensated Employee" (HCE) for testing purposes?
For nondiscrimination testing, a Highly Compensated Employee (HCE) is generally defined as an individual who: (1) owned more than 5% of the company at any time during the current or preceding year, or (2) received compensation above a certain dollar threshold in the preceding year (indexed annually by the IRS). Employers may also elect to limit the second category to the top 20% of employees ranked by compensation.3, 4
What is a "safe harbor" 401(k) plan?
A safe harbor plan is a type of 401(k) plan design that automatically satisfies certain nondiscrimination testing requirements, specifically the Actual Deferral Percentage (ADP) Test and Actual Contribution Percentage (ACP) Test. This is achieved by the employer committing to specific contribution levels, such as a guaranteed matching contribution or a non-elective contribution, that vest immediately. While safe harbor plans simplify compliance, they often require a greater employer contribution.2
How often is nondiscrimination testing performed?
Nondiscrimination testing is typically performed annually for the preceding plan year. While the tests are conducted after the plan year ends, many plan administrators recommend performing preliminary or mid-year tests to identify potential issues early and allow time for corrective measures, if needed, before the final deadline.1