Qualified retirement plans, like a 401k, have a nondiscrimination rule stating that all employees of a company must receive the same retirement benefits, regardless of their position and income level at the company.
To do this, a company must divide their employees into two different groups:
- Highly compensated employees (HCEs)
- Non-highly compensated employees (NHCEs)
The IRS sets the qualifications for each group each year. In 2022, the IRS defines an HCE as someone who owns more than 5% of the company sponsoring the plan, either directly or through attribution, regardless of income level, or earns over $130,000 per year in compensation in 2020 and 2021, or $135,000 for 2022. If determining by compensation, the plan may also limit this group to the top 20% of employees.
Any other employee who does not fall under this category is considered as a non-highly compensated employee.
What is nondiscrimination testing?
Each year, the Employee Retirement Income Security Act (ERISA) requires that employers who sponsor a qualified retirement plan undergo nondiscrimination testing to make sure that the plan does not excessively favor owners or highly compensated employees (HCEs) over non highly compensated employees (NHCEs).
All companies who sponsor a 401k plan must pass the tests in order to show that all employees at the company receive the same contribution limits, investment options, employer match, and any other benefits offered.
Put in plain English, HCEs are allowed to have slightly higher retirement benefits, but not above the relationship limit determined by the IRS, which is calculated using the nondiscrimination tests described below.
The three main types of 401k nondiscrimination tests
There are three annual nondiscrimination tests a 401k sponsor must pass:
- The Actual Deferral Percentage (ADP) test – compares employee contributions.
- The Actual Contribution Percentage (ACP) test – compares employer contributions made to employee plans.
- Top heavy test – ensures that key employees don’t own over 60% of the company’s total 401k assets.
The ADP and ACP tests measure employee contributions, and employer contributions received, for both HCEs and NHCEs to ensure that HCEs are not contributing significantly more than NHCEs, or are receiving significantly more in employer contributions compared to NHCEs.
The top heavy test measures total ownership of the plan’s assets to ensure that not more than 60% of the total assets are owned by key employees.
The Actual Deferral Percentage (ADP) test
The Actual Deferral Percentage (ADP) test compares the average salary deferrals of highly compensated employees with the average salary deferrals of non-highly compensated employees. Put another way, it compares how much income HCEs are contributing to their 401k with how much NHCEs are contributing to their 401k. The ADP is calculated by dividing the amount an employee defers by their total W-2 income.
The Actual Contribution Percentage (ACP) test
The ACP compares the average employer contributions received by all employees at the company. The ACP is calculated by dividing the employer contributions to an employee’s plan by their W-2 income.
Passing the ADP and ACP tests
If NHCEs contribute or receive employer contributions equal to or less than 2%, the maximum percentage allowed for HCEs is 2x the NHCE percentage. For example, if NHCEs contribute 1.5% of their compensation into their 401ks, HCEs are only allowed to contribute a maximum of 3% of their compensation into their 401ks. If NHCEs receive employer contributions of 1.5% of their compensation, HCEs can only receive up to 3% in employer contributions.
If NHCEs contribute or receive employer contributions between 2% to 8%, the maximum percentage allowed for HCEs is 2% above the NHCE percentage. For example, if NHCEs contribute 5% of their compensation into their 401ks, HCEs are only allowed to contribute a maximum of 7% of their compensation into their 401ks. If NHCEs receive employer contributions of 5% of their compensation, HCEs can only receive up to 7% in employer contributions.
If NHCEs contribute or receive employer contributions greater than 8%, the maximum percentage allowed for HCEs is 1.25% above the NHCE percentage. For example, if NHCEs contribute 5% of their compensation into their 401ks, HCEs are only allowed to contribute a maximum of 6.25% of their compensation into their 401ks. If NHCEs receive employer contributions of 5% of their compensation, HCEs can only receive up to 6.25% in employer contributions.
| NHCEs percentage | Maximum percentage allowed for HCEs |
|---|---|
| 2% or less | 2x the NHCE percentage |
| Over 2% but under 8% | 2% above NHCE percentage |
| Over 8% | 1.25% above NHCE percentage |
The Top Heavy Test
401k plans must also pass a third test, the top heavy test, which ensures that key employee accounts don’t hold more than 60% of the company’s 401k account plan balance. This test is a little different from the ACP and ADP tests because it looks at key employees rather than highly compensated employees.
What is a key employee?
A key employee is anyone who falls under one or more of the following categories.
- Anyone who makes over $200,000 for 2022
- Anyone who owns more than 5% of the business (either directly or through attribution)
- Anyone who owns more than 1% of the business (either directly or through attribution) and earns over $150,000 for the plan year.
Both highly compensated employees and non-highly compensated employees can fall into the category of a key employee.
Testing frequency
It’s legally required for companies to perform nondiscriminatory testing annually, and usually occurs on the last day of the plan year or the first day of the next plan year. It’s also important to conduct internal tests once or several times throughout the year to make sure that the plan is in compliance and there are no surprises on test day.
What if I fail the nondiscrimination tests?
Failing a nondiscrimination test is actually quite common. But if you fail any of the tests, corrective actions must be taken to avoid penalties.
Steps to correct a ACP or ADP test failure
If you fail the ACP or ADP tests, the IRS recommends taking one of three options:
- Refund HCEs’ contributions to bring their contribution average down (Refunds will be treated as taxable income in the year refunds are received, not the year contributions were initially made).
- Make qualified nonelective employer contributions to all NHCEs to bring their contribution average up.
- A combination of the above.
Steps to correct a top-heavy test failure
If over 60% of the plan assets are held by key employees, the plan sponsor must make corrections by taking two actions:
- Contribute at least 3% of compensation to all non-key employees for the plan year considered top-heavy.
- Vesting period must not exceed 3 years of service if using a cliff-vesting formula, and not exceed 6 years if using a graded vesting formula.
Safe Harbor 401k plan exemption
To avoid nondiscrimination testing, a company can choose to set up a special kind of 401k plan that automatically satisfies these tests.
A Safe Harbor 401k plan must adhere to one of the following guidelines:
- Match 100% of employee contributions up to 4%, but not exceed 6%.
- Match 100% of employee contributions up to 3%, and 50% of the next 2%.
- Contribute 3% of employee compensations regardless of their participation in the plan.
In addition to being except from nondiscrimination testing, a safe harbor 401k provides an incentive for their employees to save for their retirement, and can help attract top talent to work for you based on employer match contribution benefits.