What is 401k Discrimination Testing?

Every year, the Employee Retirement Income Security Act (ERISA) requires employers to undergo 401k discrimination testing to ensure plans are not discriminating against lower-income employees. This testing is usually performed by a third-party administrator, but employers should still understand the basics of how this testing works. The following questions will help you get to know the types of tests performed and what to expect.

What is a 401k discrimination testing?

The Federal Government issues nondiscrimination tests to evaluate the benefits plans of highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). Testing ensures that businesses are compliant with established federal requirements and regulations. The types of testing will vary depending on the specifics of your organization’s benefits package.

HCEs are subject to an ownership test or a compensation test to determine if they own more than a certain percentage of the company sponsoring the package or exceed a specific income level. NHCEs might participate in a minimum coverage test, compensation ratio test, ADP/ACP test, or a top-heavy determination test.

These tests are meant to confirm NHCEs are not being excluded from the same benefits that HCEs receive. They’re also used to make sure the benefits plan isn’t designed to favor HCEs. For example, a compensation ratio test would determine if an organization’s plan excludes overtime pay for NHCEs, but not HCEs. This exclusion could be discriminatory.

What is the ACP test?

The Actual Contribution Percentage (ACP) is another variation of 401k discrimination testing. It looks at the benefits, rights, and features of a plan. It compares the average percentage of matching contributions and after-tax employee contributions in HCEs and NHCEs. An ACP test makes sure that the plan is being used equally by all employees, not just HCEs. Robert Kaplan, a National Retirement Consultant, explains testing will “only work if employees across the entire income spectrum participate.”

ACP testing identifies the contribution ratio of HCEs and NHCEs. For example, if the average NHCE contribution is 3 percent then HCE contributions cannot exceed 3.75 percent.

Actual Deferral Percentage (ADP) tests are also used to compare the average salary deferral percentages between HCEs and NHCEs. This test is another way to find out if all participants are benefiting from the plan.

What is considered a highly compensated employee?

An HCE is a person who either owns more than 5 percent of the company sponsoring the plan or earns more than $120,000 per year. Compensation limit is always based on the previous year, and the ownership limit is based on the current year.

A common fear for HCEs is that their plan will fail discrimination tests. Companies who fail these tests are required to refund excess 401(k) contributions, which means they will owe more income tax for the current year. According to the IRS, HCEs whose company fails discrimination testing will receive refunds that are taxable in the year the refund is received, not the year the contribution was made. Employers who fail testing are required to issue refunds before March 15th.

Organizations who fail are required to fix their mistakes. They are also instructed to conduct an independent review to identify the problem and make qualified nonelective contributions to NHCEs. Once the error is corrected, the IRS encourages employers to avoid future mistakes by implementing “a safe harbor plan design or using automatic enrollment.” The Federal Government advises organizations to “communicate with plan administrators to ensure proper employee classification and compliance with the plan terms.”

If your company sponsors a 401(k) benefits plan, make sure you don’t fall victim to these discrimination issues. Consult with the IRS to make sure your program complies with federal laws.