Understanding the Basics of Nondiscrimination Testing

Nondiscrimination testing is a requirement for many businesses that offer employee benefit plans, such as retirement or health insurance plans. Though it may seem like a daunting task, understanding the basics of nondiscrimination testing is crucial to maintaining compliance with government regulations and ensuring a fair workplace for all employees. 

In this article, we’ll define nondiscrimination testing, explain its importance, and provide step-by-step guidance for companies looking to comply with the necessary regulations.

What Is Nondiscrimination Testing?

Nondiscrimination testing is a process that compares the contributions and benefits of highly compensated employees (HCEs) or high-ranking employees to those of non-highly compensated employees (NHCEs) within a company’s retirement plan. 

This testing is a crucial aspect of employee benefit plans, such as 401(k) plans, and is required by the Internal Revenue Service (IRS). For 401(k) plans, there are three types of required tests: ADP (actual deferral percentage), ACP (actual contribution percentage), and top-heavy 401(k) tests, all of which are quite distinct.

The ACP test focuses on employer matching contributions and employee after-tax contributions, while the ADP test examines employee pre-tax deferrals and Roth contributions. Both the ACP and ADP tests aim to maintain a balanced distribution of benefits between HCEs and NHCEs. 

In a top heavy 401k plan, over 60% of the plan assets’ value is owned by key employees—owners and the highest-paid individuals within the company. To prevent such issues, the top-heavy test focuses on the overall plan balance, making sure that the accumulated assets of key employees do not exceed 60% of the entire plan’s assets. 

These tests, while varying in their methodology, are designed to help businesses achieve a fair distribution of retirement plan benefits for all employees.

Why Is Nondiscrimination Testing Important?

Nondiscrimination testing is essential for businesses, as failing to comply with the regulations may result in severe penalties from the IRS. These penalties can include disqualification of the entire plan, resulting in tax consequences for both the business and its employees.

Companies that offer employee benefit plans, such as 401(k)s or other qualified retirement plans, are subject to nondiscrimination testing. It is crucial for these businesses to be aware of the testing requirements and ensure compliance with federal regulations to avoid negative consequences.

The Best Retirement Plan to Avoid Nondiscrimination Testing

Safe harbor 401(k) plans have gained traction among small business owners seeking to ensure compliance and equitable benefits for all employees with ease. These plans present two main contribution alternatives: the safe harbor match and the non-elective contribution.

The safe harbor match entails employers matching their employees’ contributions up to a predetermined percentage, typically 100% for the initial 3% of salary deferrals and 50% for the following 2% of salary deferrals. 

Conversely, the non-elective contribution method involves employers contributing a fixed percentage (commonly 3%) of each employee’s salary, irrespective of whether the employee participates in the plan.

The safe harbor plan is even recommended by the IRS for businesses that want to avoid any problems whatsoever.

Who Needs to Comply With Nondiscrimination Testing Regulations?

Businesses that offer qualified retirement plans such as 401(k) plans or other benefits, like group health insurance, must typically comply with nondiscrimination testing regulations. 

These rules apply to both large enterprises and small businesses, so it’s essential for all companies that provide employee benefits to understand and implement the testing requirements.

Steps to Perform Nondiscrimination Testing

If you want to successfully perform nondiscrimination testing in your company, ensure that you follow the following steps:

• Coverage and participation tests. These tests check if a reasonable percentage of NHCEs benefit from the retirement plan compared to HCEs. There are two primary tests: the ratio percentage test and the average benefit test.
• Top-heavy tests. This test reviews if the plan is top-heavy, meaning the account balances of key employees (e.g., owners and officers) exceed 60% of the total plan assets.
• ADP and ACP tests. These tests ensure that HCE contributions and deferrals do not disproportionately exceed those of the NHCEs.
• Address issues identified in the testing process. If any of the tests fail, the company must take corrective actions, such as distributing excess contributions, making additional employer contributions, or restructuring the plan. 
• Document and monitor results. Keep accurate records of the testing process and results for at least six years, as required by the IRS.

Bottom Line

Grasping the fundamentals of nondiscrimination testing is essential for companies offering employee benefit plans. Adhering to these regulations ensures a fair work environment and helps avoid IRS penalties. Plus, 81% of individuals state that retirement benefits play a vital factor in their job search, so it’s in your best interest to offer such plans.

Carrying out the required steps in nondiscrimination testing, such as coverage and participation tests, top-heavy tests, and ADP/ACP tests, enables companies to spot and rectify any potential issues. It is vital to document and track the testing process to maintain records in accordance with IRS requirements. 

By proactively participating in nondiscrimination testing, businesses can maintain compliance, foster equity, and offer valuable retirement benefits to their employees.