Nondiscrimination Testing

Purpose

N/A

Details

Overview

Many companies offer 401(k) plans for contributions in retirement investment plans. Frequently, the company provides a partial, or matching, contribution for each dollar the employee contributes to the plan. The government defers the taxes due for the amounts contributed to and earned by 401(k) plans until the employee withdraws money from the plan.

The tax advantages available to a qualified plan are contingent upon the plan covering an adequate cross section of the sponsoring employer's employees. To determine whether a plan meets this requirement there are a number of objective tests that measure the extent to which a plan benefits employees, often comparing the treatment of highly compensated employees with the treatment of non-highly compensated employees.

Nondiscrimination tests ensure that highly compensated employees do not take substantially greater advantage of this tax savings than lower-paid employees. The industry uses the term HCE, or highly compensated employee, interchangeably with key employee and non-HCE for an employee who is compensated at a lesser amount than an HCE or key employee.

A highly compensated employee is one who meets at least one of the following criteria:

Owned 5 percent of the company at any time during the determination year or the look-back year

Received compensation in excess of $85,000 during the look-back year and, at the election of the employer, is a member of the top-paid group during the look-back year.

In nondiscrimination testing for 401(k) plans, the first of two major components that determine plan status is the average deferral percentage (ADP). This percentage is calculated per employee, per annum. ADP represents the average amount of money deferred into the plan and allocated to the employees' accounts. This amount is expressed as a percentage of their compensation. The ADP of the non-HCE group determines the maximum ADP of the HCE group. In general, the HCE group may have a slightly higher ADP than the non-HCE group, but if it is too high, the plan is discriminatory and excess deferrals must be returned to the HCE group.

The second major component is the average contribution percentage (ACP). The ACP represents the average amount of employer-matching funds and employee post-tax contributions and is expressed as a percentage of compensation. You apply the ACP test in the same manner as the ADP test to measure the amounts contributed and allocated to employees' accounts.

A plan may be "disqualified" if it is discriminatory. When a plan is disqualified, the following events occur:

Some or all of the employer's income tax deduction for contributions made to the plan will be disallowed

The employee's income and tax deferrals will be lost

The interest earned on employer and employee contributions will lose its tax deferral

In addition to the 401(k) related tests, the 415 Report can be reviewed. The 415 Report identifies all employees, on a pay-period by pay-period basis, who have withheld more on a pretax basis than the government allows.

The Nondiscrimination Report program (P083600) groups together all of the tasks associated with nondiscrimination testing, and provides access to these tasks through a centralized point of entry that functions like a workbench. The workbench also provides a visual representation of current and historical test scenarios, the results of the tests, and the various stages of a current testing process. You can link to the Payroll system to review and verify the test results relating to employee/employer related plan contribution and employee compensation.

Glossary

The following terms are used throughout Nondiscrimination Testing:

Highly compensated employee (HCE)
An employee who meets at least one of the following criteria:

Owned 5 percent of the company at any time during the determination year or the look-back year

Received compensation in excess of $85,000 (indexed) during the look-back year and, at the election of the employer, is a member of the top-paid group during the look-back year.

Key employee
See Highly-compensated employee

Non-highly compensated employee (NHCE)
An employee who does not meet at least one of the following criteria:

Owned 5 percent of the company at any time during the determination year or the look-back year

Received compensation in excess of $85,000 (indexed) during the look-back year and, at the election of the employer, is a member of the top-paid group during the look-back year.

Non-key employee
See Non-highly compensated employee

Average deferral percentage (ADP)
The average amount of money deferred into a plan and allocated to the employees' accounts. This amount is expressed as a percentage of the employees' compensation.

Average contribution percentage (ACP)
The average amount of employer-matching funds and employee post-tax contributions to a plan. This amount is expressed as a percentage of the employees' total compensation.

Determination year
The 12-month period running from January 1 through December 31 of the current testing year.

Look-back year
The 12-month period running from January 1 through December 31 of the year prior to the testing year.

The processing options 1, 2 and 3 of report R083675 - 401(k) Discrimination Results are the current percentages used for final Average Deferral Percentage (ADP) and Average Contribution Percentage (ACP) testing. By federal regulation, the ADP and ACP of Highly Compensated Employees (HCEs) cannot exceed the greater of:

1.25 times the ADP of the Non-Highly Compensated Employee (NHCEs) OR

the lesser of:

2 times the ADP of the NHCEs or
2 plus the percentage points of the ADP of the NHCEs
The same rules apply when testing the ACP. Thus, in processing option 1 (Multiplier- First Test), the value 1.25 should be entered. In processing option 2 (Multiplier- Second Test), the value 2 should be entered. Finally, in processing option 3 (Factor- Second Test), the value 2 should be entered. The reason why these values are entered as processing options is for system flexibility, for the "if and when" the federal government decides to change these values.