, theyll place employees in three major groups. What is a 401k discrimination testing? This is also handy for knowing your HCE contribution limits beforehand, reducing the risk of needing to refund HCE contributions later down the line. You could also prohibit HCEs from contributing in the next plan year. When employees are filing taxes, they will need to file IRS Form 1099-R if they had any corrective distributions or refunds. But lets say you dont pass a nondiscrimination test. Heres everything (else) you need to know about 401(k) nondiscrimination testing: In the most basic terms, nondiscrimination tests (NDTs) are annual tests required to ensure that 401(k) retirement plans benefit all the employees, (not just business owners or highly-paid employees). The plan document must include the top paid group election specifically before it can be used. That is why we provide you with a local contact that manages your account from A-Z. To make it easy, weve laid out exactly what determines a persons classification as a highly-compensated employee, a non-highly compensated employee, or a key employee below. *IRS Form 1099-R: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc, can sometimes help your plan pass by using a testing method thats different from a typical nondiscrimination test. A plan fails the top-heavy test when the value of the assets in key employees accounts is more than 60% of all assets held in an employers 401(k) plan. What is Non-Discrimination Testing? Key Definitions: HCEs, NHCEs, and Key Employees, Standard Nondiscrimination Tests: ADP, ACP, and Top Heavy Tests, Safe Harbor Plans and Nondiscrimination Testing, How to Fix Failed Nondiscrimination Testing, Startups also face retirement plan implementation and nondiscrimination testing challenges. If communicated properly, they should understand that such a cap is necessary so the business does not fail IRS compliance testsespecially if the alternative is not having a retirement benefit at all. Its no secret that nondiscrimination tests were created with traditional large companies in mind. To that end, you follow the same basic procedure: Step #1: Calculate Annual HCE Contribution Rate. As long as the correction is made on a timely basis, there are no penalties. Because the government provides significant tax benefits through 401 (k) plans, it wants to ensure that these perks don't disproportionately favor high earners. However, a 414(s) definition of compensation can include certain . Because these tax benefits are so substantial, the government wants to make sure that 401(k) plans dont benefit business owners and highly-compensated employees (HCEs) over non-highly compensated employees (NHCEs, A.K.A the rest of us). Unfortunately, there isnt a fun acronym for this test. In this post weve covered definitions, tests, timelines, alternatives, and what to do in case of a failed test but thats still not everything about nondiscrimination testing. A business can either leave the testing process to an in-house team or, as in most cases, bring in a qualified third party. It is the responsibility of the company providing the 401(k) retirement plans to pass these nondiscrimination tests, or if they fail these tests, to take the appropriate remedial actions. Even though nondiscrimination testing is likely performed by a plan's recordkeeper or third-party administrator, plan sponsors need to understand the basics . Under this test, you determine a coverage fraction equal to the number of highly compensated employees (HCEs) who are allowed to participate in the plan, divided by total HCEs in the company; a coverage fraction for the . We believe relationships matter. Deferral Rate = Salary Deferral Total Compensation. See our Terms of Service for additional details. This is to ensure that a company's Medical or. As previously mentioned, using data from the prior year can help you determine HCE contribution maximums ahead of time. So, you might have more NHCEs than you think. Make a qualified matching contribution (QMAC), which is an employer matching contribution that is only made to employees based on how much of their salary they deferred. A plan can be amended to switch from prior year testing to current year testing at any time. These tests werent built with small businesses or startups in mind, and this means these small (and medium-sized) businesses can struggle much more with passing their NDTs. If you fail non-discrimination testing, you have to make corrections to the plan which can involve refunds or corrective contributions of some sort. 1. We also recommend at least a mid-year, and surprise assessment at a random point during the year. Display as a percentage. To pass the test, HCEs cant receive more than double the NHCE average a maximum of 3% in this case. Passing nondiscrimination testing is essential! Its also why we want to support employers in offering the very best retirement plans for their employees. sent me a check for 5K that I have to pay tax on now. If youve still got questions, let us know. This table represents a causal relationship: the annual NHCE contribution rate dictates the maximum allowed contribution for the HCEs. No employers are exempt from non-discrimination testing. For testing purposes, workers are classified either as highly compensated employees or non-highly compensated employees. Winterfells HCE defers 10%, so this plan fails the ADP test. Plans can allocate contributions in one of three ways: If your plan administrator tells you that your plan has failed nondiscrimination testing, there are several possible causes. If youre looking to set up a 401(k) you can feel confident about, reach out to our team and well be happy to answer any other questions you have. 0 Reply Found what you need? match, profit sharing, safe harbor contributions) can be used to offset any top-heavy minimum contribution owed to a participant. DISCLAIMER: Advisory Services offered through Prosperity Financial Group, Inc., an Independent Registered Investment Advisor. HCEs are subject to an ownership test or a compensation test to calculate whether they own more than a certain percentage of the company sponsoring the package, or whether they exceed a specific income level. Youll know your HCE contribution limits beforehand, which reduces the possibility of having to refund HCE contributions later down the line. We believe relationships matter. When tested separately, Plans A,B and C pass but Plan D fails to the tune of $10K. BUT IT DID!!! Get started with an affordable, full-service 401(k) plan. Although most companies do not experience issues, it is important to be aware of how such testing ensures proper plan operation. Human Interest can help your business uncover which plan design is best for your budgets, needs, and plausible testing scenarios. We look forward to hearing from you. A key employee is someone who makes over $185,000, owns more than 5% of the business, or owns more than 1% of the business and also makes over $150,000. NDT is a series of tests established by the Internal Revenue Service (IRS) to evaluate how fair an organization's benefits are. Compensation: Compensation is defined by the IRS includes wages and salaries, bonuses, tips, and fringe benefits. Have you ever wondered why we have to pe. Theres a lot to understand, from confusing legal terms to strict regulations that are hard to follow when setting up or adjusting your 401(k) plans. Annual NHCE Contribution Rate: Group the non-HCEs together and calculate the average annual employee deferral rate as a percentage of their total compensation. The IRS defines an HCE as an individual who: If someone doesnt meet either of those conditions, they are an NHCE. The most common tests completed include ADP/ACP test, 402 (g) limit test, 415 . Not sure which plan is for you, check out our Retirement Plan Evaluator to learn in 30-seconds. Going back to the example above, the Winterfell 401(k) failed the ADP and top-heavy tests. This isnt the standard, but it can be useful when your company has a high number of HCES in comparison to NHCEs. Lets say that a company called Winterfell Consulting offers to make a matching contributions of 50% of the income an employee defers to their 401(k) account, until the deferral amount reaches 6% of the employees W-2 income. Newly hired employees who would traditionally qualify as HCEs but who have not been with your company long enough to be paid the required $120,000+ a year will count as NHCEs until the year after they exceed the threshhold. This test compares the average percentage of the salary that participating HCEs defer to the average percentage that NHCEs defer. For your plan to pass the ADP test as per IRS guidelines, you should ensure that: (Note: The ADPs described above are in averages). Human Interest does not provide tax or legal advice. For example: In this case, Jon, the HCE, defers 10% of his compensation, while Sansa, Arya, and Bran all NHCEs contribute an average of 3%. Why Perform Non-Discrimination Testing (NDT)? Encourage contributions from all employees, especially non-highly compensated employees, through ease of use and financial literacy education. Each year, a 401 (k) plan must complete specific nondiscrimination tests which are focused on deferral contributions and employer matching contributions. To pass the ADP and ACP tests, HCE deferral rates and employer contributions need to fall below these thresholds: Note that the formula the IRS uses looks a little different from this. Publication: 401(k) Advisor. By timely, we mean that remedial action should happen the year after testing by either 30th June for EACA plans and 15th March for ACA plans. Human Interest is an affordable, full-service 401(k) and 403(b) provider that seeks to make it easy for small and medium-sized businesses to assist their employees invest for retirement. In fact, some data shows that, among new hires, automatic enrollment increases participation rates in defined contribution plans to 91%. Under IRS guidelines, a Highly Compensated Employee (HCE) is one who: Any employee that doesnt fall under this classification is known as a non-highly compensated employee(NHCE). Member FINRA/SIPC. Make a qualified non-elective contribution (QNEC), which is an employer contribution made on behalf of all eligible employees regardless of how much they contributed to the retirement plan. If your plan is on the border, this might help you squeeze past even if youve failed your standard test. This is a very specific use case, so if you have questions about this, let us know! What is the difference between a Roth 401 (k) and traditional 401 (k)? Additionally, a plan that uses the prior year testing method for the ACP test will face an automatic failure if it resumes a matching contribution after going for a year without one. 655 Montgomery Street, Suite 1800San Francisco, California 94111. March 15 th is a magical deadline for calendar year plans in the 401(k) testing world. These tests are mandated by The Employee Retirement Income Security Act (ERISA), which is a set of laws and regulations that govern almost everything related to employee retirement benefits and their administration. Nondiscrimination tests for 401 (k) plans are primarily concerned with a certain group of employees highly compensated employees (HCEs)and whether they're receiving an unfair share of a plan's benefits, rights, and features. Both the ADP and the ACP tests only look at the most recent full plan year. ACP is calculated by dividing the companys contribution to an employee by his or her W-2 income: Here, Winterfell Consulting gives the HCE, Jon, a 3% total contribution, while NHCEs Sansa, Arya, and Bran receive an average contribution of 1.5%. How the Safe Harbor 401(k) Affects the Non-Discrimination Tests . The ADP and ACP tests are part of the required nondiscrimination testing of 401 (k) plans. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. The refund would be distributed to the HCE as ordinary income in the year it is received. If youre looking for a great 401(k) for your employees, click here to request more information about Human Interest. And dont forget that a Safe Harbor 401(k) lets you skip most of these annual tests by creating incentive for more of your employees to save. There are specific deadlines. The test used to confirm that 401 (k) deferral contributions are nondiscriminatory is called the actual deferral percentage test (commonly referred to as the ADP test). Make sure the percentages fall within the acceptable ranges. Non-Discrimination Testing. A top-heavy nondiscrimination test focuses on key employees in the organization. Safe Harbor plans are structured so you can automatically pass or avoid the ADP and ACP tests altogether (unless theres a profit-sharing component to the plan). Nondiscrimination testing is required for qualified retirement plans to ensure that benefits under the plan do not discriminate in favor of officers, owners, shareholders, employees in authority of other employees or any other employee classified as a highly compensated employees (HCEs). If you're determined to be an HCE after the fact - like after you've made a full 401 (k) contribution for the year - the contribution will have to be reclassified. The top-heavy corrections in step one would bring up NHCE ADP rates to 6% and the HCE limit would be raised to 8%. If your 401(k) plan failed nondiscrimination testing, you have three options for taking corrective action: QNECs and QMACs are less popular, as they tend to be more costly and less convenient to employers. It would be in the employer's best interest to evaluate the plan design and determine if this is the most effective solution for the business. Your plan wont pass the Top Heavy Test if the quotient is greater than 60 percent. This is the deadline for any corrections due to failing ADP or ACP testing. If employees dont have the extra money to set aside, dont see the value in saving for their future, or dont know about their plan, then they may not choose to participate. Thats why 401(k) discrimination testing seeks to answer one big question: How much the company contributes to employee accounts, What percentage of assets in the plan belong to highly compensated employees and key employees, The Actual Deferral Percentage (ADP) test, The Actual Contribution Percentage (ACP) test. Because of the difficulties that arise in dealing with up-to-date employment fluctuation and retirement reporting, these calculations may be based on the prior years compensation if this is allowed in the Plan Document. We hope you find it helpful. 401(k) nondiscrimination testingWhat is it, and why is it important? Accrued a compensation of more than $130,000 if the preceding year is 2020 or 2021 and if an employer chooses, was in the top 20% of employees when ranked by compensation. Annual 401(k) non-discrimination tests can often set your business back with paperwork and expenses. Does your companys 401(k) plan benefit all your employees equally, or does it favor owners and executives who make more money? The Main Types of 401 (k) Annual Tests Annual 401 (k) non-discrimination tests are of three types: The ADP, ACP, and Top-Heavy Test. The Safe Harbor 401(k) is a particular type of retirement plan that includes an employer match. Any employee who owns more than 1 percent of the company AND earns over $150,000. Our standard, 6-phase 401 (k) audit process is comprehensive, performed virtually and on your schedule. Communicate to your employees the rules of IRS testing, both during training and also through notifications on our website. The 401(k) industry is a complex mixture of rules and regulations that are written and enforced by numerous government entities. The non-discrimination test that must be performed depends on the type of plan and how the plan is . Display as a percentage. Any employee who owns more than 5 percent of the company, or is related to the employee. Non-discrimination testing is a fancy of way of saying 401(k) plans have required annual tests to ensure that retirement plans benefit all employees and not just owners and executives. The HCE and NHCEs deferred percentages are then averaged to determine the ADP of each subset. The testing method can be changed via a plan amendment adopted no later than the last day of the year being tested (e.g., no later than December 31, 2020, for the 2020 ADP/ACP test). One way to "pass" the 401(k) non-discrimination testing is having Plan Sponsors adopt a Safe Harbor 401k Plan. Heres how to determine the maximum HCE rates: Weve already gone over the ADP, so the ACP will be a piece of cake. The Top-Heavy test looks at how much Key Employees contribute to the plan compared to everyone else. If you need help with nondiscrimination testing, or if youd like to learn more about our 401(k) Advisor services, please fill out the form below and well get back to you shortly. 401(k) non-discrimination tests(NDTs) verify that all employees, regardless of their compensation and matching contributions, are benefitting fairly from a 401(k) plan. To add to the challenge, smaller companies usually dont have the resources to provide employees with services to boost employee participation and contribution rates, like financial advising and retirement education. non-safe harbor plans). This post will help you understand everything you need to know about selecting a 401(k) provider designed to meet a startup's needs. Abide by this carefully. But it does get a bit more complex, so bear with us. Deferral Rate = Salary Deferral / Total Compensation, Step #2: Calculate Annual NHCE Deferral Rate. Sign up for an affordable and easy-to-manage 401(k). Based on a study of over 5,000 employees, weve seen that eligible employees who participate in the 401(k) had an 11% higher retention rate than those that didnt. A technically savvy 401(k) advisor may be able to get your plan to pass using a testing method different from the one you have customarily used. This test compares average NHCE salary deferral percentages to the average for the HCEs, and naturally involves the calculation of these numbers. If you decide to offer a safe harbor contribution, you may be limited to starting it at a specific time. You wont include catch-up contributions in the calculations. These include: Those last two options are less popular, as they tend to be more expensive and less convenient. If you have a Flexible Spending Account (FSA) or a Premium Only Plan (POP), the IRS requires you complete a non-discrimination test once a year. Download PDF. It wont make it painless, but it will make it faster. After all, it never hurts to check, right? Here are three tips to increase their contribution rates that can be done proactively before annual testing: Auto-enroll employees into your 401(k) plan: This is shown to increase overall participation rates. The plan failed the ADP test because, on average, the NHCEs deferred 3% of their W-2 income, which meant the HCE was only allowed to defer up to 5% of his income under the test. ), These tests measure the participation levels of HCEs and NHCEs in order to make sure plans are not overly utilized by HCEs. If you take corrective measures quickly, its quite easy to resolveand you should avoid any negative long-term consequences and penalties. For the first year of the plan (no assets in the prior year), the top-heavy determination is done on the last day of the current year. We recommend reading the sections below to understand the basics. As you read this, also keep in mind that its possible to set up a Safe Harbor 401(k) plan, that's exempt from most nondiscrimination testing., To give everyone an opportunity to save for the future, a 401(k) plan cant favor highly compensated employees (HCEs) or key employees (such as owners). Passing nondiscrimination testing is essential. Whether you've been tasked with 401(k) administration, you've just started a new 401(k) for your company, or you're dealing with failed testing for your existing 401(k), there's a lot of ground to cover when understanding and dealing with nondiscrimination testing. Nondiscrimination tests take a magnifying glass to three key numbers: Thats why there are three key annual nondiscrimination tests to pass each year: These tests verify that deferred wages and employer matching contributions dont discriminate in favor of highly compensated employees. HCEs and NHCEs are mutually exclusive categories, so all other eligible employees who do not meet the above tests are considered NHCEs. The business matches 100% of employee retirement plan contributions up to 3%, as well as a 50% match of the next 2%. Includes a mandatory, tax-deductible employer contribution to a 401(k), which can also provide an advantage for recruiting and retaining talented employees. Our first nondiscrimination test is the Actual Deferral Percentage (ADP) test, which compares the average salary deferral percentages of HCEs to that of NHCEs. Divide the total key employee account balance by the total account plan balance, and express this number as a percentage. 401 (k) Audit Process and Documentation. Determining whos an NHCE isnt always as easy as looking at everyones job description and salary and checking them off. Many small businesses prefer the simplicity of the . A top-heavy test will assess the value of the assets to ensure that the key employees do not own more than 60% . Small and medium-sized companies, like family-owned businesses, generally have more HCEs and key employees. Reach out to a knowledgeable 401(k) Advisor to help your plan pass by using a testing method thats different from a typical nondiscrimination test. A Qualified Non-Elective Contribution (QNEC) is a way for employers to correct for a failed nondiscrimination test (NDT) or make up for an employee's lost opportunity to make elective deferrals. However, because of the way the Safe Harbor 401(k) is structured, the plan allows the employer to automatically pass the non-discrimination test or avoid it altogether through the . An employee will be an HCE based on compensation if the employees annual compensation in the lookback year was $135,000 or more (if the preceding year is 2021). III. The 3% contribution can be offset by other employer contributions (but not deferrals). Failing the tests could result in tax penalties, refunds, and fines which you were not prepared for. In addition to skipping most nondiscrimination tests, Safe Harbor plans with a matching contribution encourage your employees to contribute to the plan, making your 401(k) another weapon your recruiting and retention arsenal. Non-discrimination testing is a set of IRS-prescribed tests that evaluate the fairness of an organization's benefit plans. Any company officer (CEO, CFO, etc) who has a compensation of $170,000+. Startups also face retirement plan implementation and nondiscrimination testing challenges. These nondiscrimination tests for 401 (k) plans are called the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. Mandated by ERISA, annual nondiscrimination tests help ensure that 401 (k) plans benefit all employeesnot just business owners or highly compensated employees (HCEs). The ACP Test: The Winterfell NHCEs received an average contribution that was 1.5% of their W-2 income. When calculating the ADP, you take total employee 401(k) contributions divided by their total compensation of the calendar year. And, those lower paid employees should be contributing to the plan as well. The ADP and ACP tests apply to "traditional" 401 (k) plans (i.e. If you find yourself in charge of the 401(k) or needing to deal with nondiscrimination testing, dont worry! The Internal Revenue Service (IRS) requires certain health and welfare plans to undergo annual non-discrimination testing to ensure that plans do not discriminate in favor of highly compensated or certain key employees. Basically, QNECs are contributions made on behalf of the employee - usually a non-highly compensated employee (NHCE) - that are immediately 100% . Gather together your HCE matching or after-tax contribution rates and average them. Startups also face unique problems with implementing 401(k)s and passing nondiscrimination tests. In order to satisfy section 401 (a) (4), a plan must satisfy each of the requirements of this paragraph (b). If the Key employees total account balance exceeds 60% of Key and non-key balances, the plan is top-heavy. Startups are often structured differently from traditional companies, with high numbers of HCEs in proportion to the minimal get it up-and-running first startup staff. In order to promote fairness in the retirement savings process, The Employee Retirement Income Security Act (ERISA) established 401(k) nondiscrimination tests. Since 2008, these refunds have been taxable in the year they are made. Well, our friends at the IRS have made that piece of the equation a little more complex, so lets take a closer look at what each nondiscrimination test measures, how to apply them, and what it means if your plan fails. The Actual Deferral Percentage Test (ADP) This includes prior year payroll and census information, company ownership percentages, etc. The IRS wont impose any penalties on a plan sponsor if they fail a test, as long as they take corrective actions on time. To ensure a 401(k) plan isnt discriminating or favoring specific employees, it must pass a set of annual tests. This percentage reveals how relatively engaged in the plan each employee type is at a glance. Any company officer (CEO, CFO, COO, etc.) When determining who is an HCE due to compensation, were only considering compensation in the lookback year. Additionally, because startups are usually not profitable for some period of time, they may not have the means to provide a safe harbor plan, the easiest way to avoid NDTs and the associated headaches.

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