How to Stay Compliant for 401(k) Nondiscrimination Testing
The end of the year means a lot of things for small business owners: closing out budgets, getting your year-end orders completed, and benefits enrollment. Whether you’re opening a new 401(k) or sticking with your existing plan, you might be facing IRS testing to make sure your plan treats all employees fairly.
These tests are called nondiscrimination tests, and they are designed to find out if highly compensated employees are able to save money for retirement at a rate that is disproportionately favorable compared to the rate at which rank-and-file employees can save. Small business owners can stay compliant with 401(k) nondiscrimination testing rules by:
- Understanding what a highly compensated employee is.
- Encouraging rank-and-file employee participation.
- Designing a plan with employer contributions that automatically passes IRS testing.
- Keeping up with annual IRS changes.
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Understand what highly compensated means:
Understanding how employees are defined is an important step toward compliance.
- A highly compensated employee (HCE) owns more than 5% of the business at any time during the year or preceding year or earned more than $135,000 in 2022 or was designated as the “top paid group” (which often comprises the top 20% in terms of salary)
- A non-highly compensated employee (NHCE) is anyone who is eligible to participate in the plan who doesn’t meet the criteria
- Key employees can include HCEs or NHCEs if they own more than 5% of the company, if they are the parent/child/spouse of someone who owns more than 5% of the company, or if they own more than 1% of the company and more than $150,000
If the plan fails nondiscrimination testing, refunds may be due back to the HCEs, or you may need to make contributions to non-HCEs to bring their contribution ratio up. In the worst-case scenario, the whole plan could fail and become disqualified.
Encourage widespread 401(k) plan participation
Financial wellness advising and retirement education training can help boost employee participation rates, though these services can be cost-prohibitive for small business employers.
Establishing a plan with automatic enrollment is one way around this issue, as it provides employers with a three-year tax credit that helps offset the costs of setting up a new plan.
Employees can always opt out, but this strategy has shown to double or even triple the rate of participation, particularly among younger employees and those earning less than $30,000.
Most commonly, auto-enrollment plans deduct at least 3% of an employee’s pay, increasing by 1% a year to a maximum of 10%.
Design a plan that passes
Plan providers often recommend Safe Harbor 401(k)s for small businesses. Though these small business 401(k) retirement plans require employer matching or non-elective contributions, they automatically pass nondiscrimination tests and negate the need for annual plan auditing.
A Safe Harbor matching formula may be:
- Traditional: Employer matches 100% of salary deferrals on the first 3% of compensation plus 50% of salary deferrals on the next 2% of compensation
- Enhanced: Employer matches 100% of salary deferrals up to 3-6% of compensation
- Non-elective: Employer contributes at least 3% of employee pay up to the limit, regardless of what employees themselves contribute
Keep up with annual IRS changes
Every year, the IRS adjusts certain figures in response to inflation and rising salaries. These figures are typically announced at the end of October, so keep your eyes on this space for those updates.
Contact 401(k) plan administrator Ubiquity for more details on setting up a small business retirement savings plan.