401(k) Nondiscrimination Testing

The federal government allows substantial tax breaks for companies that pledge to take care of their employees by extending generous retirement savings benefits.

Testing ensures that businesses are compliant with federal regulations and that non-highly-compensated employees have the same access to tax advantage as the owners and key executives.

There are three required nondiscrimination tests:

Actual Deferral Percentage Test

Otherwise called the ADP test, this annual calculation compares the average salary deferrals of highly compensated employees to the average salary deferrals of non-highly compensated employees. The total W2 income is divided by the amount the individual employee deferred to the plan to come up with a deferral percentage.

Actual Contribution Percentage Test

Also known as the ACP test, this annual calculation compares the average employer contributions given to highly compensated employees vs. non-highly compensated employees. The total W2 income is divided by the amount the employer deferred to the plan to come up with an ACP deferral percentage.

Top Heavy Test

Sponsors fail a top-heavy test if over 60% of the plan’s assets are held by key employees. By definition, a key employee in 2023 either: makes over $215,000; owns 5% or more of the company; or owns 1% or more of the company and makes over $150,000.

Here are criteria for passing the IRS nondiscrimination tests for 401(k) plans:

• If the ADP or ACP for NHCE is 0-2%, the HCE percentage must be less than 2x greater.
• If the ADP or ACP for NHCE is 2-8%, the HCEs must be less than 2% greater.
• If the ADP or ACP for NHCEs is above 8%, the HCEs must not be over 1.25x greater.
• If the value of assets in HCE accounts is over 60% of total assets in the plan, the top-heavy test fails.

The ADP and ACP tests assess the most recent and full plan year. The top-heavy test looks at the balance as of December 31st of the previous year (or this year if it is the first year of the plan).

If a plan sponsor fails any of these tests, they have 12 months to correct the error. Otherwise, sponsors may incur penalty fees from the IRS equal to $100 per day per NHCE who is discriminated against to a maximum of $500,000 per year. Furthermore, plan sponsors can be opened to fiduciary liability lawsuits or plan disqualification.

There are several ways to fix the problem:

• Return contributions back to highly-compensated employees
• Contribute more to non-highly-compensated employees
• Do a combination of the two solutions above

Plan administrators can also run audits and conduct mid-year plan testing. They can educate and encourage more rank-and-file employees to participate in the plan or auto-enroll employees who do not specifically opt out of the plan.

The plan administrator can also draw up caps and strict rules for contributions to decrease the likelihood of failing.

A Safe Harbor 401(k) provision offers a way of structuring the plan to automatically pass all tests. A Safe Harbor provision can be suspended, removed, or amended at any point in the year as long as employees receive at least 30 days’ notice.

A plan can be established as a Safe Harbor 401(k), or the administrator can add a Safe Harbor provision at any point in a plan year. The plan will be exempt from nondiscrimination test requirements, but the employer must:

• Contribute 100% on employee contributions up to 3% of an employee’s deferral
• Contribute 50% on employee contributions from 3-6% of the employee’s deferral
• Contribute 3% of the employee’s salary, regardless of how much the employee contributes

Once the Safe Harbor minimum contribution is satisfied, sponsors can defer the maximum $22,500 and more easily reward top employees with profit-sharing contributions up to the individual maximum of $66,000. Like a traditional 401(k), employees can still be incentivized to participate with matching contributions.

All employer contributions must be 100% vested. While not having to forfeit any employer contributions makes it easier for employees to leave the company, offering such a generous match is an effective way to build employee loyalty and reduce turnover.

A Safe Harbor provision can best suit the needs of small business employers looking for maximum retirement savings, profit-sharing, and tax advantages. Some plan flexibility will need to be sacrificed, but a Safe Harbor is generally easier to administer.

A Safe Harbor may not be the least expensive way to pass testing, but it’s definitely the easiest. If you cannot afford to pay 3% of all employees’ salaries, you may consider the other methods mentioned. However, a Safe Harbor plan can allow HCEs and company owners the ability to maximize their retirement savings and tax benefits, while also making employees happier.

Keep in mind that all contributions employers make to their employees’ plans are tax-deductible and not counted toward the payroll tax obligation.

Contact Ubiquity to learn more about small business 401(k) plans and the Safe Harbor provision. We offer plan setup and administration for a modest, flat monthly fee.

We never charge you based on assets under management because your fees shouldn’t grow with your account balance. We work with small business clients just like you, so we have your best interests at heart. Each Ubiquity retirement sales consultant has more than ten years’ worth of experience in small business retirement planning to walk sponsors through finding and setting up the right plan based on the employer and employees’ needs.