When it comes to tax-deferred retirement savings plans, like 401 (k) plans, the Internal Revenue Service (IRS) carefully scrutinizes the contributions of highly compensated employees (HCEs) to. These nondiscrimination tests review the average benefits provided to two groups of employeeshighly compensated employees (referred to as HCEs) and key employeesand compare them to the average benefits provided to the non-HCEs or non-key employees. You must take the appropriate remedial actions, or your plan can lose its qualified status. Youve now got all the tools you need to face down this particular 401(k) plan administration challenge. The ADP and ACP tests apply to traditional 401(k) plans (i.e. As previously mentioned, using data from the prior year can help you determine HCE contribution maximums ahead of time. If an employee owned more than 5% of the interest in the business at any time during the determination year OR the lookback year, regardless of how much compensation that person earned or received, that person is an HCE. These tests follow federal regulations that have been established for every type of benefit plan, including retirement plans. We recommend you also look into NHCE plan participation and contribution strategies. (As an aside, if you type 'non-key' without the hyphen, auto-correct tries to change it 'monkey'.) Basically, QNECs are contributions made on behalf of the employee - usually a non-highly compensated employee (NHCE) - that are immediately 100% . Deadline for notice delivery for Safe Harbor plans with a January 1st effective date. HCE (highly-compensated employees) and NHCE (non-highly compensated employees), The standard approaches: ADP test and ACP test, A third test: The top-heavy determination, Action steps for the ADP, ACP, and top-heavy tests. Non-discrimination Requirements . 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). 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%. If you want to learn more about how to improve your 401(k) participation, In this post weve covered definitions, tests, timelines, alternatives, and what to do in case of a failed test but thats still not, about nondiscrimination testing. Its up to the plan sponsor to make sure theres broad participation. Average the compensation ratios for each group. The 401(k) annual tests are governed by ERISA a set of regulations and laws related to employee retirement benefits and administration. When calculating the ADP, you take total employee 401(k) contributions divided by their total compensation of the calendar year. If Winterfells match equals 3% of compensation paid for each employee at the end of each year, no further contributions will need to be made to correct a top-heavy failure for that year. From the IRS's perspective, the reason non-discrimination testing exists is to ensure that qualified retirement plans are benefiting all employees and not just the owners or highly compensated employees. 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: Owned more than 5% of the business interest during the year or any preceding year regardless of the compensation amount. You dont want to deal with this same anxiety again, so preempt it with a little bit of proactivity. As we mentioned above, using the prior years data can help you determine HCE contribution maximums ahead of time. Why does it matter? non-safe harbor plans). The government of the United States provides significant tax benefits via the use of 401(k) retirement plans. The safe harbor plan provides all eligible employees with a fixed, mandatory matching contribution from the employer. Accordingly, business owners with a safe harbor 401k must either: Make the dollar-for-dollar matching contribution (for all participating employees) on the first 4% of the employee's compensation, or Are You Getting A+ Value From Your 401(k) Fiduciary Advisor? If your plan is suspected to be top-heavy, you may also wish to exclude Key employees or ask them not to contribute for the current plan year so the employer can avoid the 3% top-heavy minimum contribution, if required. If your plan is on the border, this might help you squeeze past even if youve failed your standard test. 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 . New companies are generally have a high number of HCEs in proportion to NHCEs, and since they may be operating lean and mean for some period of time, they might not be able to sidestep nondiscrimination testing with a Safe Harbor plan. making more than $170,000. When your workforce has a higher proportion of HCEs, NHCE contributions must be higher. 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. Prosperity Financial Group, Inc. and Fortune Financial Services, Inc. are separate entities. Participation in a 401(k) plan is optional. All your eligible employees that dont fit the above HCE requirements are considered non-highly compensated employees or NHCEs. The IRS 401(k) Fix-It Guide has useful information on all kinds of situations you may encounter, but for the ADP and ACP tests, it recommends one of these courses of action: Its important to know that if refunds are made, they will be treated as taxable income for the HCEs who receive them. Here's a quick summary of important NDT deadlines: October 1: Deadline to launch a startup safe harbor match 401 (k) plan for the current calendar year. New 401(k) retirement plans naturally cant use the prior year information. Mark these on your calendar to streamline the testing process. Businesses who want to establish a safe harbor plan for the current year must get the first deferral in by this date. Annual 401(k) non-discrimination tests can often set your business back with paperwork and expenses. HCEs and NHCEs are mutually exclusive categories, so all other eligible employees who do not meet the above tests are considered NHCEs. When employees are filing taxes, they will need to file IRS Form 1099-R* if they had any corrective distributions or refunds. Does your companys 401(k) plan benefit all your employees equally, or does it favor owners and executives who make more money? Non-discrimination testing (also known as compliance testing) examines the contributions of Key and Highly Compensated Employees to determine whether all employees are treated equally by a company's 401 ( k ) plan. In this article, well give a broad overview of how 401(k) nondiscrimination testing works. I didn't think it would affect us, since it hasn't in the past. While most traditional, large companies have no issues passing, the tests were not designed with startups and SMBs in mind and can be confusing and difficult to navigate. If youre looking for a great 401(k) for your employees, click here to request more information about Human Interest. Key employees are another category to be aware of, and there are several ways that both highly and non-highly compensated employees can qualify as key.. Lets dive in. Gather your HCE contribution rates, then average them. But lets say you dont pass a nondiscrimination test. This is to ensure that a company's Medical or. Gather together your NHCE contribution rates and average them. Its a businesss responsibility to ensure they pass the 401(k) non-discrimination tests. That is, lower paid employees should have similar access to the plan as highly paid employees. When using the prior years information, youll also be comparing average contribution rates from the prior calendar year, not the current year. Failing to meet the IRS's standards can mean fines, penalties, and bureaucratic headaches. Add up the sum of account balances of the Key Employee participants in your plan. Divide the total key employee account balance by the total account plan balance, and express this number as a percentage. Were here to provide answers. There are two annual nondiscrimination tests a 401(k) sponsor must pass: Generally, plans must also pass a third compliance test, the Top-Heavy test, each year, or else they are subject to additional employer contributions to keep the plan in qualified status. sent me a check for 5K that I have to pay tax on now. 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. If you have questions about the information outlined above or need assistance with your 401 (k) plan audit, JLK Rosenberger can help. If a plan is top-heavy, youll need to contribute 3% of compensation for all non-key employees in employment as of the last day of the plan year. March 15 th for 12/31 plan yearend). Were here to provide answers. If you fail to meet the IRS standards, it can mean fines, penalties, and other bureaucratic headaches. compensation definition of compensation and can be used for non-discrimination testing. How the Safe Harbor 401(k) Affects the Non-Discrimination Tests . A nondiscrimination rule is an ERISA-required clause of qualified retirement plans that mandate all eligible employees receive the same benefits. Non-discrimination testing is a set of IRS-prescribed tests that evaluate the fairness of an organization's benefit plans. Well be using several acronyms in our walkthrough of nondiscrimination testing. A note on calculating HCE salaries by prior year vs. current year: Prior year means that the average deferral rate for HCEs in the current year (i.e. Passing annual nondiscrimination tests is a crucial part of a 401(k) plans administration. By guiding you along the 401(k) setup process, we can help your business avoid any NDT issuesso you can focus on core business functions. However, if they are the parent, child or spouse of an employee who owns more than 5 percent of the company, NHCEs can also be key employees even if they dont meet the compensation requirements. The annual maximum HCE deferral rate is based off the contribution rates of your NHCEs. If you dont do either of these things, youll have to make a 3% nonelective contribution to all eligible participants. ). To calculate the ACP, divide the amount of an employees total contribution by their w-2 income. Provides a tremendous incentive for employees to save for their future and allows all employees to contribute the maximum allowable amounts to their 401(k). We also recommend at least a mid-year, and surprise assessment at a random point during the year. Not sure which plan is for you, check out our Retirement Plan Evaluator to learn in 30-seconds. 401(k) Nondiscrimination Tests Are ImportantAttention Is Required. 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). An incomplete, late, or inadequate 401 (k) audit report may result in significant penalties and plan termination. According to the IRS, this annual test compares the average salary deferrals of highly compensated employees to that of non-highly compensated employees. For instance, if you fail the top heavy test mid-year, you can limit HCE contributions until the plan passes. If your plan failed nondiscrimination testing, you have to take corrective action. We look forward to hearing from you. Up-to-date employment fluctuation and retirement reporting creates administrative challenges, so if your companys Plan Document allows it, you can use the prior years information. If you dont do either of these things, youll have to make a 3 percent nonelective contribution to all eligible participants. Going back to the example above, the Winterfell 401(k) failed the ADP and top-heavy tests. Even if you passed with this little trick, youll still want to look into Step #3. 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. If youre just started a 401(k), you cant use prior year information, so the IRS allows you to use 3 percent as the NHCE average deferral percentage. Non-highly compensated employees (NHCEs) are individuals who: Key employees are the final important category. According to the IRS 401(k) Plan Overview: [These tests] verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.. 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. We strongly advocate for proactive, regular monitoring and tracking of contribution percentages (Human Interest can help your company with this). To that end, you follow the same basic procedure: Step #1: Calculate Annual HCE Contribution Rate. Knowing how 401(k) non-discrimination tests work will help you understand how to remain compliant and save you an extra load of costs. 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. That means the ADP of HCEs cant be more than 5% (the 3% NHCEs deferred, plus 2%). Youll know your HCE contribution limits beforehand, which reduces the possibility of having to refund HCE contributions later down the line. and updates the requirements on NDTs, such as who classifies as a HCE or NHCE. 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. An HCE is technically defined as an employee who meets either of the following qualifications, as outlined by the Internal Revenue Service: Ownership: When determining who is an HCE due to ownership, we must evaluate two time periods: the plan year being tested (the determination year) and the preceding year (the lookback year). Any employee who owns more than 5% of the company, OR is the parent, child or spouse of someone who owns more than 5% of the company. Under the safe harbor design, you need to commit to one year (which needs to be renewed on an annual basis). Step #3: Compare and Make Your Determination. 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. This is how the HCE provisions can limit 401 (k) plan contributions by highly compensated employees. Our standard, 6-phase 401 (k) audit process is comprehensive, performed virtually and on your schedule. It turns out that the HCE receives 3%, so this plan passes the ACP test by the narrowest of margins. A plan must meet IRS qualification requirements to qualify. Companies who fail discrimination testing are required to refund excess 401 (k) contributions. To address any risk early, its highly advisable to conduct plan testing throughout the year to stay in front of things. To ensure a 401(k) plan isnt discriminating or favoring specific employees, it must pass a set of annual tests. Its plain to see why HCEs are often key employees. Why the surprise test? , theyll place employees in three major groups.
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