There are a lot of benefits that come with a 401(k) retirement savings plan. Not only is it a great incentive to retain employees, but it’s a great way to plan for retirement and save on taxes. However, because of the substantial tax benefits that go with a 401(k), the government has set up a series of annual tests that make sure that the 401(k) plans do not “discriminate” or unfairly benefit individual company owners or the highly-compensated employees.
Non-Discrimination Testing: What Is It?
Every year, the government issues nondiscrimination tests through the Employee Retirement Income Security Act (ERISA) to review the 401(k) plans of the highly compensated employees (HCEs) and the non-highly compensated employees (NHCEs). These tests are in place to ensure that the benefit plans are not discriminating against lower-income employees, and that all the employees are taking advantage of the retirement plan.
The HCE is defined by the IRS, as an individual who owns more than 5% of the interest in the company OR receives payment of more than $125,000 if the previous year is 2019; and $130,000 if the prior year was 2020 AND, was in the top 20% of employees when ranked by total compensation. If someone doesn’t meet these conditions, they are an NHCE.
The IRS defines Key Employees as someone making over $180,000 in 2019 OR anyone who owns more than 5% of the business, OR anyone who owns more than 1% of the company and makes over $150,000 for the plan year.
The Actual Deferral Percentage (ADP) Test
The IRS uses the ADP test to compare what the average deferral percentage is by HCEs compared to the average deferral percentage of NHCEs
The Actual Contribution Percentage (ACP) Test
Rather than tracking deferment, the ACP test compares the average employer contributions received by HCEs and NHCEs.
The Top Heavy Test
The Top Heavy Test focuses on a company’s “key employees” and tests the plan’s balance as of December 31st of the previous year (or current year, if it is the plan’s first year). A 401(k) plan will fail under this test if the value of the assets in it’s key employees’ accounts is more than 60% of all assets held in an employer’s 401(k) plan.
Passing The Tests
In order for the companies to pass these tests, the calculations must show that the deferred contributions of the HCEs and the key owners do not significantly exceed those of lower-paid employees. If a company fails these tests, they will be faced with corrective actions, which includes increased taxes and refunding some of the contributions made by the HCEs, or funding contributions to the NHCEs until the tests are passed.
How the Safe Harbor 401(k) Affects the Non-Discrimination Tests
The Safe Harbor 401(k) is a particular type of retirement plan that includes an employer match. 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 employer allocated contributions. It’s a great option, especially for small businesses, who may find it hard to pass these non-discrimination tests.
Is a Safe Harbor 401(k) Right for You? (2019) Employee Benefits Article. Paychex Worx
Safe Harbor 401(k) Plans: Answers To Common Questions. (2016) By Eric Droblyen. Employee Fiduciary
Safe Harbor FAQ: What Employers Should Know About 401(k) Compliance Testing. (2017). Employee Benefits Article. Paychex Worx
401(k) Plan Fix-It Guide – The plan was top-heavy and required minimum contributions weren’t made to the policy. (2019).Retirement Plans. IRS
What Is a Safe Harbor 401(k)? (2019). By Melissa Phipps. The Balance