What is the process for non-discrimination testing?

To help ensure that companies extend their 401k plans equitably to employees, the IRS requires that the benefits received by more amply paid employees aren’t disproportionately more favorable than those provided to employees that are paid less.

This provision is enforced via “non-discrimination testing.”

Types of Employees

Non-discrimination testing is performed for two different categories of employees:
Key Employees and Highly Compensated Employees (HCEs).

• Non-discrimination testing for Key Employees is performed using the Top-Heavy test
• Non-discrimination testing for HCEs is performed using the ADP and ACP Tests

The Top-Heavy Test

The Top-Heavy test looks at how much Key Employees contribute to the plan compared to everyone else. If Key Employee balances exceed 60% of the entire plan balance at the end of the plan year, the employer is required to make a 3% contribution to the non-key employees to be non-discriminatory.

The ADP Test

The Average Deferral Percentage (ADP) of all HCEs, as a group, can be no more than 2 percentage points greater (or 125% of, whichever is more) than the non-HCEs, as a group.

This is known as the ADP test. If a plan fails the ADP test, it essentially has two options to come into compliance:

• It can have a return of excess done to the HCEs to bring their ADP to a lower, passing, level.
• Or, it can process a “qualified non-elective contribution” (QNEC) to some or all of the non-HCEs to raise their ADP to a passing level. Any reimbursements made to employees will be subject to tax, and will lose the advantage of contributing to a fund with pre-tax money.

The ACP Test

The Actual Contribution Percentage (ACP) test is similar to the ADP test, only it tests the employer contributions rather than employee contributions.

Conclusion

Non-discrimination testing involves a Top-Heavy test for key employees and ACD/ADP tests for highly compensated employees.