You probably realize that your business-owner clients that offer 401(k)s have a lot of compliance issues to deal with. One of the major ones, especially for small- and medium-sized businesses, is the annual non-discrimination testing. Doing and passing their annual non-discrimination testing is very important for your clients to be able to save as much for retirement tax-deferred as you have planned.
Why Is Non-Discrimination Testing Required?
Because of all the benefits the government offers for companies that sponsor 401(k) plans, they want to make sure that they really are helping those the government is most concerned about, the rank-and-file employees. They don’t want top-level employees to be favored and those that need to save for retirement the most to be discriminated against. So, they introduced non-discrimination testing.
Non-discrimination testing is the responsibility of the plan sponsor, your client, and is used to ensure that top employees don’t contribute significantly more than the rest of the employees.
Types Of Employees
Because non-discrimination testing compares one employee against another, you need to first know how they are separated and who falls into which category. There are three categories of employees used for non-discrimination testing:
Highly Compensated Employees (HCE)
Per the IRS, a HCE is anyone who either:
- Owned more than 5% interest in the business at any time during the year or preceding year, regardless of how much compensation they earned or received; or
- Earned $120,000 or more in annual compensation, and if the employer chooses, was in the top 20% of employees when ranked by compensation.
Non-Highly Compensated Employees (NHCE)
NHCEs are anyone who does not qualify as a HCE. The two categories are mutually exclusive.
Key employees can be either HCEs or NHCEs. To be considered a key employee, someone must meet at least one of the following qualifications:
- Any officer whose annual compensation is $175,000 or more.
- Any employee who owns more than 5% of the company or is directly related to someone who does.
- Any employee who owns more than 1% of the company and earns over $150,000.
These are the tests that your clients must run on their retirement plans every single year. These tests determine how much key employees and HCEs are allowed to contribute to their retirement plans.
Actual Deferral Percentage (ADP) Test
First, you need to calculate the average annual HCE contribution rate as a percentage of their compensation. Then, do the exact same calculation for NHCEs.
- If NHCEs contribute 2% or less, HCEs are limited to contributing double the NHCE rate.
- If NHCEs contribute 2-8%, the HCEs are limited to contributing 2% more than the NHCE rate.
- If NHCEs contribute more than 8%, the HCEs are limited to contributing 1.25 times the NHCE rate.
Actual Contribution Percentage (ACP) Test
This test is only for companies that offer an employer match. It is basically the same as the ADP test, but instead of using only employee contributions, it includes the employer match and after-tax contributions in the calculations as well.
This test involves grouping key employees together and calculating their total account balance. The key employees’ total account balance cannot exceed 60% of the entire plan’s account balance.
Help With Non-Discrimination Testing
As you can see, non-discrimination testing is very important for your business-owner clients. Not only is it required to stay compliant, but it also determines how much your client and other top employees are allowed to save on a tax-deferred basis.
However, non-discrimination testing can be complicated. Much of it is based on compensation, which changes with raises and the hiring and departures of employees. Compensation and employment are not static, making the calculations challenging and different from year to year. If you have a client that could use some help with his or her non-discrimination testing, email me today at firstname.lastname@example.org. As a pension specialist, I can guide them through the testing and help them follow up if the results aren’t where they would like them to be.
About Kenny Phan
Kenny Phan is a Managing Partner at FinancialFocus Retirement Plan Services, a 3(16) fiduciary. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses in the greater Phoenix area, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.