Non-Discrimination Testing
What Is Non-Discrimination Testing?
Non-discrimination testing (NDT) is a set of tests created by the Internal Revenue Service (IRS) to determine if a company’s benefits are fair for all eligible employees—not just highly-compensated employees (HCEs).
What Is the Purpose of Testing for Discrimination?
NDT ensures that HCEs abide by a benefits contribution rate that non-highly compensated employees (NHCEs) can match, increasing financial equality in the workplace.
Moreover, a company’s contributions to plans like a 401(k) are tax deductible. Regulating HCEs contributions in turn ensures that business owners don’t also unfairly benefit from substantial tax advantages.
Is Non-Discrimination Testing Required?
NDT was originally established for 401(k) plans but now applies to certain plans under Section 125. Examples include health savings plans like flexible spending accounts (FSAs), health savings accounts (HSAs), and health reimbursement accounts (HRAs).
How to Perform Non-Discrimination Testing
There are different NDTs for benefit plan types. For instance, the required NDTs for 401(k) offerings are different from those for health insurance plans.
The three most common NDTs for retirement plans are the:
- Actual Deferral Percentage (ADP) Test
- Actual Contribution Percentage (ACP) Test
- Top-Heavy Test
Actual Deferral Percentage (ADP) Test
The ADP test is designed to compare the average salary deferrals of HCEs to the average salary deferrals of NHCEs for their 401(k) plans. In other words, this test evaluates if there is a significant disparity between the two groups’ contributions. If HCEs make significantly higher contributions, this indicates possible discrimination and the employer’s plan may fail the test.
To conduct this test, calculate these two percentages:
- Annual HCE Contribution Rate: Divide the average deferrals of HCEs by their average annual compensation.
- Annual NHCE Contribution Rate: Divide the average deferrals of your NHCEs by their average annual compensation.
Compare the two percentages to ensure their differences fall within reasonable levels. To pass this test, the IRS stipulates that the ADP for HCEs cannot exceed the greater of:
- 125% of the ADP for the group of NHCEs
- 200% of the ADP for the group of NHCEs
- The ADP for the NHCEs plus 2%
Actual Contribution Percentage (ACP) Test
This test is similar to the ADP test, but it also includes employer-matched contributions and after-tax contributions from employees.
To conduct the ACP test, add the average employer contribution and after-tax contribution to the employee’s deferrals. Then divide the total by their average annual compensation.
Compare the ACP percentages of HCEs and NHCEs to ensure all employees are receiving fair compensation.To pass this test, the ACP for HCEs cannot exceed:
- 125% of the NHCEs’ ACP for matching contributions
- 200% of the NHCEs’ ACP for after-tax contributions
- The ACP of the NHCEs plus 2%
Top-Heavy Test
The top-heavy test evaluates if key employees benefit more from a company’s retirement plans. The IRS defines key employees as:
- Individuals making over $215,000 a year
- Anyone who owns more than 5% of the company
- Those who own more than 1% of the company and make over $150,000 a year
The top-heavy test evaluates if a 401(k) plan is balanced. If key employees own more than 60% of all assets from the employer’s benefit plan, it fails the NDT.
When Is Non-Discrimination Test Correction Due?
If employers fail NDTs, they will have to take specific corrective measures to bring the plan into compliance (e.g., making additional contributions on behalf of NHCEs).
The corrective action needed and the deadline depend on the type of NDT and the employer plan’s specific provisions. For example, if a plan fails the ADP or ACP test, the employer will have 2.5 months after the end of the plan year to make corrections.
It’s best to err on the side of caution and conduct NDTs at the beginning or middle of the plan year. This way, if the results reveal non-compliance, employers will have ample time to make corrections.