What is Compliance & Non-Discrimination Testing?
A guide for employers on the amount of testing that must be verified annually when offering a 401(k) plan in order to retain tax-qualified status.
In order to retain tax-qualified status, a 401(k) plan must not discriminate in favor of key owners and officers, nor highly compensated employees. This is verified annually by a number of tests, which include:
- Contribution and Deduction Limits
- Coverage Tests
- ADP & ACP Tests
- Top-Heavy Test (and minimum contributions, if applicable)
Types of Contribution Limits
Before we dive into non-discrimination testing, there are several individual- and plan-level limits that Betterment assists in reviewing each year, including:
|Type of Limit||What is it?||Notes for 2020 plan year|
|401(a)(30) / 402(g) / 414(v) Deferral Limits||Limits the amount a participant may contribute via 401(k) deductions. The personal 402(g) limit is based on the calendar year.l Note that traditional (pre-tax) and Roth contributions together must be limited (there aren’t separate limits for each).||$19,500 is the maximum amount a participant may defer into their 401(k) plan for 2020. A participant age 50 or older during the year may defer an additional $6,500 in ‘catch-up’ contributions if permitted by the plan.|
|415 Annual Additions Limit||Limits the total contributions allocated to an eligible participant for the year4. This includes the employee contributions and all employer contributions and forfeiture allocations.||For plan years ending in 2020, the limit was a total of $57,0001 + up to $6,500 in catch up deferral contributions if permitted by the plan.|
|Employer Level Deduction Limit||Employers are limited to total contributions (excluding employee deferrals) not exceeding 25% of eligible compensation for the plan year.||N/A|
* Adjusted annually; see the most recent Cost of Living Adjustments table.
- Adjusted annually; see the most recent Cost of Living Adjustments table.
- Note that determining ownership can be further complicated by family attribution rules, determined under IRC §318.
- Adjusted annually; see the most recent Cost of Living Adjustments table.
- This limit is an IRS imposed limit based on the calendar year. Plan’s that use a ‘plan year’ not ending December 31st base their allocation limit on the year in which the plan year ends. This is different than the compensation limits, which are based on the start of the plan year.
Classifying Employees for Tests
Each of these non-discrimination tests compares how the plan benefits defined groups of employees. Before performing nondiscrimination testing, employees are categorized for the plan year as a highly compensated employee (HCE) or non-highly compensated employee (NHCE), and as Key or non-Key.
Each is defined below for plan years ending December 31, 2020.
A highly compensated employee (HCE) is an employee who meets one or more of the following criteria:
- Prior (Lookback) Year Compensation – earned over $125,000 in 2019¹; some plans may limit this to the top 20% of earners in 2019 (known as the top-paid group election); or
- Ownership in Current or Prior Year – owns² over 5% of (1) outstanding corporate stock, (2) voting power across corporate stock, or (3) capital or profits of an entity not considered a corporation
A key employee is an employee who meets one or more of the following criteria during the plan year:
- Ownership over 5%: owns over 5% of (1) outstanding corporate stock, (2) voting power across corporate stock, or (3) capital or profits of an entity not considered a corporation
- Ownership over 1%: owns over 1% of the stock, voting power, capital, or profits, and earned over $150,000.
- Officer: an officer of the employer who earned over $185,000³; this may be limited to the lesser of 50 officers or the greater of 3 or 10% of the employee count.
Non-highly compensated employees (NHCEs) and non-Key employees are those that do not meet the definitions above. Once employee categories are determined, they are used in the following tests:
Coverage tests determine the ratios of employees eligible for and benefiting from the plan, to show the plan fairly covers your employee base. Specifically, it reviews the ratio of HCEs benefitting from the plan (i.e., of employees considered Highly Compensated, how many expressed as a percentage are benefitting) against the ratio of NHCEs benefitting from the plan (similarly, of the employee base, what percentage are benefitting from the plan). Typically, the NHCE percentage benefiting must be at least 70% or 0.7 times the percentage of HCEs considered benefitting for the year, or further testing is required.
These tests are performed across three sections of a 401(k) plan: the employee contributions, matching, and after-tax contributions, and non-elective (employer, non-matching) contributions.
The Actual Deferral Percentage (ADP) Test and the Actual Contribution Percentage (ACP) Test look to ensure that as a portion of total compensation, Highly Compensated employees are not above to save significantly higher than the employee base. The tests compare the average deferral (traditional + Roth deferral) and contribution (matching + after-tax deferral) rates between HCEs and NHCEs.
Essentially, the IRS limits the disparity between the two groups based on the average rate of the NHCE group:
NHCE Average %
HCE Average %
|Under 2%||2 x NHCE Rate|
|2% to 8%||2% + NHCE Rate|
|Over 8%||1.25 x NHCE Rate|
If a plan fails the ADP and/or ACP test, the employer may have several correction options, which include refunds to HCEs and/or contributions to NHCEs. Betterment can assist with determining these corrective options.
Top heavy determination
Top-heavy determination is another element of the compliance testing process and is an important annual determination that may result in additional required contributions to employees. This test analyzes the accrued benefits between two groups: Key employees and non-Key employees.
A plan is considered top-heavy when the total value (account balance with adjustments related to rollovers, terminated accounts, and a five-year lookback of distributions) of the Key employees’ plan accounts is greater than 60% of the total value (also adjusted as noted above) of the plan assets, as of the end of the prior plan year (exception: the first plan year is determined based on the last day of that year).
If the plan is considered top-heavy for the year, employers must make a contribution of up to 3% to non-key employees; note that this can be reduced or avoided if no Key employee makes or receives contributions for the year (including forfeiture allocations).
Betterment can assist with determining the top-heavy status as well as minimum contributions due, if any.
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