401(k) compliance testing confirms you’re meeting the Internal Revenue Service (IRS) standards for retirement plans so that you and your employees can take advantage of the tax and other benefits available through your plan.

Company-sponsored retirement plans support employees in planning for their financial futures and are a great tool you can use to attract and retain top talent. However, in order for the plan to remain compliant, it must pass certain tests each year to confirm that all eligible employees have the opportunity to experience the retirement plan’s advantages—not just highly paid employees, officers, and owners.

In this article, we’ll review the different types of nondiscrimination tests that employers should be familiar with.

The Basics: Understanding Highly Compensated and Key Employees

Before jumping into the different types of nondiscrimination tests, you should understand two important terms—highly compensated and key employees. These concepts serve as the foundation for the IRS’s nondiscrimination tests.

Types of 401(k) Nondiscrimination Tests

The following common nondiscrimination tests may apply to your 401(k) plan.

Actual Deferral Percentage (ADP) Test

The ADP test compares the percentage of both pre-tax and Roth employee deferral contributions deducted from payroll for HCEs against those for NHCEs. Catch-up contributions available to participants over age 50 are not included in the ADP test.

To pass the ADP test, the HCE average contribution rate cannot exceed the greater of:

• 125% of the NHCE average rate

OR

• The lesser of:
  • 200% of the NHCE average rate, or
  • The NHCE average rate plus 2%

The ADP percentages for NHCEs may be based on current or prior-year contributions. The plan document contains the election for either current or prior year contributions.

Actual Contribution Percentage (ACP) Test

The ACP test uses the same calculations as the ADP test, except it compares the average employer matching contribution percentage of HCEs against the average for NHCEs. It also includes after-tax employee contributions, if allowed by the plan.

Top-Heavy Test

A retirement plan is top-heavy if the company owners and key employees hold more than 60% of the plan assets’ value. The top-heavy test is conducted annually based on the account balances of the prior plan year’s last day.

If your top-heavy ratio exceeds 60%, then your business typically pays a minimum contribution (such as 3%) to non-key employees.

Minimum Coverage Test

The minimum coverage test confirms that a retirement plan benefits enough NHCEs. This test uses the Ratio Percentage Test (RPT) to examine the ratios of employees who are “eligible” to participate (i.e., those meeting minimum age and service requirements) and those who are “benefiting” from the plan (i.e., those who actually receive a contribution). If at least 70% of NHCEs benefit from the plan, it passes the RPT minimum coverage test.

However, beyond the RPT test, there is another method called the Average Benefits Test (ABT), which is slightly more complex. To determine minimum coverage, you can use either the RRT or the ABT, or a combination of both, depending on the specific needs and structure of your plan.

Compensation Ratio Test

Not every plan will have to complete the Compensation Ratio Test. It is only required for plans that exclude certain types of compensation. This test confirms that the retirement plan’s compensation definition does not disproportionately benefit HCEs. To determine this:

1. Calculate the compensation ratio for each participating employee.
2. Divide the participating employees into an HCE and NHCE group.
3. Average the compensation ratios for each group.

To pass the test, your average ratio for the HCE group may not exceed the average ratio for the NHCE group by more than a certain amount, typically within three percentage points of the NHCE’s average.

What Happens if My Plan Fails a Nondiscrimination Test?

If your 401(k) plan fails any applicable nondiscrimination tests, you must take corrective action within specific timelines specified by the IRS. The action needed will depend on which test was failed and certain other plan-specific factors, but in general, failing one or more annual tests could require you to make an additional contribution to your plan or make refunds to your HCEs for a portion of their contributions. The IRS and DOL may also impose other penalties or taxes; in some cases, they may disqualify the plan.

Partner With a Trusted Recordkeeper to Make Compliance Testing a Breeze

By bundling all retirement plan services with Vestwell, such as investment management, recordkeeping, and compliance support, you can more easily administer your retirement plan while avoiding nondiscrimination testing hiccups along the way. Vestwell offers several services designed to help businesses streamline the compliance testing process:

• Customized Plan Design: Our Plan Design team collaborates with employers from the start, tailoring their plan and making recommendations to meet the custom needs of each individual business.
• Annual Compliance Reminders and Census Collection: Throughout the testing season, our Client Services team keeps employers updated on the need-to-knows of staying compliant. This involves sending multiple reminders to submit employee census data on time to meet IRS deadlines.
• Detailed Compliance Testing and Follow-Up: Once employers provide the census data, Vestwell completes all necessary testing. If any issues arise, our team is available to meet with employers and advisors to review results, propose solutions, and consult on ways to prevent future issues.

Conclusion

Compliance testing can be complicated. However, Vestwell’s experienced professionals can help you navigate a retirement plan’s legal requirements, protecting you and your employees’ financial futures.

Want to learn more about keeping your retirement plan compliant? Vestwell helps businesses of all sizes administer and manage workplace retirement plans. Click here to get started.