As Plan Sponsors, the subject of annual nondiscrimination testing can be somewhat confusing. Every year your recordkeeper likely asks you for a file of information on each employee in order to perform various calculations. The process they use to let you know if you pass or fail can seem a little mysterious to the average person who isn’t running compliance tests all day long. This primer aims to take some of the mystery out of nondiscrimination testing and give a high-level overview of the purpose of each test.
Understanding the Purpose of Nondiscrimination Tests
In order to understand the various tests that must be completed each year, you must first understand the spirit of ERISA: fairness, fairness, fairness. The whole aim of nondiscrimination testing is just that – nondiscrimination. The IRS wants to ensure the opportunities to participate and the benefits given are fairly distributed among high and low earners alike. As such, they require qualified plans to prove that equal opportunity through compliance testing. You will often see or hear phrases like Highly-Compensated Employee (HCE) or Safe Harbor when the subject of nondiscrimination testing comes up but do you know what they actually mean?
Below are some common, frequently-used terms:
Highly Compensated Employee (HCE): Anyone owning more than 5% OR anyone who has compensation in excess of $120,000 annually.
Non-Highly Compensated Employee (NHCE): Anyone not categorized as a highly-compensated employee.
Key Employee: Anyone owning more than 5% at any time during the year, OR anyone owning more than 1% with compensation in excess of $150,000, OR an officer with annual compensation in excess of $170,000.
Safe Harbor: A designation given to a plan meeting certain employer contribution requirements.
Top Heavy: A designation given to a plan which has more than 60% of plan assets held by key employees.
Examining the most common Nondiscrimination Tests
Now understanding these common terms, you will be able to better understand how each of the tests work. For most plans, six tests are typically run each year: Coverage Test, ADP Test, ACP Test, 402(g) Limits Test, 415(c) or Annual Additions Test, and Top Heavy Test. We will look at each test and examine what is measured and common correction methods.
410(b) Coverage Test:
This test measures the ratio of HCEs to NHCEs that are benefitting under the plan. In order to be in compliance, a plan must ensure that it provides benefits to a significant number of NHCEs. The IRS isn’t concerned with the HCEs. It’s all about the NHCEs.
There are two ways to pass the coverage test:
Ratio Percentage Test – This is the primary test to show that a significant number of NHCEs are covered by the plan. A plan passes this test if it can show the percentage of NHCEs "covered" or benefitting under the plan is equal to at least 70% of the number of HCEs benefitting. An employee is considered "benefitting" from the plan if they are eligible to participate. They do not have to actively contribute to be "benefitting."
Average Benefits Test – If a plan cannot pass the Ratio Percentage Test to demonstrate adequate coverage of NHCEs, they may still pass coverage under the less common Average Benefits Test. This test involves two parts and is quite complicated. The first part is to show that the plan is not discriminating based on class of employee (part-time, named employees not eligible to participate, etc.) and the second part creates a coverage percentage for NHCEs and HCEs by taking into account the safe-harbor and unsafe-harbor percentages.
Average Deferral Percentage (ADP) Test:
This test measures the average percentage of employee deferrals for HCEs and NHCEs which includes both pre-tax and Roth contributions. Once the NHCE and HCE ADPs are determined, the test examines if the HCE ADP exceeds the limits below:
If the HCE ADP exceeds that which is deemed acceptable by the IRS, the most common method for correction is through ADP refunds to the HCEs of the excess contributions and any associated earnings, as well as forfeiture of related match contributions. If the plan allows for catch-up contributions, and a participant has not contributed the maximum catch-up allowed, excess deferrals may be re-characterized as catch-up and therefore offset the ADP refund amount.
A second, less-common correction method is for the employer to issue qualified non-elective contributions (QNECs) to NHCEs in order to boost their ADP until it’s in an acceptable range. Because this represents a bigger cost to the company, it is not frequently utilized.
Actual Contribution Percentage (ACP) Test:
This test measures the average contribution rate for all employer match contributions and, if applicable, any after-tax contributions for HCEs and NHCEs. As with the ADP test, the ACP maximum HCE percentage is determined based on the chart below:
If the plan fails the ACP test, the most common correction method is to return the vested portion of the excess aggregate contributions, adjusted for any gains and losses, to the HCEs. Any unvested portions are forfeited. Again, the goal is to get the ACP of the HCEs within an acceptable range.
Additionally, you may choose to correct a failed ACP test through a qualified matching contribution (QMAC) to the NHCEs.
*Please note: If your plan is considered a Safe Harbor plan, you are not subject to ADP/ACP testing. The tests will still be completed by your recordkeeper; however, you are automatically deemed to pass these tests as a benefit of your Safe Harbor status. There are a couple of ways to gain Safe Harbor status: 1) offer a non-elective employer contribution of 3% or more to eligible employees, 2) offer the Safe Harbor basic match formula of 100% of the first 3% of compensation and 50% on the next 2% of compensation for a total match of 4%, or 3) offer a more generous match formula under the Safe Harbor enhanced match and gain the same benefits.
402(g) Limit Test:
This test is an end-of-year check to ensure no one is deferring above the IRS elective deferral limit for the year. For 2016, that limit is $18,000 if you’re under the age of 50 or an additional $5,000 for a total of $24,000 if you’re 50 or above. The correction for a failed test is quite simple: distribute the excess deferrals to the employee and issue a 1099-R for the taxable amount.
415(c) Annual Additions Limit Test:
This test is another end-of-year check to ensure an IRS limit is not being exceeded. The IRS limit in question is the annual additions limit – that is, the maximum amount of contributions that can be contributed to a participant’s account, including all employee and employer contributions. For 2016, that limit is $53,000. The correction for a failed test is also a refund like the 402(g) correction; however, the correction for annual additions is a multi-step process. First, you would refund any unmatched employee contributions. If you still need to refund additional monies, you would then refund any matched employee contributions and forfeit the related employer match. Finally, you would forfeit any employer Profit Sharing contributions.
As we learned from our commonly-used terms listed above, a plan is considered top-heavy if more than 60% of plan assets are held by key employees. Therefore, the top-heavy test looks at a plan to determine if the percentage of assets held by key employees falls within the acceptable ratio set forth by the IRS. The correction for a failed top-heavy test is fairly simple: generally, the employer will provide a 3% contribution to all non-key employees including any lost earnings.
The various non-discrimination tests can be confusing, even for the most adept Plan Sponsor. As with many of the processes involved in maintaining IRS retirement plan compliance, one small administrative misstep can potentially be a major headache for a Plan Sponsor. It’s worth the effort to understand these tests and review your plan annually to ensure you are following the necessary guidelines. A little work on the front end can save you time and effort on the back end.
If you have any questions about your plan’s non-discrimination testing or administration, contact your Advisor today.
About InTrust Fiduciary Group
InTrust Fiduciary Group is an independent, fee-only Registered Investment Advisory (RIA) firm specializing in ERISA retirement plan consulting services. The firm provides investment consulting, plan design consulting, fiduciary oversight and provider management services. InTrust Fiduciary represents approximately $2 billion in client assets with offices in Austin and San Antonio, Texas. To learn more, please visit www.intrustfiduciary.com.