Retirement 101: Non-Discrimination Testing
Matt Ruttenberg
Build a custom 401(k) for your business | Co-Owner & Director of Business Development of Life, Inc. Retirement Services
There are a lot of benefits that come with a 401(k) retirement savings plan. Not only is it a great incentive to retain employees, but it’s a great way to plan for retirement and save on taxes. However, because of the substantial tax benefits that go with a 401(k), the government has set up a series of annual tests that make sure that the 401(k) plans do not “discriminate” or unfairly benefit individual company owners or the highly-compensated employees.
Non-Discrimination Testing: What Is It?
Every year, the government issues nondiscrimination tests through the Employee Retirement Income Security Act (ERISA) to review the 401(k) plans of the highly compensated employees (HCEs) and the non-highly compensated employees (NHCEs). These tests are in place to ensure that the benefit plans are not discriminating against lower-income employees and that all the employees are taking advantage of the retirement plan.
Basic Terms:
The HCE is defined by the IRS, as an individual who owns more than 5% of the interest in the company OR receives payment of more than $125,000 if the previous year is 2019; and $130,000 if the prior year was 2020 AND, was in the top 20% of employees when ranked by total compensation. If someone doesn’t meet these conditions, they are an NHCE.
The IRS defines Key Employees as someone making over $180,000 in 2019 OR anyone who owns more than 5% of the business, OR anyone who owns more than 1% of the company and makes over $150,000 for the plan year.
The Actual Deferral Percentage (ADP) Test
The IRS uses the ADP test to compare what the average deferral percentage is by HCEs compared to the average deferral percentage of NHCEs.
The Actual Contribution Percentage (ACP) Test
Rather than tracking deferment, the ACP test compares the average employer contributions received by HCEs and NHCEs.