Updated November 8, 2016
Life isn’t always fair. Johnny Carson used to say that if life were fair, Elvis would be alive and the impersonators would be dead.
Nevertheless, some things are supposed to be fair.
Take your 401(k) plan. Traditional 401(k) plans are not allowed to discriminate, at least when it comes to the salary deferrals and matching contributions for highly compensated employees (HCEs).
401(k) Nondiscrimination Rules
The IRS implemented rules to prevent such discrimination by limiting the plan benefits accruing to an employer’s highly compensated employees as a group relative to its group of nonhighly compensated employees (NHCEs).
These nondiscrimination rules are known as the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test.
Plan sponsors must test their traditional 401(k) plans each year — and, optionally, more often — for discrimination. Generally, they have a choice of basing the calculations on current or prior-year data, but the method chosen must be specified in the plan document. The prior-year method reduces the chance of failing the nondiscrimination testing as various calculated limits are known in advance.
If your plan does not pass nondiscrimination testing, then you (as employer and plan sponsor) will be required to limit the contributions of highly compensated individuals, and perhaps even return a portion of their deferred salary.
Highly Compensated Employees and Nonhighly Compensated Employees Defined
To apply these nondiscrimination tests, it’s essential to correctly distinguish between highly compensated employees and those that are not considered to be highly compensated.
A highly compensated employee is generally an eligible employee who was either of the following:
a five percent or more owner of the employer at any time during the current or prior plan year, regardless of the amount of his or her compensation, or
an employee who received compensation of more than $120,000 for the prior year (2015 – 2017, and inflation-adjusted for subsequent years) and, if the employer elects, was in the top 20 percent of employees based on compensation.
All other eligible employees are considered nonhighly compensated employees (NHCEs), whether or not they participate in the plan.
Actual Deferral Percentage (ADP) Test
The ADP test is an annual test that compares the average salary deferral rate of highly compensated employees to the average salary deferral rate of nonhighly compensated employees.
An employee’s salary deferral percentage is the elective amount of compensation that is deferred to the 401(k) plan — including pre-tax and Roth deferrals, but not catch-up contributions — divided by the amount of compensation before the deferral, and expressed as a percentage. By averaging the salary deferral for all HCEs, you get the actual deferral percentage (ADP) of the HCE group – and similarly, the ADP for the NHCE group.
You pass the test if the ADP for your HCE group doesn’t exceed:
that of the NHCE group by 1.25 percent or more, or
the lesser of:
— 200 percent of the NHCE ADP, or
— the NHCE ADP plus 2 percent.
Actual Contribution Percentage (ACP) Test
The ACP test is similar to the ADP test, except the numerator of the calculation is the amount of matching contributions, rather than the elective amount of compensation deferred to the plan. The calculation must include employees who worked at least 500 hours during the year, regardless of whether they met other qualification requirements.
The requirements to pass this test are the same as for the ADP test.
Stimulating NHCE participation is critical to enabling your employees — both HCE and NHCE — to get the maximum benefit from your 401(k) plan. And, as the tests demonstrate, the contributions of your key employees may be limited by the amount of contributions from your other employees.
There are several approaches you can take to increase NHCE participation in your plan, including the following:
providing an employer match
educating your employees on the tax and financial benefits they gain from participation
providing for an automatic enrollment
Now is a great time to test your plan to determine its status. And if it’s failing the nondiscrimination tests, to take corrective action before year-end.
If you have any questions or concerns, give us a call.