Steering through the intricate terrain of IRS non-discrimination testing for IRS 401(k) plans needs precision and foresight. Annually, these tests serve as the litmus test for equitable distribution of benefits and adherence to 401k contribution limits for highly compensated employee (HCEs), safeguarding against disproportionate advantages for HCEs. Timely completion, typically following year-end, is imperative to avoid dire repercussions like IRS penalties, lost tax deductions, or worse, plan disqualification. The comprehension of the fundamentals of the tests used is crucial for HR professionals, business owners, and employees. This article simplifies the nuances of 401(k) testing, offering indispensable insights and remedies for potential pitfalls.
What does the term “Non-discrimination” testing imply?
IRS 401(k) non-discrimination testing is a crucial IRS-mandated process aimed at ensuring the equitable operation of 401(k) plans, preventing disproportionate benefits for highly-compensated employees (HCEs). It involves comparing the average contribution rates between HCEs and
non-highly compensated employees (NHCEs). A significant gap in contribution rates may lead to the plan failing the test and being deemed non-compliant with 401(k) regulations. This assessment, conducted annually, evaluates five key areas: eligibility, contributions, vesting, distributions, and
top-heavy requirements. These tests ascertain that eligibility rules, contribution rates, vesting periods, distribution rules, and asset distribution within the plan are fair and uniform across both HCEs and NHCEs.
Who are Highly Compensated Employees (HCE)?
An HCE, or Highly-Compensated Employee, is defined by the IRS based on two criteria: ownership and compensation. Ownership entails assessing an employee’s stake in the business during two distinct periods: the plan year under evaluation (the determination year) and the preceding year, also called the lookback year. If an employee owned more than 5% of the business interest at any point during either the determination or lookback year, irrespective of their compensation level, they are classified as a 401(k) HCE. Additionally, as per 401k and highly compensated employees requirements, individuals related to an HCE through ownership, defined through family attribution
(spouse, children, parents, and grandparents), are also treated as HCEs, excluding in-laws, siblings, or grandchildren.
Compensation, as defined by the IRS, encompasses various forms such as wages, salaries, bonuses, tips, and fringe benefits. For determining HCE status based on compensation, only the previous year’s compensation is considered. For the preceding year 2024, meeting the threshold to be classified as a 401(k) HCE based on compensation entails earning an annual income surpassing $155,000, aligning with the highly compensated employee 401k.
It’s essential to note that HCEs and NHCEs (Non-Highly Compensated Employees) are mutually exclusive categories. Employees not meeting the aforementioned criteria for high compensated employee 401(k) are classified as NHCEs.
What do you mean by Key Employees?
In addition to the IRS Highly Compensated Employee and Non-Highly Compensated Employee designations, an individual is categorized as a Key Employee if they meet any of the following conditions as per IRS 401(k) rules, during the determination year (the year where plan qualifies as per top heavy test) –
- Compensation: Any officer whose annual compensation exceeds $220,000 for the determination year 2024 (or $215,000 for the determination year 2023), regardless of their ownership stake or relationship status within the
- Ownership or Relationship: Any employee who holds more than a 5% ownership stake in the company or is directly related to an individual who
- Ownership and Compensation: Any employee who possesses more than a 1% ownership interest in the company and earns an annual income surpassing $155,000 (not adjusted for inflation).
What are the Major Non-discrimination tests?
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Actual Deferral Percentage (ADP) Test
- As per the IRS 401(k) rules, this test compares the average salary deferrals of highly compensated employees (HCEs) with that of non-highly compensated employees (NHCEs). Each employee’s deferral percentage is calculated as the percentage of compensation deferred to the 401(k)
- ADP is determined by dividing the amount an employee defers by their total W-2 income, providing insight into the contribution levels of both HCEs and
2. Actual Contribution Percentage (ACP) Test
- Similar to the ADP test, the ACP test compares the average employer contributions received by a Highly Compensated Employee 401(k) and Non-Highly Compensated Employees, rather than their
- ACP is calculated by dividing the company’s contribution to an employee by their W-2 income, ensuring fairness in employer contributions across different employee.
3. Top-Heavy Determination Test
- While not technically a nondiscrimination test, a Top Heavy determination assesses whether key employees hold more than 60% of the total plan assets, as per the 401(k) IRS
- It compares the account balances of key employees to non-key employees using data from the last day of the previous 12-month testing
- If key employees’ total account balance exceeds 60% of key and non-key balances, the plan is deemed top-heavy.
- In such cases, the employer is generally required to make a minimum contribution of 3% of each non-key participant’s compensation to address the top-heavy This contribution can be offset by any employer contributions made for the year.
What are the fundamental Annual Compliances applicable with respect to Non-Discrimination Testing?
Each year, 401(k) plan administrators conduct tests to verify that contributions to participants’ accounts comply with IRS-prescribed limits. Adhering to these limits is crucial for maintaining regulatory compliance and avoiding penalties or adverse tax implications. These limits encompass the following-
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Annual Additions Limit (IRC Section 415):
- Defined as the total of employee and employer contributions, including any reallocated forfeitures, credited to a participant’s account during the limitation year (typically the plan year).
- For the year 2024, the Section 415 limit is the lesser of:
- 100% of the participant’s
- $69,000 ($76,500, incorporating catch-up contributions).
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Elective Deferral Limit (IRC Section 402(g)):
- Applicable to both pre-tax and Roth salary
- The 402(g) limit for 2024 stands at $23,000 ($30,500 for participants eligible for catch-up contributions).
- Exceeding the 402(g) limit necessitates distributing the excess amount by April 15 of the subsequent year to prevent double-taxation.
How can you address a Failing 401(k) plan?
In the event of a failed test within your 401(k) plan, prompt corrective measures are imperative to mitigate potential repercussions. While encountering such scenarios is not uncommon, neglecting corrective action can lead to significant consequences.
The IRS 401(k) Fix-It Guide offers comprehensive guidance for navigating various plan-related issues. Specifically concerning the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, the guide proposes the following remedial actions:
- Refund Highly Compensated Employees’ (HCEs) contributions to reduce average contribution rates to acceptable levels, OR
- Make qualified non-elective employer contributions (QNEC) to all Non-Highly Compensated Employees (NHCEs) to elevate their contribution rates to meet the minimum threshold for test passage, OR
- A combination of both aforementioned corrective
Choosing the appropriate corrective action depends on the specific circumstances of the plan’s failure and its participants’ demographics.
Conclusion
Conducting the annual non-discrimination tests is pivotal for the seamless administration of as per 401(k) IRS code regulations. As evidenced by the resolution of a failing plan, remedying test failures can result in unfavorable outcomes for employees or necessitate unexpected employer contributions. To proactively manage any potential risks, it is strongly recommended to conduct plan testing throughout the year, ensuring timely measures are in place to address any issues that may arise. Our team at USAIndiaCFO can provide proficient support to manage non-discrimination testing, ensuring compliance and optimal outcomes for 401(k) plans.