Compliance

401(k) Nondiscrimination Tests Explained

With acronyms like ADP, ACP, NHCEs, and HCEs, the technicality of 401(k) plan nondiscrimination testing may seem overwhelming.

By PLANSPONSOR staff editors@plansponsor.com | December 01, 2014
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Even though nondiscrimination testing is likely performed by a plan’s recordkeeper or third-party administrator (TPA), plan sponsors need to understand the basics of the tests, including the types of contributions that are tested, the methods used and the consequences of failing.

The Tests

The Employee Retirement Income Security Act (ERISA) requires several tests each year to prove 401(k) plans do not discriminate in favor of employees with higher incomes.

For some of the tests, employees are divided between non-highly compensated employees (NHCEs) and highly compensated employees (HCEs). The Internal Revenue Service (IRS) defines "highly compensated employee" as an individual who:

  • Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
  • For the preceding year, received compensation from the business of more than $115,000 (if the preceding year is 2013 or 2014; $120,000 if the preceding year is 2015), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.

 

The compensation used for determining whether an employee is an HCE is indexed each year.

Robert Richter, vice president with SunGard’s wealth and retirement unit, breaks the nondiscrimination rules into three parts. First, he says, there are rules to ensure there is broad coverage of employees; those compose the 410(b) coverage test.

Next, once you have a sufficient number of NHCEs covered, you look at the benefits, rights and features of the plan to ensure they are nondiscriminatory. This is tested by the ADP and ACP tests.

ADP stands for actual deferral percentage, explains Robert Kaplan, national retirement consultant for Voya Retirement Solutions. This test compares the average of salary deferral percentages for HCEs with the average of salary deferral percentages for NHCEs. The ADP test applies to pre-tax and Roth elective deferrals. Kaplan says the purpose of this test is to ensure that all participants, both HCEs and NHCEs, are benefitting from the plan. 

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