Nondiscrimination tests for defined contribution (DC) and defined benefit (DB) plans are based on plan years, so for those plans with a calendar year plan year end, the time to think about nondiscrimination testing is now.
Testing required by plan type
For 401(k) plans, required nondiscrimination testing includes Section 410(b) coverage testing, the average deferral percentage (ADP) test on employee deferrals, the average contribution percentage (ACP) test on employer matching contributions and certain after-tax employee deferrals, and top heavy testing.
David Levine, ERISA attorney and principal with Groom Law Group, Chartered, in Washington, D.C., adds that in certain cases—for example, when plans may offer different matching contribution formulas for different employee locations—a benefits rights and features test may need to be performed.
For 403(b) plans, coverage testing and ADP testing is taken care of by the universal availability requirement, which provides that if an employer permits one employee to defer salary into a 403(b) plan, the employer must extend this offer to all employees of the organization. Exceptions include:
- Employees who are eligible to defer to a governmental 457(b) plan;
- Employees eligible to defer to a 401(k) or another 403(b) plan of the employer;
- Employees who are nonresident aliens with no U.S.-earned income;
- Employees who are students performing services described in Section 3121(b)(10); and
- Employees who normally work fewer than 20 hours per week.
ACP testing is required for 403(b) plans, but according to Levine, no top heavy testing is required.
For profit sharing plans without a 401(k) deferral option, coverage testing, minimum participation testing and top heavy testing are required. In addition, Employee Retirement Income Security Act (ERISA) Section 401(a)(4) testing is required. Amy Ouellette, director of retirement services at Betterment for Business in New York City, says this is called general nondiscrimination testing.
Levine says the same testing is required for money purchase pension plans as for profit sharing plans.
For defined benefit (DB) plans, including cash balance plans, general nondiscrimination, top heavy and minimum participation testing is required. Levine and Mark Carolan, senior associate with Groom Law Group, agree that testing for employee stock ownership plans (ESOPs) requires its own discussion.
For governmental plans, Levine says no testing is required; the Economic Growth and Tax Reconciliation Relief Act of 2001 (EGTRRA) and the Pension Protection Act of 2006 (PPA) formally carved them out.
Most testing does not have specified due dates. According to Ouellette, the timing of testing is typically dictated by requirements for corrections. For example, excess distributions to correct ADP and ACP testing failures are due 2 1/2 months after plan year end, so that testing is usually done in time to make those distributions. Ouellette explains that plan sponsors have up to 12 months to make corrections—which can instead be made by a qualified nonelective contribution (QNEC) to all non-highly compensated employees (NHCE). But if the employer is making corrections by a distribution of excess amounts, those corrections need to be made by 2 1/2 months following plan year end to avoid excise taxes on those distributions.
For coverage, top heavy and general nondiscrimination testing, when a QNEC contribution is required to be made by the plan sponsor, testing should be done in time to make those contributions by the deadline offered for plan sponsors to get a tax deduction for those contributions. See the 2019 ERISA Plan Compliance Calendar.
Preparing for nondiscrimination testing
Ouellette says Betterment asks for two sets of information to be provided by plan sponsors, in the forms of a census and questionnaire. The questionnaire is critical she says, as it can affect who is considered a highly compensated employee (HCE) or a key employee. The questionnaire asks about changes in ownership, acquisition of new entities and new partners. For example, a 5% owner may have married someone in the company or hired his son.
According to Carolan, census data includes hire dates, termination dates, deferral elections, contributions made during the year, and proper employment status. These could be active, eligible but not participating, leave of absence, etc. He says some recordkeepers and third-party administrators (TPAs) will help generate this data from the payroll interface, but plan sponsors need to make sure the data is correct; they cannot blame the recordkeeper if it is not.
Ouellette says Betterment tries to make it as easy for clients as possible. “We download what was given to us throughout year and send it to the plan sponsor to make sure it is correct.” She points out that employees who are eligible, but not participating, are included in ADP and ACP testing.
It is also important to properly determine who is an HCE for ADP and ACP testing and who is a key employee for top heavy testing. 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 the limit announced by the IRS (See Maximum Benefit and Contribution Limits Table 2019), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
A key employee is an employee (including a former or deceased employee) who at any time during the plan year was an officer making more than the amount announced by the IRS (also in the Maximum Benefit and Contribution Limits Table) for the plan year being tested; was an owner of more than 5% of the business; or was an owner of more than 1% of the business and making more than $150,000 for the plan year.