What Does Nondiscrimination Testing Mean?


By Constantine Mezhinsky

One of the most commonly misunderstood or even sometimes ignored aspects of employee benefit plan administration relates to compliance and nondiscrimination testing. Certain tests are required to be performed annually to ensure that a plan is operating in accordance with the Internal Revenue Code (IRC). Often the plan’s recordkeeper or third-party administrator will complete the testing, and so perhaps, the substance of the tests is not always fully understood.

Generally, the purpose of these tests is to ensure that highly compensated employees (HCEs) do not receive a favorable portion of benefits or contributions compared to non-highly compensated employees (NHCEs).

The crucial first step is to identify the employees who fall into the category of an HCE. According to IRC Section 414(q), an HCE is any employee who was either a 5% owner at any time during the year or prior year, or was paid in excess of $115,000 by the employer during the previous year. This dollar amount is subject to change each year.

The following tests are commonly performed in order to ensure compliance with applicable requirements:

Minimum Coverage Test - This test is designed to ensure that benefits do not discriminate against NHCEs. One way to pass this test is to prove that the percentage of NHCEs covered by the plan is at least 70 percent of the percentage of HCEs covered. Alternatively, the plan can satisfy the coverage test if the average benefits of the NHCEs, expressed as a percentage of compensation, is at least 70 percent of that for the HCEs. The IRC allows for certain exclusions in determining coverage, such as employees covered by a collective bargaining agreement.

Actual Deferral Percentage Test (ADP Test) - This test is designed to determine whether in a 401(k) plan, elective pre-tax and/or post-tax deferrals (Roth 401(k) contributions) made by HCEs and those made by NHCEs are unfairly skewed. Certain thresholds are set by the IRC in order to determine whether the test is satisfied.

Actual Contribution Percentage (ACP Test) - This test is designed similar in nature to the ADP test above, but it measures the employer matching contributions and certain non-Roth employee post-tax contributions for a 401(k) plan to determine whether contributions are unfairly skewed.

If a plan fails any one of these or other compliance tests, it is crucial for a plan to take timely corrective action. Failure to do so could result in plan disqualification. Schneider Downs can offer expertise in both understanding these tests and necessary corrective actions. The IRS website is also a great resource for guidance on corrective actions.

Overall, it is important for a plan administrator to take the time to understand the required tests for their plan(s), understand the nature of these tests, and take corrective action as soon as practicably possible to avoid further repercussions.

© 2013 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.

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© 2019 Schneider Downs. All rights-reserved. All content on this site is property of Schneider Downs unless otherwise noted and should not be used without written permission.