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- 27 Feb 2023Zenefits Review
Annual non-discrimination testing is a mandated IRS evaluation test of a company’s retirement, welfare, and health plans to ensure 401(k) plans benefit every employee equally. Non-discrimination testing is a part of the Employee Retirement Income Security Act (ERISA) federal law, where all employees have the chance to get equal benefits with no discrimination.
If a company passes the non-discrimination testing, it shows that the employer doesn’t discriminate between the employees on their paychecks.
The IRS relies on the evaluation test to:
IRS categorizes employees based on their income level and employment status before non-discrimination testing. The main categories are as follows:
A company should provide all employees with appropriate benefits according to federal law. Employers can learn mainly three things by understanding non-discrimination testing.
HCEs have the upper hand in contributing a more significant portion of their earnings to the 401(k) account and Health Savings Accounts (HSAs). Companies usually set up a similar match rate for all employees contributing to these accounts. It may not be inequality, but it is inequity.
A benefit only becomes beneficial when every employee's position is considered when deciding to match the rate. Otherwise, it will lead to inequity in benefits received from the company and IRS tax exemption for NHCEs.
For example, an HCE can easily fulfill its match rate of 5% annually. Still, when the match rate depends on the salary of a much lower-paid employee, they will not be compensated enough by the company because they were paying only 1% of their annual salary. It creates inequity in the workplace, causing the lack of salary increments due to higher benefit compensation for the HCEs.
The IRS evaluation test should take place at the end of the current year's plan. Employers should include all employees in the testing and appoint a preferred, reliable person with all the payroll information to complete the test.
Moreover, employers should check NDT once early or in the middle of the year to keep track of any discrimination.
The company’s chosen benefit plans will require the employers to take different NDTs. 401(k) benefit plans’ tests vary broadly from other health insurance plans’ tests.
Here are the four common NDTs performed by employers.
410(b) coverage tests mainly determine the ratios of eligibility of employees and the ratio of HCEs from NHCEs benefitting from the health plans. NHCEs must benefit 0.7 times more than HCEs to pass the current plan.
These annual coverage tests consider varying contributions, such as after-tax contributions, non-elective contributions, and employee and employer matching contributions.
The test compares the income deferral of HCEs to that of NHCEs to measure the employees' engagement in health plans. It assures equity between HCEs and NHCEs by ensuring that high-paid employers are not saving significantly higher than low-paid employees.
Employers need two percentages for ADP Test.
The following IRS criteria outline the requirements to pass the ADP test.
The test only applies if the company makes employer contributions because it compares the received average contributions by NHCEs and HCEs.
The criteria for ACP are the same as ADP, except that it includes employer matching rates and after-tax contributions to calculate the average contribution rate.
The test analyzes the rising benefits of two groups: Key and Non-Key employees. A health plan is top-heavy when the key employees' health plan accounts are more than or equal to 60% of the non-key employees' plan accounts at the end of the current year's plan.
To resolve this issue and pass the test, employers need to contribute to non-key employees, which cannot be less than 3% of the contribution of key employees.
An employer and HR leader can easily improve their chances of passing the non-discrimination test by following simple practices.
IRS requires annual nondiscrimination testing to avoid any disproportional benefits circulating in the company. So, it is mainly the date when the company last took NDT.
For example, if an employer performed NDT on September 21, 2021, then the due date of the test is September 21, 2022.
The best way to avoid any problematic situations, such as non-compliance with IRS guidelines, is to perform the test at the beginning or middle of the year. It gives the employer opportunity and time to correct any imbalances or improve health plans to get approval for the non-discrimination test.
