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.
Why Does IRS rely on Non-Discrimination Tests?
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:
Check that all workers or employees receive equal and non-taxable benefits.
Ensure employers meet tax credit criteria.
Ensure proper health reimbursement arrangements and individual medical plans.
How does Income Status classify Employees for Non-Discrimination Testing?
IRS categorizes employees based on their income level and employment status before non-discrimination testing. The main categories are as follows:
According to IRS, an employee falls into the Highly Compensated Employee (HCE) category when:
One owns more than 5% of capital or profits in a business, corporate stocks, or corporate stocks’ voting power.
One who receives $130,000 or more compensation for a year.
According to IRS, an employee falls into the Non-Highly Compensated Employee(NHCE) category when:
One does not meet the criteria for the HCE category.
According to IRS, an employee falls into the Key Employee (KE) category when:
Owns more than 1% of voting power, capital, or profits.
One who has earned more than $150,000.
Holds more than 5% of corporate stocks.
Why Should Employers Care about Non-Discrimination Testing?
A company should provide all employees with appropriate benefits according to federal law. Employers can learn mainly three things by understanding non-discrimination testing.
To reflect equality in the employees’ benefit plans.
To avoid tax penalties and bureaucratic problems.
To favor both the employees and the employers of the company.
Is the Same Match Rate for Employees Discriminatory?
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.
When Should NDT (Non-Discrimination Testing) Take Place?
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.
What are the Common Non-Discrimination Tests?
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
Actual Deferral Percentage (ADP) Test
Actual Contribution Percentage (ACP) Test
Top-Heavy Determination Test
1. 410(b) Coverage Tests
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.
2. Actual Deferral Percentage Test (ADP)
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.
HCE contribution rate: Divide the average deferral rate (ADP) for all the eligible HCEs by their average annual compensation to get the HCE contribution rate.
NHCE contribution rate: Divide the average deferral rate (ADP) for all the NHCEs by their average annual compensation to get the NHCE contribution rate.
The following IRS criteria outline the requirements to pass the ADP test.
HCEs’ ADP must not exceed NHCEs’ ADP+2%
NHCEs’ ADP must be more or equal to 200% of HCEs’ ADP
HCEs’ ADP must be less than 125% of NHCE’s ADP
3. Actual Contribution Percentage Test (ACP)
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.
4. Top-Heavy Determination Test
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.
What Can Employers Do to Get Better Results in Non-Discrimination Testing?
An employer and HR leader can easily improve their chances of passing the non-discrimination test by following simple practices.
Know the fundamental aspects of the test
A certified, competent consultant can help understand the complex non-discrimination testing process.
Make the information for the retirement plans available for the employees
Offer automatic enrollment in the retirement program for better employee participation
Due Date of Non-Discrimination Testing
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.