There are several nondiscrimination tests you have to pass for your 401(k) program to receive a clean bill of health. Failing them could lead to losing your plan or worse.
Most small business owners struggle to navigate the complexities of setting up a 401(k) plan for their employees. It is also expensive, and most micro-enterprises cannot afford it. This is because many employers don't know that there are ways to make employee benefits affordable.
Another obstacle to providing a 401(k) is the complex, compulsory non-discriminatory annual testing obligations. Due to these challenges, businesses are increasingly outsourcing their retirement plans to a Professional Employer Organization. One of the crucial advantages of a PEO retirement plan is that you don't have to worry about non-discriminatory testing. They will do it for you.
What is a Nondiscrimination Test?
A nondiscrimination test is a fairness evaluation. It ensures that the highly compensated employees (HCEs) are not getting an unfair share of the retirement benefits, rights, and features. Regardless of their positions within the organization, all employees are entitled to the same benefits.
Failure to meet the IRS standards on this test may attract hefty penalties and fines. The ultimate objective is to ensure your company does not favor the highly compensated in its 401(k) plan.
The nondiscrimination test revolves around HCEs and key employees. The US government provides substantial tax benefits through 401(k) plans. Therefore, it has to deter the 401(k) program from benefiting the HCEs at the expense of the non-highly compensated.
Who are the Highly-Compensated Employees?
Highly compensated employees receive a remuneration of $135,000 or more from an employer sponsoring their 401(k) plan. The compensation includes the salary, bonuses, commissions, overtime, and salary deferrals.
Who are the Key Employees?
Additionally, an individual who owns a 5% stake of the company covering their 401(k) also falls within the highly-compensated employees bracket. This rule applies to your family's joint shareholding. For instance, if you own 2% of the business, but your wife and son have 1.5% each, you are still part of HCEs. However, these people are known as key employees.
A person who owns 1% of the company and receives a $150,000 or more remuneration package is also a key employee. If you are an officer of the organization sponsoring the 401(k) retirement program and receive a salary of $185,000 or more, you are a key employee.
What are the Most Common Nondiscrimination Tests?
There are several 401(k) nondiscrimination tests. Here are the most common ones:
1. Minimum-Coverage Tests
The minimum coverage test compares the percentage of highly compensated employees against that of the non-highly paid workers. If the ratio of non-highly paid employees is at least 70% of the covered HCEs, the test is satisfactory.
2. Compensation Ratio Tests
The compensation ratio test considers the earnings of the HCEs and NHCEs. It computes the average of both the HCEs and the NHCEs. To satisfy the test, the median of the HCEs should not exceed that of the NHCEs by more than 3%.
3. ADP Test
The average deferral percentage measures the average salary deferral percentages of the HCEs against that of non-highly paid workers. It considers the after-tax Roth and pre-tax deferrals. However, it ignores the no catch-up contributions of individuals above 50 years of age. To satisfy the test, the ADP of the HCE should not exceed that of the NHCEs by more than 2%. Further, the contribution of HCEs should not be more than double that of NHCEs.
4. Top Heavy Determination Test
A plan is said to be top-heavy when 60% of its assets belong to the key employees. The 401(k) provider checks this ratio annually against the account balances of the previous year. If the ratio surpasses the 60% mark, the employer has to pay a minimum of 3% benefits to the respective accounts of the NHCEs.
5. ACP Test
The Actual Deferral Percentage test considers the employee's 401(k) contributions or salary deferral. It compares the average contribution rate of the HCEs and the NHCEs. The deferral or contribution rate of the HCEs should not exceed that of NHCEs by 125%.
How Do You Correct a Failed 401(K) Plan?
There are several ways to correct a failed 401(k) plan. Below are the two main procedures:
Refund HCEs Contributions
When your 401(k) plan fails the ACP and ADP tests, you must take the necessary corrective measures. First off, you could refund the HCEs contributions. The process entails giving back the tax-deferred funds that key employers contributed to the plan. However, these refunds are taxable to the highly-compensated employees for the year in question.
Make Qualified Nonelective Employer Contributions
This corrective option requires the employer to make qualified nonelective contributions for the non-highly compensated employees. The contributions should not come from their monthly paycheck. Instead, the employer should pay directly into the 401(k) plan. If these payments are made within 12 months, the tax will not apply.
The good news is that small business owners can reduce the expense of providing a 401(k) plan for their workforce. Partnering with a PEO is one of the best approaches to doing so. A PEO can keep the costs of a retirement plan down because they pool all their clients together.
This reduces the total administrative expenses of a PEO's clients. The average ROI of a PEO is 27.2%, so you don't have to worry about HR outsourcing leading to a significant loss of cash flow. Working with a Professional Employer Organization will free up time for you to concentrate on your core business while they take care of your 401(k) plan.
