Non-discrimination testing is a way to ensure employers are offering equitable benefits to highly-paid and non-highly paid employees. Section 125 plan sponsors and employers offering specific other employee benefits are required by the IRS to conduct non-discrimination testing annually, so it’s not something you can choose to ignore.
What Is IRS Non-Discrimination Testing?
Non-discrimination testing (sometimes styled nondiscrimination testing or non discrimination testing, or abbreviated to NDT) is testing employers must carry out annually if they offer specific employee benefits.
The testing helps to ensure that there is no discrimination between highly compensated employees (HCEs) and non-highly compensated employees (NHCEs) around 401(k) plans and other in-scope benefits.
These benefits deliver pension provision, health care and other benefits on a pre-tax basis and can potentially discriminate in favor of employees who earn more. They also have the potential to reduce the tax employers pay on benefits. For these reasons, the IRS mandates annual testing to prevent this discrimination.
What Is the Purpose of Non-Discrimination Testing?
Non-discrimination testing is designed, in the words of the IRS:
“to ensure that the contributions made by and for rank-and-file employees (non-highly compensated employees (NHCE)) are proportional to contributions made for owners and managers (highly compensated employees (HCE)).”
In this way, non-discrimination testing identifies whether your employer-provided benefits disadvantage non-highly compensated employees compared to those more highly compensated.
In addition, 401k non-discrimination testing helps the IRS to ensure that it receives appropriate tax by ensuring that plan sponsors meet their tax obligations.
As with other regulations, the penalties for non-compliance can be significant. Any organization that is shown via testing not to comply with IRS requirements on taxable benefits can face penalties, with the company and employees forced to pay any tax due.
How Does the IRS Define an HCE and NHCE for Non-Discrimination Testing?
Understanding what is considered a highly compensated employee is crucial to your non-discrimination testing. The IRS uses two tests to categorize highly compensated employees:
- Ownership test: if an employee owns or has owned 5% or more of the business during the current plan year or the 12-month period prior to the current plan year.
- Compensation test: if an employee received compensation from the business over a certain amount (currently more than $130,000 in 2020 or 2021).
The employer can also categorize HCEs as being within the top 20% of employees when ranked by compensation.
All other employees are categorized as non-highly compensated employees (NHCEs).
Why Is Compliance With IRS Non-Discrimination Testing Important?
Complying with IRS requirements on non-discrimination testing is important for two reasons:
- It’s mandatory. Any employer who offers a retirement plan under Section 125 of the IRS code (sometimes called a Section 125 plan or cafeteria plan) must carry out non-discrimination testing. These plans include not only pension plans but also health savings plans like flexible spending accounts (FSAs), health reimbursement arrangements (HRAs), and health savings accounts (HSAs).
- It helps you meet your obligations around environmental, social and governance (ESG) factors.
In 2022, regulatory compliance is more important than ever, as organizations strive to deliver on legislative and societal expectations. Non-discrimination testing for retirement plans is a valuable and non-negotiable element of your wider governance, risk and compliance (GRC) strategy.
By testing to identify any non-compliant practices — and rectifying any issues that emerge — you also address compensation equity issues as part of your ESG strategy. This focus on equality is increasingly important as organizations recognize that demonstrating ESG proactivity isn’t just a compliance issue but positively good for business.
How To Perform Non-Discrimination Testing
The requirements around non-discrimination are clear, as are the benefits of carrying it out.
Now we turn to the practicalities: how should you carry out non-discrimination testing?
When Should You Carry Out Non-Discrimination Testing?
You should conduct your non-discrimination testing on the last day of the current plan year. The “current plan year” is different for every organization, depending on when your plans took effect. So there is no set date, and you should ensure those responsible know your due date to avoid late filings and IRS penalties.
It may also be worth carrying out a practice or trial-run test earlier in the plan year. This will enable you to see whether there are any shortfalls in your current approach and take any steps needed to ensure you comply by the end of the plan year.
Which Employees Should Be Included in Your Non-Discrimination Testing?
IRS non-discrimination testing should include all employees who were employed on any day during that plan year.
Who Should Carry Out Non-Discrimination Testing?
Non-discrimination testing is conducted by someone who can access your payroll information. In practice, this means it is usually led by the HR department, sometimes with help from external consultants. Compliance, audit and leadership teams will also have close involvement and interest in the testing process and its outcomes.
What Non-Discrimination Tests Should You Perform?
The tests you perform depend on the type of plan you are testing. Among the most common non-discrimination testing approaches are:
The Actual Deferral Percentage (ADP) Test
The actual deferral percentage is the percentage of wages employees under a 401(k) retirement plan “defer” (in other words, that they have deducted from their paycheck towards their 401(k) plan).
The IRS is keen that the percentages among HCEs and NHCEs are not vastly dissimilar and has some set criteria to ensure this:
- HCEs don’t defer more than 125 percent of the ADP from the NHCEs
- HCEs don’t defer less than 200 percent of the ADP from the NHCEs
- The ADP of the HCEs doesn’t exceed the NHCEs’ ADP plus two percent
The Annual Contribution Percentage (ACP) Test
This follows the same approach as the ADP Test, down to the criteria used by the IRS to determine non-discrimination, but the ACP Test counts employer-matched contributions and after-tax contributions to the plan alongside pre-tax deductions.
Again, the IRS requires that contributions are proportional between HCEs and NHCEs.
The Top-Heavy Test
The top-heavy test aims to identify whether your owners and most highly-paid employees own a disproportionate amount of the plan’s assets. The IRS defines a plan as top-heavy if the business’s owners and “key employees” own more than 60% of the value of the plan assets.
How does the IRS define “key employees”? They are defined as:
- Those earning more than $185,000 a year
- Those owning more than 5% of the company
- Those who own more than 1% of the company AND earn more than $150,000 a year
After Your Non-Discrimination Testing — What Next?
Hopefully, you now have an understanding of non-discrimination testing and what you need to do to comply with IRS requirements. But of course, testing isn’t the whole picture, and there will be remedial action if your testing shows that your benefits plans aren’t compliant.
Not only that, but IRS non-discrimination testing will be just one of a wealth of compliance responsibilities your organization faces. Regulatory compliance obligations seem to become more wide-ranging and prescriptive every year, with business leaders needing to decode their numerous obligations and tackle them head-on.
Stay on top of your obligations, deliver fast, focused responses to compliance challenges and demonstrate compliance internally and externally. Find out more about how your organization could benefit from Regulatory Compliance Management from Diligent.