Avoid these four common 401(k) nondiscrimination testing mistakes

One of the fundamental tenets of qualified retirement plans is that they can’t favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). To satisfy this requirement, 401(k) plan sponsors must perform annual nondiscrimination tests. Successful testing depends on having accurate information, so we’ve identified four common data errors and tips to help you avoid them.

Annual testing requirements for 401(k) plans

Before delving into the mistakes, let's take a brief look at the nondiscrimination tests required under the Internal Revenue Code. These tests help ensure HCEs don’t receive a disproportionate share of the plan benefits.

Nondiscrimination test

Description

Minimum coverage test

Determines if the plan is covering enough NHCEs based on the 70% test, ratio percentage test, or average benefit test

Actual deferral percentage (ADP) test

(non-safe harbor 401(k) plans)

Compares the average annual elective deferral rates of HCEs and NHCEs

 

Actual contribution percentage (ACP) test

(non-safe harbor 401(k) plans)

Compares the average annual employer matching contributions and after-tax employee contributions of HCEs and NHCEs

 

Top-heavy test

Looks at the accrued benefits of key employees, which can’t exceed 60% of a 401(k) plan’s total benefits

Common 401(k) nondiscrimination testing mistakes

When it comes to performing the tests above, the popular saying “bad data in, bad data out” holds true. Inaccurate information can lead to false negative or positive results, meaning you might think your plan passed when it really didn’t, or you were aware that your plan failed, but due to bad data, were unaware of the degree. Either way, plan qualification may be compromised. 

These four common testing errors fall into the bad input category: 

1 Using the wrong compensation: For testing purposes, plan sponsors must use a definition of compensation as required under the IRS regulations, and for purposes of calculating plan contributions, must use the definition in the plan document, which may be different from W-2 wages. Not using the right definition can cause an employee to be misclassified as highly or non-highly compensated and skew the requisite nondiscrimination testing results.

2 Excluding eligible employees: The plan document also outlines eligibility requirements for both voluntary and automatic enrollment. If these requirements aren’t followed properly, it can cause inaccurate coverage calculations and result in “missed deferrals,” both of which are plan failures that must be corrected.  

3 Using the wrong IRS limits: The IRS imposes annual retirement plan compensation and contribution limits, including the maximum compensation a sponsor can consider when determining contributions, an annual 401(k) deferral limit, and an income threshold for key employees and HCEs. Using the wrong figures can have a direct impact on a plan’s ADP, ACP, and top-heavy tests.

4 Excluding employees from related businesses: If a company shares common ownership with another company (to a specified degree), the IRS will treat them as one entity for purposes of coverage and 401(k) nondiscrimination testing. These situations are referred to as controlled groups. Not including employees from a related business has the same implications as excluding eligible employees. 

Ways to help avoid 401(k) nondiscrimination testing errors

So how can you help ensure you have good data? It boils down to education, communication, and documentation.

Verify the accuracy of employee census data used for testing, including compensation, contribution amounts, hire dates, and termination dates.

Establish written policies and procedures that outline the testing process, roles and responsibilities, and key dates.

Educate everyone involved about your plan’s provisions and testing policies, including your internal benefits team, payroll provider, third-party administrator, and recordkeeper.  

With the proper preparation and oversight, you can potentially avoid common data errors and feel more confident in your nondiscrimination test results.

 

The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.

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