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Each year, 401(k) plans must pass certain IRS-mandated nondiscrimination tests to confirm Highly-Compensated Employees (HCEs) do not disproportionately benefit and no IRS contribution limits are exceeded. These tests are often completed soon after the close of the year so test correction and tax deduction deadlines are not missed. For calendar-based 401(k) plans, that means now.
While a professional Third-Party Administrator (TPA) will usually complete these tests, I recommend business owners understand their basics and deadlines because the consequences for late testing and/or correction can be severe – including IRS penalties, missed tax deductions, and even plan disqualification.
If you’re a business owner, here’s what I think you should know.
The Major 401(k) Nondiscrimination Tests
401(k) nondiscrimination tests must be passed to demonstrate that annual contributions do not impermissibly discriminate in favor of HCEs. For 2024, an HCE is defined as an individual that meets one of the following criteria:
- They own more than 5% of the employer (either directly or by family attribution) at any time during 2024 or 2023
- They received more than $150,000 in compensation from the employer during 2023. A plan can limit this group to the top 20% of employees, ranked by compensation, in its governing plan document.
The major 401(k) nondiscrimination tests include:
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Purpose of Test |
To demonstrate the plan covered (i.e., benefitted) enough non-HCEs during the year. |
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Calculation |
To pass the coverage test, each contribution made to the plan during the year (e.g., elective salary deferrals, matching, and profit sharing) must satisfy either the ratio percentage or the average benefit test. The ratio percentage test is the most common. To pass this test, the following calculation must equal or exceed 70%: (# of eligible non-HCEs that benefitted from the contribution / # of eligible non-HCEs employed by the company) / (# of eligible HCEs that benefitted from the contribution / # of eligible HCEs employed by the company) |
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Correction method |
To correct a failed coverage test, the plan must adopt a corrective amendment, up to 9½ months following the close of the plan year in which the failure occurred, to retroactively expand plan coverage. When a plan’s salary deferral feature fails the coverage test, a Qualified Nonelective Contribution (QNEC) must be contributed to the non-HCEs to correct their “missed deferral opportunity.” |
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Comments |
A plan can disregard the following employees when coverage testing:
A controlled group or affiliated service group is considered a single employer by ERISA. |
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Purpose |
To demonstrate the rate of salary deferrals - including pre-tax and Roth deferrals, but not catch-ups - made to HCEs during the year did not exceed the non-HCE rate by no more than the permitted amount. |
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Calculation |
An ADP is calculated by averaging the deferral percentages of the HCE and non-HCE groups. To pass the ADP test, the ADP of the HCE group cannot exceed the greater of:
The non-HCE group ADP can be based on the group’s current or prior year contributions. |
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Correction Method |
The most common correction method is refunding the contributions made to HCEs in the amount necessary to pass the ADP test. A 10% excise tax will usually apply to refunds made after March 15, 2024 (2 1/2 months following the close of the year). The final deadline for refunds is December 31, 2024 (12 months following the close of the year). |
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Comments |
Safe harbor 401(k) plans are not subject to the ADP test. Thanks to the SECURE Act, a 401(k) plan can adopt safe harbor status up to the last day of plan year following the year in which the plan failed the ADP test by making a 4% nonelective contribution. |
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Purpose |
To demonstrate the rate of matching and voluntary after-tax contributions made to HCEs during the year did not exceed the non-HCE rate by no more than the permitted amount. |
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Calculation |
Same as the ADP test. |
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Correction Method |
Same as the ADP test. |
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Comments |
Safe harbor 401(k) plans are not subject to ADP testing. |
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Purpose |
Most often, the test is used to demonstrate a “new comparability” profit sharing contribution does not discriminate in favor of HCEs by more than the permitted amount. |
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Calculation |
Most new comparability contributions pass the general test by actuarially converting participant allocation rates to a benefit at retirement. This “cross-testing” can make a 15% contribution to a 55-year-old (with 10 years to retirement) as valuable) for purposes of the general test as a 5% contribution to a 30-year-old (with 35 years to retirement. However, all non-HCEs must receive a “gateway minimum” contribution before a new comparability contribution can be cross-tested. This contribution must equal to the lesser of:
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Correction Method |
New comparability contributions rarely “fail” the general test. Instead, non-HCE contribution rates are increased until the test passes – the worst-case scenario being either a pro rata contribution or no contribution at all. |
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Comments |
Age-weighted profit sharing contributions and age- or service-based matching contributions must also pass the general nondiscrimination test |
The Top Heavy Test
401(k) plans are also subject to an IRC §416 top heavy test. A 401(k) plan is considered top heavy for a plan year when the account balances of “Key Employees” exceed 60% of total plan assets as of the last day of the prior plan year. A Key Employee is defined as any employee (including former or deceased employees), who at any time during the plan year was:
- An officer making over $220,000 (2024 limit).
- A 5% owner of the business (a 5% owner is someone who owns more than 5% of the business)
- An employee owning more than 1% of the business and making over $150,000 for the plan year
When a 401(k) plan is top heavy, non-Key Employees must generally receive an employer contribution equal to 3% of their annual compensation. Any employer matching or profit sharing contributions can be used to offset this top heavy minimum contribution requirement. Safe harbor 401(k) plans can automatically satisfy the minimum contribution requirement when certain conditions are met.
Annual Contribution Limits
401(k) plan participants must be tested each year to confirm the contributions made to their account do not exceed IRS-mandated contribution limits. These limits include:
- Annual Additions Limit (IRC §415) – “Annual Additions” represent the sum of employee and employer contributions (including any reallocated forfeitures) made to a participant’s account during the limitation year (generally, the plan year). For 2024, the 415 limit is the lesser of:
- 100% of the participant’s compensation
- $69,000 ($76,500 including catch-up contributions)
- Elective Deferral Limit (IRC §402(g)) – This limit applies to pre-tax and Roth salary deferrals. For 2024, the 402(g) limit is $23,000 ($30,500 for catch-up eligible participants). If the 402(g) limit is exceeded, the excess must be distributed by April 15 of the following year to avoid double-taxation.
401(k) Nondiscrimination Tests are Important – Attention is Required
401(k) plans offer valuable tax benefits to employers and employees alike. These benefits are not free, however – to be eligible, employers must keep their 401(k) plan in compliance with IRS qualification requirements.
One of the most technical qualification requirements is annual nondiscrimination and limits testing. Fortunately, a professional TPA most often completes this work today. However, employers should still understand testing basics even when a TPA is hired. Why? Employers have a fiduciary duty to monitor their 401(k) TPA for performance and knowing the tests to expect each year can make that job easier.
