401(k) plans provide participants with great tax benefits: mainly the ability to create substantial wealth through compound interest on a tax-deferred or tax-free basis. Be aware that the government wants those tax benefits to be available to all workers, not just business owners and the most valuable employees.
401(k) Nondiscrimination Testing
To ensure that everyone is benefiting equally, the IRS established several tests that 401(k) plans must be able to pass on to maintain their qualified status. These tests simply ensure that the opportunity to save for retirement in a tax-advantaged way is being provided in a fair manner.
Nondiscrimination testing works by splitting employees into two groups and comparing participation levels in the plan. Highly Compensated Employees (HCEs) are those who are a 5% owner or earned more than $125,000 for 2019. Non-Highly Compensated Employees (NHCEs) are all the rest.
Two main tests are the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP). The ADP test compares what employees put into the plan (salary Deferrals) and The ACP test compares company matching (employer Contributions). If your HCEs and NHCEs are not participating relatively equally, the plan fails nondiscrimination testing. A third test is the Top-Heavy test. A plan is top-heavy when the total value of the plan accounts of key employees is more than 60% of the value of all plan assets.
Consequences of Nondiscrimination Testing Failure
If your plan administrator tells you that your plan has failed nondiscrimination testing, there are several possible causes. Perhaps you haven’t made it accessible to enough employees, or not enough employees are participating, or the lower-level employees are not benefiting sufficiently compared to the top employees.
No matter the cause, you’ll need to act to fix the issues. If you don’t, your plan can lose its qualified status. That means that all the tax benefits related to your 401(k) plan would go away, and you and all of your employees could be left with a hefty tax bill.
There are two common fixes for a plan that has failed nondiscrimination testing, and neither is terribly desirable. Highly compensated employees may have to remove their previous salary deferrals from the plan or include them as taxable income. On the other hand, your company could also be forced to make extra year-end contributions on behalf of employees to even things out.
How to Prevent Nondiscrimination Testing Failure
Being proactive in making sure your plan will pass nondiscrimination testing is a better solution than having to fix a failed plan after the fact. You don’t want to tell your key employees (and yourself) that you need to claw back any 401(k) contributions; just as bad is having to dip into company cash to make unplanned matching contributions all around.
The first thing that you should do is ensure that your requirements for participation are not too strict. If too many of your employees are not eligible, then you may want to consider changing your eligibility requirements. Remember, if you’re spending the time and money to sponsor a 401(k), you want as many of your employees as possible to be able to take advantage of it to save for the future.
Another important step in maintaining compliance is motivating rank-and-file employees to participate. This can be challenging if they are low-wage employees without a lot of margin in their finances. However, it is not impossible.
One popular way to encourage employees to participate is by offering matching contributions. The offer of free money is enough for many workers to find room in their budgets to save. Adding a safe-harbor 401(k) plan will ensure that you will pass basic nondiscrimination testing even if you and every one of your highly compensated employees contributes the individual max ($19,000) to the plan.
Another option that many plan sponsors have had success with is automatic enrollment. Instead of making your employees do the work of enrolling, you do it for them. Then they would only have to expend extra effort to get out of the plan. Research has shown that employees are much more likely to participate in a 401(k) plan if automatically enrolled. When enrollment is voluntary, only 47% of new employees enroll in their company retirement plan. However, when enrolled automatically, 93% of employees stay enrolled.
How We Can Help
At Fi-Care, we can help you with your 401(k) plan so that you don’t fail your nondiscrimination testing again. More than that, though, we can help your employees. We offer the Fi-Care Financial Wellness Benefits program for business owners who truly care about their employees and their financial futures.
Beyond just protecting your 401(k) plan, we can help your employees understand the importance of saving for retirement, refocus their lives to be able to save, and set the foundation for a solid financial future. This will all benefit your workers, your 401(k) plan, and ultimately you as the business owner. If you would like to know more about how we can help your employees and your 401(k) plan, call (844) 377-4963 or email Fifirstname.lastname@example.org. You can also book an appointment online here.
Sean Condon is a wealth advisor with more than a decade of industry experience. He specializes in helping entrepreneurs build a culture of financial confidence by offering their employees unprecedented access to a CERTIFIED FINANCIAL PLANNER™ professional. Taking an owner’s approach, Sean does his best to understand the many elements of his clients’ entrepreneurial journeys. He works in a technically competent and caring manner to reduce his clients’ anxiety about money issues and serves as a fiduciary by always putting his clients’ best interests first. Learn more about Sean by connecting with him on LinkedIn.
Perritt Capital Management, Inc. is the Registered Investment Advisor for Windgate Wealth Management accounts. Neither Perritt Capital Management or Windgate Wealth Management provides tax advice. Consult your professional tax advisor for questions concerning your personal and business tax or financial situation.
Perritt Capital Management and Windgate Wealth Management are not responsible for, and expressly disclaim all liability for, reliance on any information contained in these third-party sites. No guarantee that information provided in these sites is correct, complete, and up-to-date.
Information here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed.
First published June 2019.