Non-Discrimination Testing in a 401(k) plan refers to a series of tests required by the Internal Revenue Service (IRS) to ensure that a 401(k) plan does not unfairly favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). These tests check that the contributions made by the HCEs are proportional in relation to those made by NHCEs, maintaining fairness and balance in the benefits provided by the retirement plan.
There are several types of non-discrimination tests, including:
- Actual Deferral Percentage (ADP) Test: This test compares the average salary deferrals of HCEs to that of NHCEs, ensuring that the average deferral percentage of HCEs does not excessively exceed that of NHCEs.
- Actual Contribution Percentage (ACP) Test: Similar to the ADP test, the ACP test compares the average employer matching contributions and after-tax employee contributions between the two groups.
- Top-Heavy Test: This test determines whether the majority of plan assets are held by key employees, which would indicate that the plan is top-heavy. A plan is generally considered top-heavy when key employees hold more than 60% of the total value of the plan assets.
These tests are conducted annually to maintain the tax-qualified status of the 401(k) plan. If a plan fails any of these tests, it must take corrective actions, such as refunding contributions to HCEs or making additional contributions to NHCEs. These tests are part of compliance measures aimed at maintaining the integrity of the tax benefits associated with employer-sponsored retirement plans.