What Is Nondiscrimination Testing?

Nondiscrimination testing (NDT) is a set of tests created by the Internal Revenue Service (IRS) to determine whether a company's benefits are fair to all eligible employees – not just  highly-compensated employees (HCEs)  .

What is the purpose of testing for discrimination?

The NDT ensures that HCEs adhere to benefit contribution rates that non-highly compensated employees (NHCEs) can also meet, increasing financial equality in the workplace.

In addition,  company contributions to plans such as a 401(k) are tax deductible. Regulating HCE contributions in turn ensures that business owners do   not unfairly benefit from  substantial tax benefits .

Is nondiscrimination testing necessary?

NDT was originally established for 401(k) plans, but it now  applies to certain plans under Section 125. Examples  include health savings plans such as flexible spending accounts ( FSAs  ), health savings accounts (  HSAs  ), and health reimbursement accounts (  HRAs  )  .

How to Conduct Non-Discrimination Testing

There are different NDTs for benefit plan types. For example, the NDTs required for 401(k) offerings are different from those for health insurance plans.

The three most common NDTs for retirement plans are:

1. Actual Delay Percentage (ADP) Testing
2. Actual Contribution Percentage (ACP) Test
3. Top-heavy testing

Actual Delay Percentage (ADP) Testing

The ADP test  is designed to compare the average salary deferral of HCEs to the average salary deferral of NHCEs' 401(k) plans. In other words, this test evaluates whether there is a significant disparity between the contributions of the two groups. If HCEs contribute significantly more, this indicates potential discrimination and the employer's plan may fail the test.

To perform this test, calculate these two percentages:

• Annual HCE Contribution Rate:  Divide the HCE's average deferral by their average annual compensation.
• Annual NHCE contribution rate:  Divide your NHCE's average deferral by their average annual compensation.

Compare the two percentages to make sure their differences are within reasonable levels. To pass this test, the IRS stipulates that  the ADP for the HCE  cannot be greater than the following:

• 125% of ADP for NHCE group
• 200% of ADP for NHCE group
• ADP plus 2% for NHCE

Actual Contribution Percentage (ACP) Test

This test is similar to the ADP test, but also includes employer contributions and after-tax contributions made by employees.

To perform the ACP test, add the average employer contribution and after-tax contributions to the employee's deferral. Then divide the total amount by their average annual compensation.

Compare the ACP percentages for HCEs and NHCEs to make sure all employees are being compensated appropriately. To pass this test,  the ACP for HCEs cannot be more than  :

• 125% of ACP of NHCE for matching contribution
• 200% of ACP of NHCE for post-tax contributions
• ACP of NHCE plus 2%

Top-heavy testing

The top-heavy test evaluates whether key employees benefit disproportionately from a company's retirement plans.  The IRS defines key employees as  :

• Individuals earning more than $215,000 per year
• Any person who holds more than 5% of the company
• People who own more than 1% of the company and make more than $150,000 a year

The top-heavy test evaluates whether a 401(k) plan is balanced. If key employees own  more than 60% of all assets from the employer's benefit plan  , it fails the NDT.

When should nondiscrimination testing be improved?

It's best to err on the side of caution and conduct the NDT at the beginning or middle of the plan year. That way, if the results reveal noncompliance, employers will have enough time to make corrections.