Understanding 401(k) Annual Compliance Testing

These yearly required tests are meant to ensure everyone is benefiting from your 401(k) plan.

If your company has a 401(k) plan—or if you’re considering starting one in the future—you may have heard about annual compliance testing, also known as nondiscrimination testing. But what is it really? And how can you help your plan pass these important compliance tests? Read on for our explanation.

What is annual compliance testing?

Mandated by ERISA, annual compliance testing helps ensure that 401(k) plans benefit all employees—not just business owners or highly compensated employees. Because the government provides significant tax benefits through 401(k) plans, it wants to ensure that these perks don’t disproportionately favor high earners.

We’ll dive deeper into nondiscrimination testing, but let’s first discuss an important component of 401(k) compliance: contribution limits.

What contribution limits do I need to know about?

Because of the tax advantages given to 401(k) plan contributions, the IRS puts a limit on the amount that employers and employees can contribute. Here’s a quick overview:

1. This limit is an IRS imposed limit based on the calendar year. Plans that use a ‘plan year’ not ending December 31st base their allocation limit on the year in which the plan year ends. This is different from the compensation limits, which are based on the start of the plan year.
2. Adjusted annually; see most recent Cost of Living Adjustments table here.

What is nondiscrimination testing designed to achieve?

Essentially, nondiscrimination testing has three main goals:

1.   To measure employee retirement plan participation levels to ensure that the plan isn’t “discriminating” against lower-income employees.
2.   To ensure that people of all income levels have equal access to—and awareness of—the company’s retirement plan.
3.   To encourage employers to be good stewards of their employees’ futures by making any necessary adjustments to level the playing field (such as matching employees’ contributions)

Where do I begin?

Before you embark on annual compliance testing, you’ll need to categorize your employees by income level and employee status. Here are the main categories (and acronyms):

Highly compensated employee (HCE)—According to the IRS, an employee who meets one or more of the following criteria:

• Prior (lookback) year compensation—For plan years ending in 2023, earned over $135,000 in the preceding plan year; some plans may limit this to the top 20% of earners (known as the top-paid group election), which would be outlined in your plan document; or
• Ownership in current or prior year—Owns more than 5% of (1) outstanding corporate stock, (2) voting power across corporate stock, or (3) capital or profits of an entity not considered a corporation

Non-highly compensated employee (NHCE)—Someone who does not meet the above criteria.

Key employee—According to the IRS, an employee who meets one or more of the following criteria during the plan year:

• Ownership over 5%—Owns more than 5% of (1) outstanding corporate stock, (2) voting power across corporate stock, or (3) capital or profits of an entity not considered a corporation.
• Ownership over 1%—Owns more than 1% of the stock, voting power, capital, or profits, and earned more than $150,000.
• Officer—An officer of the employer who earned more than $215,000 for 2023; this may be limited to the lesser of 50 officers or the greater of 3 or 10% of the employee count.

Non-key employee—Someone who does not meet the above criteria.

What are the tests that need to be performed?

Below are the tests typically performed for 401(k) plans.  Betterment will perform each of these tests on behalf of your plan and inform you of the results.

1. 410(b) Coverage Tests—These tests determine the ratios of employees eligible for and benefitting from the plan to show that the plan fairly covers your employee base.

Specifically, these tests review the ratio of HCEs benefitting from the plan against the ratio of NHCEs benefitting from the plan. Typically, the NHCE percentage benefitting must be at least 70% or 0.7 times the percentage of HCEs considered benefitting for the year, or further testing is required.

These annual tests are performed across different contribution types: employee contributions, employer matching contributions, after-tax contributions, and non-elective (employer, non-matching) contributions.

2. Actual deferral percentage (ADP) test—Compares the average salary deferral of HCEs to that of non-highly compensated employees (NHCEs). This test includes pre-tax and Roth deferrals, but not catch-up contributions. Essentially, it measures the level of engagement of HCEs vs. NHCEs to make sure that high income earners aren’t saving at a significantly higher rate than the rest of the employee base.

Specifically, two percentages are calculated:

• HCE ADP—The average deferral rate (ADR) for each HCE is calculated by dividing the employee’s elective deferrals by their salary. The HCE ADP is calculated by averaging the ADR for all eligible HCEs (even those who chose not to defer).
• NHCE ADP—The average deferral rate (ADR) for each NHCE is calculated by dividing the employee’s elective deferrals by their salary. The NHCE ADP is calculated by averaging the ADR for all eligible NHCEs (even those who chose not to defer).

The following table shows how the IRS limits the disparity between HCE and NHCE average contribution rates. For example, if the NHCEs contributed 3%, the HCEs can only defer 5% (or less) on average.

3. Actual contribution percentage (ACP) test—Compares the average employer contributions received by HCEs and NHCEs. (So this test is only required if you make employer contributions.)

Conveniently, the calculations and breakdowns are the same as with the ADP test, but the average contribution rate calculation includes both employer matching contributions and after-tax contributions.

4. Top-heavy determination—Evaluates whether or not the total value of the plan accounts of “key employees” is more than 60% of the value of all plan assets. Simply put, it analyzes the accrued benefits between two groups: Key employees and non-Key employees.

A plan is considered top-heavy when the total value (account balance with adjustments related to rollovers, terminated accounts, and a five-year lookback of distributions) of the Key employees’ plan accounts is greater than 60% of the total value (also adjusted as noted above) of the plan assets, as of the end of the prior plan year. (Exception: The first plan year is determined based on the last day of that year).

If the plan is considered top-heavy for the year, employers must make a contribution to non-key employees. The top-heavy minimum contribution is the lesser of 3% of compensation or the highest percentage contributed for key employees. However, this can be reduced or avoided if no key employee makes or receives contributions for the year (including forfeiture allocations).

What happens if my plan fails these tests?

If your plan fails the ADP and ACP tests, you’ll need to fix the imbalance by returning 401(k) plan contributions to your HCEs or by making additional employer contributions to your NHCEs. If you have to refund contributions, that money may be subject to state and federal taxes. Plus, if you don’t correct the issue in a timely manner, there could also be a 10% penalty fee and other serious ramifications.

Why is it common to fail testing?

Small and mid-size businesses may struggle to pass if they have a relatively high number of HCEs. If HCEs contribute a lot to the plan, but non-highly compensated employees (NHCEs) don’t, there’s a chance that the 401(k) plan will not pass nondiscrimination testing. It’s actually easier for large companies to pass the tests because they have many employees at varying income levels contributing to the plan.

How can I help my plan pass the tests?

It pays to prepare for nondiscrimination testing. Here are a few tips that can make a difference:

• Add automatic enrollment —By adding an auto-enrollment feature to your 401(k) plan, you can automatically deduct elective deferrals from your employees’ wages unless they opt out. It’s a simple way to boost participation rates and help your employees start saving. In fact, the government is getting more behind auto-enrollment; SECURE 2.0 mandates plans that launched after Dec. 29, 2022 add automatic enrollment to the plan by Jan. 1, 2025. 
• Add a Safe Harbor provision to your 401(k) plan—Safe Harbor plan design typically makes compliance testing easier to pass.
• Make it easy to enroll in your plan—Is your 401(k) plan enrollment process confusing and cumbersome? If so, it might be stopping employees from enrolling. Consider partnering with a tech-savvy provider like Betterment that can help your employees enroll quickly and easily—and support them on every step of their retirement saving journey. Learn more now.
• Encourage your employees to save—Whether you send emails or host employee meetings, it’s important to get the word out about saving for retirement through the plan. That’s because the more NHCEs that participate, the better chance you have of passing the nondiscrimination tests. (Plus, you’re helping your team save for their future.)
• Add automatic escalation - By adding automatic escalation, you can ensure that participants who are automatically enrolled in the plan continue to increase their deferral rate by 1% annually until a cap is reached (generally 15%). It’s a great way to increase your employees retirement savings and to engage them in the plan.

How can Betterment help?

Nondiscrimination testing and many other aspects of 401(k) plan administration can be complex. That’s why we do everything in our power to help make it easier for you as a plan sponsor. We help with year-end compliance testing, including ADP/ACP testing, top-heavy testing, annual additions testing, deferral limit testing, and coverage testing.

With our intuitive online platform, you can better manage your plan and get the support you need along the way. Ready to learn more? Let's talk. 

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