Non-Discrimination Testing

What is Non-Discrimination Testing?

Non-discrimination testing is a set of IRS-prescribed tests that evaluate the fairness of an organization’s benefit plans. These tests ensure highly-compensated employees stay within a benefits contribution rate that lower-compensated employees can match, helping make benefit plans (and the company matches and tax breaks that go with them) more equitable and accessible. 

What Is the Purpose of Testing for Discrimination?

These IRS-prescribed tests determine if employer-provided benefit plans disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). This is to ensure all employees have equal access to their company’s plans, thus supporting increased financial equality in the workplace. 

Non-discrimination testing is also critical for the U.S. government’s tax benefits for retirement savings plans. Since tax benefits from those plans are substantial, the IRS wants to make sure a company’s 401(k) plan doesn’t benefit company owners unfairly.

How Does the IRS Categorize Employees for Non-Discrimination Testing?

According to the IRS, a highly compensated employee (HCE) meets one of the following criteria: 

• Someone who owned more than five percent of the interest in a business at any time during the current or preceding year, regardless of how much compensation that person earned or received

• Someone who received compensation from the business in excess of 130,000 dollars for this year or the preceding year

• (Optional) Someone in the top 20 percent of employees when ranked by compensation

All other employees are non-highly compensated employees (NHCEs).

How Can the Same Match Rate Be Discriminatory?

Due to their financial situation, HCEs have the potential to contribute larger percentages of their total compensation to tax-free financial vehicles like 401(k) accounts and Health Savings Accounts (HSAs). It’s a common practice for companies to set up a company match for contributions to these accounts; however, if lower-compensated employees don’t have the means to contribute at a similar rate as highly-compensated employees, this can lead to inequity in benefit amounts received from the organization and tax exemption received from the IRS. 

For example, let’s say a company has ten HCEs who all earn 325,000 dollars annually. This makes their 401(k) contribution easy to calculate: if they contribute six percent, then they’ll hit the 2021 maximum yearly 401(k) contribution of 19,500 dollars. Now let’s say the company offers an employer match of up to six percent: for these ten employees, the company will spend 195,000 dollars in benefits compensation on this benefit. 

Meanwhile, this company also has positions with an average salary of 50,000 dollars, and due to the cost of living, the average 401(k) contribution for employees with this salary is just one percent (500 dollars a year). It would take 390 of these employees to match the dollar amount the company spends on the ten HCEs. 

Then to add insult to injury, this nightmare company could rationalize a lack of salary increases due to the cost of benefits, especially if the same disparity occurs in their HSAs. Non-discrimination testing helps prevent such imbalances from developing, encouraging companies to structure their total compensation plans so their benefits can benefit all employees. 

Is Non-Discrimination Testing Required?

Non-discrimination testing is required for employers who offer retirement plans maintained by section 125 of the Internal Revenue (IRS) code. This includes health savings plans like flexible spending accounts (FSAs), health reimbursement arrangements (HRAs), and HSAs.

How to Perform Non-Discrimination Testing

Different benefit plans will require you to pass varying non-discrimination tests. For example, the tests for your 401(k) offerings are different from those for your health insurance plans.

The three most common non-discrimination tests are:

• Actual Deferral Percentage (ADP) Test

• Actual Contribution Percentage (ACP) Test

• Top-Heavy Test

Actual Deferral Percentage (ADP) Test

The ADP test is designed to compare the salary deferrals of HCEs to the salary deferrals of NHCEs. This test calculates the level of engagement an employee has in their benefit plan by showing what percentage of their total salary goes toward it. 

To conduct this test, you need two percentages: 

• Annual HCE contribution rate: Divide the average deferrals of your HCE employees by their average annual compensation.

• Annual NHCE contribution rate: Divide the average deferrals of your NHCE employees by their average annual compensation.

Compare the two percentages to ensure their differences fall within reasonable levels. In order to pass this test, the IRS has outlined the following criteria:

• HCEs don’t exceed 125 percent of the ADP from the NHCEs

• HCEs aren’t less than 200 percent of the ADP from the NHCEs

• The ADP of the HCEs doesn’t exceed the ADP of the NHCEs plus two percent

Actual Contribution Percentage (ACP) Test

This test is virtually the same as the ADP test, but it also includes employer-matched contributions and after-tax contributions from employees.

To calculate this test, add the average employer contribution and after-tax contribution to the employee’s deferrals. Then divide by their average annual compensation. 

Compare the HCE and NHCE percentages to ensure all employees are receiving fair compensation. In order to pass this test, the IRS has outlined the following criteria:

• HCEs don’t exceed 125 percent of the ACP from the NHCEs

• HCEs aren’t less than 200 percent of the ACP from the NHCEs

• The ACP of the HCEs doesn’t exceed the ACP of the NHCEs plus two percent

Top-Heavy Test

The top-heavy test focuses on the compensation towards “key employees,” which the IRS defines as:

• An employee making over 185,000 dollars a year

• Anyone who owns more than five percent of the company

• Employees who own more than one percent of the company and make over 150,000 dollars a year

The top-heavy test measures the balance of a plan. If the value of the assets in key employees’ accounts exceeds 60 percent of all assets from the employer’s benefit plan, it fails the top-heavy non-discrimination test.

When Is Non-Discrimination Testing Due?

Non-discrimination testing is due +9yearly by the final day of the plan year, so it depends on when your benefit plans went into effect. Mark the date your plan renews every year to make sure you submit your test results and avoid penalties from the IRS.

Don’t wait to conduct the test right at the deadline. If your test results reveal you are not compliant with the IRS’s guidelines, you won’t have time to correct those errors.

Instead, you should perform the tests at the beginning or middle of the plan’s year. This will give you time to correct imbalances in your compensation.