What is non-discrimination testing?

In the United States, non-discrimination testing, or NDT, is a yearly examination of an organization's benefits program to confirm that highly compensated employees (HCEs) do not have better benefits or more access to benefits than other employees. 

Under the Employee Retirement Income Security Act (ERISA), for a retirement plan to be considered qualified, it must not be selective or discriminatory, and all employees who are eligible for a 401(k) retirement plan must have equal access to the same investment options, employer match amounts, and tax deductions.

Under the Internal Revenue Code (IRC), the Internal Revenue Service (IRS) requires non-discrimination testing to maintain the retirement plan's qualified status and safe harbor provisions under ERISA.

Although the IRS originally instituted NDT to regulate 401(k) plans, it has evolved to apply to some plans under IRC Section 125, including health savings accounts (HSAs), health reimbursement accounts (HRAs), and flexible spending accounts (FSAs). 

NDTs should take place annually. Reports from these tests are due to the IRS by the last day of the plan year. Keep in mind that if an employer fails the NDTs, they must correct the issues to bring the plan up to compliance. 

The corrective measures the IRS requires and the deadline to correct the issues depend on the type of NDT and the details of the employer's specific plan. Therefore, it is a good idea to conduct NDTs no later than the middle of the plan year so the employer has plenty of time to correct any issues that arise.

NDT establishes that employers charge HCEs and non-highly compensated employees (NHCEs) the same benefits contribution rate. 

Also, because an organization's 401(k) contributions are tax-deductible, NDT confirms that employers do not receive unfair tax advantages. 

In short, NDT safeguards financial equality in the workplace. 

Different benefit types require different NDTs. The three main types of non-discrimination testing for retirement plans are the Actual Deferral Percentage (ADP) test, the Actual Contribution Percentage (ACP) test, and the Top-Heavy Test.

Other tests apply to other types of plans. Some other NDTs may include:

• Eligibility test

• Benefits test

• Key employee concentration test

• More-than-5% owners concentration test

• 55% average benefits test

The specific testing procedures and requirements can vary depending on the type of plan, its features, and any pertinent regulation changes. Employers must stay informed about current laws and regulations, and consult with experts to maintain compliance in their various benefits plans.

Let's dig further into how to conduct two of the most common types of NDTs: the ADP test and the ACP test.

Actual Deferral Percentage (ADP) test

This test compares the average salary deferrals of HCEs and NHCEs for their 401(k) contributions, looking for any significant differences between the two employee classes. Markedly higher contributions by HCEs could indicate possible discrimination, and the plan could fail the test as a result.

To administer the ADP test, calculate the following two percentages:

• Annual HCE Contribution Rate: Calculate by dividing HCEs' average deferrals by the group's average annual compensation.

• Annual NHCE Contribution Rate: Calculate by dividing NHCEs' average deferrals by the group's average annual compensation. 

To pass the ADP test, the IRS requires the ADP for HCEs not to exceed the greater of:

• 125% of the NHCE group's ADP

• The lesser of 200% of the NHCE group's ADP or the NHCE group's ADP plus 2%

Actual Contribution Percentage (ACP) test

The ACP test involves each group's annual contribution rates as well as employer-matched contributions and after-tax employee contributions.

To administer the ACP test, add the average employer-matched contribution and after-tax employee contribution to the average employee deferrals for each group (HCEs and NHCEs). Then divide each total by that group's average annual compensation. 

To pass the ACP test, the IRS requires the ACP for HCEs not to exceed the greater of:

• 125% of the NHCE group's ACP

• The lesser of 200% of the NHCE group's ACP or the NHCE group's ACP plus 2%