The Employee Retirement Income Security Act (ERISA) requires several tests each year to prove 401(k) plans do not discriminate in favor of employees with higher incomes.
For some of the tests, employees are divided between non-highly compensated employees (NHCEs) and highly compensated employees (HCEs). The Internal Revenue Service (IRS) defines “highly compensated employee” as an individual who:
Owned more than 5% of the interest in the business at any time during the testing year or the preceding year (including certain family members via attribution rules), regardless of how much compensation that person earned or received, OR
Received compensation from the business of more than $120,000, during the preceding year AND, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
The compensation used for determining whether an employee is an HCE is indexed each year.
The ACP, or actual contribution percentage test, compares the average of the percentage of matching contributions and after-tax employee contributions for HCEs versus NHCEs. Matching contributions and voluntary employee after-tax contributions (different from Roth elective deferrals) are included in this test. The purpose of the ACP is to ensure that the actual usage of the plan feature is widespread and not used merely by the HCEs. “Plans subject to testing only work if employees across the entire income spectrum participate,”.
Next, once you have a sufficient number of NHCEs covered, you look at the benefits, rights and features of the plan to ensure they are nondiscriminatory. This is tested by the ADP and ACP tests.
ADP stands for actual deferral percentage, this test compares the average of salary deferral percentages for HCEs with the average of salary deferral percentages for NHCEs. The ADP test applies to pre-tax and Roth elective deferrals. The purpose of this test is to ensure that all participants, both HCEs and NHCEs, are benefitting from the plan.
Finally, there is a test to ensure the 401(k) plan is not top-heavy; this looks at overall benefits that have been accumulated by key employees. Generally, if more than 60% of the overall assets in the plan are attributable to key employees (different from HCEs), then the plan is top-heavy and certain minimum benefits may need to be provided to the non-key employees. Defined by the IRS, a key employee is any former or deceased employee who at any time during the plan year was an officer making more than $170,000 (this is indexed each year); was an owner of more than 5% of the business; or was an owner of more than 1% of the business and making more than $150,000 for the plan year.