Highly Compensated Employees: What You Need To Know To Pass Your Non-Discrimination Tests

April 20, 2018 by Evan Ross
Highly Compensated Employee

Employers start 401(k)s for lots of reasons. Some consider a 401(k) a great recruitment tool. Others may see the plan as a tool for retaining employees.

A very common role for the 401(k) is helping company owners and key employees shelter more income from taxes. This year an employee can save up to $55,000 with help from matching or profit sharing contributions. That kind of saving can turbo-charge a retirement nest egg.

But sometimes the realities of the running a 401(k) interfere with these goals.

For example, passing non-discrimination tests can put a lid on how much some employees can contribute.

We’ll talk more about retaining your 401(k)’s flexibility towards the end of the post. Now, let’s review non-discrimination testing.

Non-Discrimination Testing – Why Highly Compensated Employees Matter

The idea behind non-discrimination rules is that 401(k) benefits should be broadly shared. That is, lower paid employees should have similar access to the plan as highly paid employees. And, those lower paid employees should be contributing to the plan as well.

For testing purposes, employees fall into two groups. These are Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). There are specific definitions used to describe each.

Let’s take the HCEs first. HCEs are generally those employees who:

  • Were a more than 5% owner during the current or preceding plan year, or
  • Earned more than $120,000 in the prior plan year.
  • Or the employer can define HCEs as those in the 20% of employees ranked by compensation.

And NHCE’s? That’s everyone else.

Key Employees

While we all may think of ourselves as key employees, the IRS has their own definition.

One of the four tests divides employees into “key employees” and everyone else. A key employee is generally one who:

  • Owns more than 5% of the company, or
  • Owns more than 1% of the company and earned more than $150,000, or
  • Is an officer making more than $175,000.

Criteria for Passing Non-Discrimination Tests

Now that we understand the major groups of employees, let’s look at the tests themselves. There are four types of tests used to see if a plan discriminates.

Coverage Test

The coverage test determines if non-highly compensated employees benefit from the plan like the highly compensated employees. The term “benefiting” generally means having access to the 401(k). For example, the plan may say that certain HCEs are not allowed to join the 401(k). These “excluded classifications” might be sales managers or even relatives of the owners. The plan may also exclude certain NHCEs. The coverage test makes sure that NHCEs are not singled out.

The primary measure of coverage is the Ratio Percentage Test. This is the percentage of NHCEs benefiting from the plan compared to the percentage of HCEs benefiting.

Here’s how the calculation works:

  1. Count the number of NHCE’s benefiting from the plan. Divide by the total number of NHCEs.
  2. Count the number of HCE’s benefiting from the plan. Divide by the total number of HCEs.
  3. Divide the #1 by #2. The ratio must be 70% or greater for a plan to pass.

In both steps 1 and 2, the total number employees does not have to include those the plan can exclude by law. For example, workers under 21 or those employed less than a year.

If a plan fails the Ratio Percentage Test, it can still avoid making a correction. But it must pass a secondary test called the Average Benefits Test. The mechanics of this test can get complicated. The idea is to prove that group classifications don’t discriminate, and benefits received by the groups are comparable.

Top Heavy Test

The top-heavy test evaluates accumulated assets. It compares assets of key employees to total plan assets. A plan is top-heavy if key employees account for more than 60% of plan assets.

Average Deferral Percentage Test (ADP)

The ADP test compares the average deferral rate of  highly compensated employees to non-highly compensated employees. The deferral rate is the employee contribution as a percentage of compensation. The calculation includes all employees eligible to make a deferral, even if they don’t contribute. The ratio of the two average deferral rates drives the test results.

Plans can pass the ADP test one of two ways.

One way is to pass the “125% test.” In this case, the average HCE deferral cannot exceed 125% of the average NHCE deferral. So if the average HCE deferral is 5%, and the average NHCE deferral is 3.9%, the plan fails this test. That’s because 5% is greater than 125% x 3.9% which is 4.9%.

The plan can still pass the ADP test under an alternate method. Here, the HCE deferral rate must be less than the smaller of these two calculations:

1) 200% of the NHCE rate.

2) The NHCE rate plus 2%.

Let’s stay with our example and run this second option. Our HCE rate is 5% and the NHCE rate is 3.9%. Let’s see how the plan fares:

Formula 1: 200% x 3.9% = 7.8%

Formula 2: 2% + 3.9% = 5.9%

The lesser of the two figures is 5.9%. So the plan passes as the HCE rate of 5% is less than the allowed rate of 5.9% under this second option.

The Average Contribution Percentage Test (ACP)

The ACP test compares matching employer contributions along with any after-tax employee contributions. Otherwise, the test calculations are the same.

What Happens If Your Plan Fails a Non-Discrimination Test?

Failing any of the four non-discrimination tests requires the plan to make a correction.

  • A failed coverage test means the 401(k) benefits should be more broadly available. A correction usually means expanding plan coverage of NHCEs.
  • A failed ADP test means that HCE’s on average contributed much more of their salaries to the 401(k) than NHCEs. This can also account for a failed ACP test which measures matching contributions. The remedy can mean making “corrective distributions.” That’s 401(k) lingo for returning enough HCE contributions so that the plan passes.

Another way to correct a failed ADP test is to make contributions to the NHCEs. But this could be a significant use of company cash flow.

  • Finally, if a 401(k) is top-heavy, the employer generally must contribute up to 3% of compensation for all non-key employees.

Impact of Test Results on Highly Compensated Employees

Highly compensated employees are important to your business – that’s why they are highly compensated!

It’s important to attract and keep such employees, but testing can make this a challenge. That’s because the amount NHCEs contribute can affect how much your HCEs can save for retirement.

Let’s say the average HCE salary is $150,000. If these employees want to max out their deferral at $18,500, that’s a contribution rate of 12.3%.

Now let’s say the average deferral rate of NHCEs is 5%. If we run that 5% number through the formulas above, we see that the most the HCE’s can contribute is an average 7%, not 12.3%. So even passing these tests can frustrate HCEs trying to sock away money for retirement.

And, remember those “corrective distributions.” A company always returning HCE contributions might be annoying its most valued employees.

If you want to learn more about ADP and ACP testing, visit our blog post.

The Safe Harbor Solution

One way avoid ADP and ACP testing is to adopt a Safe Harbor plan. The plain becomes exempt from the tests in exchange for regular contributions to all eligible employees.

There are a few ways to gain the Safe Harbor test exemption. One way is to match employee contributions dollar-for-dollar on the first 3% of deferrals, and 50% on the next 2%. That results in a maximum 4% match.

Another option is to make a 3% “non-elective” contribution to each eligible employee even if not in the plan. The two approaches are similar. But actual employee participation and deferrals affects the cost of the first.

Yet another approach includes automatic enrollment and specific employer contribution levels. This is a qualified automatic contribution arrangement (QACA). This plan matches dollar-for-dollar on the first 1% of an employee’s deferral, plus a 50% match on deferrals up to 6%. That comes out to a maximum 3.5% mandatory match.

Adopting a Safe Harbor plan means that your highly compensated employees can max out their contributions no matter how much others contribute. But don’t forget the trade-off. The company commits to regular contributions.

If you are considering a Safe Harbor plan, be sure to check out our Safe Harbor Resource Center.

The Alternative to Safe Harbor? Engaged Employees!

There is an alternative to a Safe Harbor plan, and that’s great employee engagement. That means generating enough interest to make sure your plan passes non-discrimination tests.

The key is getting employees to join the plan and save at high rates. Automatic enrollment is a great way to get most employees participating. And increasing the participation rate is a great way to boost the amount HCEs can contribute. Here’s why:

The ADP and ACP tests don’t just include employees contributing to the plan. If someone is eligible, but doesn’t join the 401(k), that contribution goes down as 0% in the test calculations. But if that employee is automatically enrolled, the 0% jumps up to the default deferral rate.

And while we’re on the subject of automation, automatic escalation can also help. Employees don’t have to remember to boost their savings rate each year. And growing contributions can help your NHCEs and HCEs save more for retirement.

A user-friendly, low hassle plan accessible by mobile device is another key to engagement.

Bottom line, an engaging, automated plan can get more employees enrolled and contributing at high levels.

Want to Learn More About How Highly Compensated Employees Affect Your Plan?

If you want help avoiding corrective distributions, passing non-discrimination tests, and allowing your HCEs to increase their deferrals, talk to us today.

ForUsAll takes on both the 401(k) investment and administration responsibilities – so that smaller companies can reduce the liability and workload associated with offering a retirement benefit.

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Evan is on a mission to use the power of storytelling to change the world for the better. And what better way to change the world than to help everyday Americans retire with comfort and dignity? After studying English & Creative Writing at UC Irvine, Evan honed his marketing craft at a digital advertising agency before being put in charge of building an automotive tech company's marketing department from the ground up. Now, Evan creates content and communications that help professionals at small and mid-sized businesses lower their fees, minimize their liability, and turn their 401(k)s into recruiting and retention machines. In his free time, Evan can be found playing hockey, writing short stories, and embarking on reckless round-the-world odysseys.

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