Non discrimination testing

Non-Discrimination Testing refers to a set of IRS-mandated evaluations designed to ensure employee benefit plans are equitable and do not disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). These tests are essential for maintaining the tax-advantaged status of plans like 401(k)s and Section 125 benefits such as Flexible Spending Accounts (FSAs).

Purpose: The core goal of NDT is to promote fairness in workplace benefits by ensuring that all eligible employees—regardless of compensation level—have access to similar opportunities and advantages within employer-sponsored benefit plans.

Highly Compensated Employee (HCE)

Definition: An employee classified as “highly compensated” based on IRS criteria. Typically, this includes individuals who earned above a specific annual compensation threshold (e.g., $150,000–$215,000) or who own a significant percentage of company equity.

Non-Highly Compensated Employee (NHCE)

Definition: Any employee who does not meet the criteria for being classified as an HCE. These individuals are the primary group used as a comparison benchmark in NDT evaluations.

401(k) Non-Discrimination Testing

Definition: NDT as it applies to 401(k) retirement savings plans. These tests ensure that HCEs do not receive a disproportionate benefit in the form of higher contribution levels or plan assets relative to NHCEs.

Flexible Spending Account (FSA) Non-Discrimination Testing

Definition: Non-Discrimination Testing for Section 125 cafeteria plans that include FSAs. These accounts allow employees to contribute pre-tax dollars for qualified medical or dependent care expenses. However, to maintain tax-exempt status, FSA offerings must not unduly favor HCEs.

Actual Deferral Percentage (ADP) Test

Definition: A regulatory test for 401(k) plans that compares the average salary deferral percentages of HCEs to those of NHCEs.

Actual Contribution Percentage (ACP) Test

• Definition: An extension of the ADP test, the ACP test incorporates additional plan contributions—like employer matches and after-tax employee contributions.
• Purpose: To ensure that all forms of contribution are equally accessible and beneficial to employees across compensation levels.
• Compliance Thresholds: Follows similar comparative rules as the ADP test, but with matching and after-tax contributions factored in.

Top-Heavy Test

Definition: A 401(k)-specific test used to determine whether the majority of plan assets are concentrated among “key employees.”

Key Employees Include:

• Employees earning over a specified income threshold.
• Employees owning over 5% (or in some cases 1%) of the company.

Test Pass Requirement: No more than 60% of plan assets may be owned by key employees. If this threshold is exceeded, employers must make minimum contributions (typically 3% of pay) to all eligible NHCEs.

Corrective Action Window

Definition: The IRS grants a 2.5-month period after the plan year-end for employers to resolve failed ADP or ACP tests. Actions might include:

• Distributing excess contributions.
• Making additional contributions to NHCEs.
• Adjusting plan design for future years.

Voluntary Mid-Year Testing

Definition: An employer-driven practice of performing NDT before year-end. While not required, it provides early insight into compliance status, enabling corrective measures with minimal disruption.

Key Takeaway

Non-Discrimination Testing is essential for ensuring benefit plan equity, preserving tax-advantaged statuses, and reinforcing a culture of fairness. Whether managing a 401(k) plan or offering FSAs through a cafeteria plan, staying compliant with NDT requirements supports long-term financial health for both employees and employers.