Non-discrimination testing (NDT) is a series of tests required by the IRS (and other government agencies) to ensure that a company’s employee benefit plans, such as retirement and healthcare plans, do not unfairly favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs).
The main idea is to prevent a situation where a company’s owners or top executives get a disproportionate share of the tax-advantaged benefits, leaving little for the rest of the workforce. If a company fails these tests, the benefits become taxable for the HCEs, and in some cases, the entire plan could be at risk of losing its tax-qualified status.
The Purpose of Non-Discrimination Testing
The government offers significant tax benefits for both employers and employees who participate in qualified benefit plans. In exchange for these tax breaks, the government requires proof that the plans are not designed or operated in a way that is discriminatory.
NDT is a way of ensuring that:
- Equal Access: The plan is available to a broad group of employees, not just a select few HCEs.
- Equitable Contributions: The average contributions made by HCEs are in line with the average contributions made by NHCEs. This prevents HCEs from “maxing out” their benefits while NHCEs contribute very little.
- Fair Benefits: The benefits provided by the plan are fair and not tilted in favor of the highest earners.
How Non-Discrimination Testing Works
The specific tests vary depending on the type of plan, but they all involve comparing the participation levels and contributions of HCEs to those of NHCEs. For example, common tests for 401(k) plans include:
- Actual Deferral Percentage (ADP) Test: This test compares the average percentage of salary that HCEs contribute to their 401(k) to the average percentage contributed by NHCEs. The HCE average cannot exceed the NHCE average by more than a certain amount (e.g., 2 percentage points or 125%, whichever is greater).
- Actual Contribution Percentage (ACP) Test: Similar to the ADP test, but this one also includes employer matching contributions and employee after-tax contributions.
- Top-Heavy Test: This test is for retirement plans and checks if the total account balances of “key employees” (a specific IRS definition that includes certain owners and officers) make up more than 60% of the plan’s total assets.
Passing these tests is a crucial annual compliance requirement for many companies. It’s an essential part of responsible plan management and ensures that the tax advantages of these benefits are available to everyone.