In order to retain tax-qualified status, a 401(k) plan must not discriminate in favor of owners and highly compensated employees. This can be verified by a number of tests, which include:
- Coverage Tests
- Various Contributions Limits
- ADP & ACP Tests
- Top-Heavy Test (and minimum contributions, if applicable)
Types of Employees
Each of these non-discrimination tests compares how the plan benefits defined groups of employees. Before performing nondiscrimination testing, employees are categorized for the plan year as a highly compensated employee (HCE) or non-highly compensated employee (NHCE), and as Key or non-Key.
Each of these types of employees are defined below for plan years ending December 31, 2018.
A highly compensated employee (HCE) is an employee who meets one or more of the following criteria:
- Prior (Lookback) Year Compensation – earned over $120,000 in 20171; some plans may limit this to the top 20% of earners in 2017 (known as the top paid group election); or
- Ownership in Current or Prior Year – owns2 over 5% of (1) outstanding corporate stock, (2) voting power across corporate stock, or (3) capital or profits of an entity not considered a corporation
A Key employee is an employee who meets one or more of the following criteria during the plan year:
- Ownership over 5%: owns over 5% of (1) outstanding corporate stock, (2) voting power across corporate stock, or (3) capital or profits of an entity not considered a corporation
- Ownership over 1%: owns over 1% of the stock, voting power, capital, or profits, and earned over $150,000.
- Officer: an officer of the employer who earned over $175,0003; this may be limited to the lesser of 50 officers, or the greater of 3 or 10% of the employee count.
Non-highly compensated employees (NHCEs) and non-Key employees are those that do not meet the definitions above. Once employee categories are determined, they are used in the following tests:
Coverage tests review the ratio of HCEs eligible for and benefitting from the plan against the ratio of NHCEs eligible for and benefitting from the plan. Typically, the ratio of NHCEs benefitting to HCEs benefitting must be over 70%, or further testing is required.
These tests are performed across three sections of a 401(k) plan: the employee contributions, matching and after-tax contributions, and non-elective (employer, non-matching) contributions.
The Actual Deferral Percentage (ADP) Test and the Actual Contribution Percentage (ACP) Test look at the average deferral (traditional + Roth deferral) and contribution (matching + after-tax deferral) rates between HCEs and NHCEs.
Essentially, the IRS limits the disparity between the two groups based on the average rate of the NHCE group:
NHCE Average %
HCE Average %
|Under 2%||2 x NHCE Rate|
|2% to 8%||2% + NHCE Rate|
|Over 8%||1.25 x NHCE Rate|
If a plan fails the ADP and/or ACP test, the employer may have several correction options, which include refunds to HCEs and/or contributions to NHCEs. Betterment can assist with determining these corrective options.
Top heavy determination
Top-heavy determination is another element of the compliance testing process. This is not technically a non-discrimination test, but it’s an important annual determination that may result in required contributions to plan participants. This test analyzes the accrued benefits between two groups: Key employees and non-Key employees.
A plan is considered top-heavy when the total value (account balance with adjustments related to rollovers, terminated accounts, and a five-year lookback of distributions) of the Key employees’ plan accounts is greater than 60% of the total value (also adjusted as noted above) of the plan assets, as of the end of the plan year.
If the plan is considered top-heavy based on the determination period, typically as of December 31 of the prior year, non-Key employees are due up to 3% in employer contributions if any Key employee makes or receives contributions for the year (including forfeiture allocations).
Betterment can assist with determining the top-heavy status as well as minimum contributions due, if any.
Types of Contribution Limits
|Type of Limit||What is it?||Notes for 2018 plan year|
|401(a)(30) / 402(g) / 414(v) Deferral Limits||Limits the amount a participant may contribute via 401(k) deductions. This is a calendar year limit.||$18,500 is the maximum amount a participant may defer into their 401(k) plan for 2018. A participant age 50 or older during the calendar year may defer an additional $6,000 in ‘catch-up’ contributions if permitted by the plan.|
|415 Annual Additions Limit||Limits the total contributions allocated to an eligible participant for the year4. This includes the employee contributions and all employer contributions and forfeiture allocations.||For plan years ending in 2018, the limit was a total of $55,000* + up to $6,000 in catch up deferral contributions if permitted by the plan.|
|Employer Level Deduction Limit||Employers are limited to total contributions (excluding employee deferrals) not exceeding 25% of eligible compensation for the plan year.||N/A|
* Subject to change by IRS.
1. Adjusted annually; see most recent Cost of Living Adjustments table here. ↩
2. Note that determining ownership can be further complicated by family attribution rules, determined under IRC §318. ↩
3. Adjusted annually; see most recent Cost of Living Adjustments table here. ↩
4. This limit is an IRS imposed limit based on the calendar year. Plan’s that use a ‘plan year’ not ending December 31st base their allocation limit on the year in which the plan year ends. This is different than the compensation limits, which are based on the start of the plan year. ↩