Read More

Nondiscrimination Testing: Next Steps if Your Qualified Plan Fails the Test

Earlier this year, PLANSPONSOR cited a 2022 study showing that as many as 1 in 3 companies fail annual 401(k) nondiscrimination testing. If it happens to you or your client’s organization, do you know what steps to take next?

The purpose of nondiscrimination testing for 401(k) benefit plans is to ensure that a company’s qualified plans do not discriminate in favor of the organization’s higher wage earners, key employees or company owners. Another way to look at 401(k) nondiscrimination testing is that the process reveals if the plan equitably provides both lower and higher-wage earners a tax-advantaged opportunity to save for retirement.

Testing is Not Optional

If an organization offers a retirement plan under Section 125 of the IRS code, there’s no getting around the requirement to undergo nondiscrimination testing annually. NDT, or nondiscrimination testing, is mandated as part of ERISA, the Employee Retirement Income Security Act, and regulated by the IRS. Testing is conducted on the last day of the current plan year, which varies for each organization and is typically carried out by the third-party advisor (TPA), the company’s HR department or its plan recordkeeper.

If your plan fails the ADP or ACP test … the plan has 2½ months after the end of the plan year being tested to correct excess contributions.
—Internal Revenue Service (IRS)

The Refund No One Wants

The Actual Deferral Percentage test (ADP) is one of several specific nondiscrimination tests. The ADP test establishes a plan’s average deferral percentage by comparing the deferral percentage of highly compensated employees to the average deferral percentage of non-highly compensated employees.

When a 401(k) plan fails the ADP (or other) NDT, one solution is to refund a portion of the deferrals made by the high-wage earners. This corrective distribution is known as a 401(k) refund, but it is a refund that employees do not want to receive.

While returning money to the employee who paid into the plan generally alleviates the company’s problem, the company incurs administrative costs in issuing and documenting the refund, must meet refund deadlines and may lose a competitive edge in attracting top talent because of a less-appealing benefit offering.

The refund becomes taxable earnings for the employee, and an opportunity for tax-deferred retirement savings, an area already limited by federal regulations on plan contributions, is further diminished.

Options and Alternatives

When looking for an alternative to the 401(k) refund, a company may consider making design changes to its qualified plan and explore a safe harbor 401(k). Safe harbor plans require that a company make mandatory contributions to the plan, which sometimes makes these plans cost-prohibitive for the company.

Automatic enrollment of all employees into an organization’s 401(k) plan is another strategy to help a company meet discrimination testing requirements. Auto-enrollment allows an employer to deduct elective deferrals from wages unless the employee elects to contribute a different amount or not contribute at all. Auto-enrollment doesn’t mandate deferrals but does typically improve plan participation levels.

However, specific verticals may find auto-enrollment unrealistic. When a company match is provided to all employees, organizations with high turnover rates may find themselves contributing to the retirement plans of workers with less company loyalty.
Retail, the hospitality industry and some manufacturing sectors are examples of workforces that inherently include a higher percentage of short-term workers or employees who remain with the company but opt out of participation in a 401(k) plan. In these situations, the plan sponsor may cap the amount of income that higher wage earners can defer into the 401(k) plan, ensuring that no 401(k) refunds will be necessary.

A nonqualified deferred compensation plan (NQDC) can offer an effective workaround to what can otherwise be a lose-lose situation. One viable strategy is for the employee to receive the 401(k) refund check and then take advantage of a 401(k) Refund Offset. This refund check cannot go directly to the employee’s NQDC plan. But, for tax purposes, the increased salary deferral and refund check can offset each other. The company can offer an NQDC plan with a company match to ensure plan participants receive an amount equal to the 401(k) match had it not been capped because of discrimination issues.

No Organization is Too Big to Fail

Although larger organizations sometimes find it easier than smaller companies to keep their 401(k) plan percentages “in balance” and avoid failing nondiscrimination testing, in the current business climate, any company can be at risk of failing.

At the height of the pandemic, layoffs, furloughs and companies reducing salaries or suspending their benefits match increased. A year later, many of those same companies raised wages and benefit offerings above pre-pandemic levels to compete for reliable employees. On the employee side, redefined personal values and the inflationary economy have led some plan participants to change their deferral rates, making them higher, lower or even putting participation on hold.

Nondiscrimination pre-testing throughout the year has always been a proactive strategy. In recent years intermittent self-testing has taken on new significance in helping plan sponsors stay on the right side of nondiscrimination testing challenges.

Want to read more about nonqualified deferred compensation plans? Check out our recent articles: CFO Decision-Making That Drives Employee Retention and IRS Audits and the Nonqualified Deferred Compensation Plan.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.

Investment advice is offered through OneDigital Investment Advisors, an SEC-registered investment adviser and wholly owned subsidiary of OneDigital.