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401(k) Nondiscrimination Testing Study – What % of Plans Fail?

Eric Droblyen

on January 19th, 2022

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401(k) plans must pass certain IRS-mandated nondiscrimination tests annually to confirm Highly-Compensated Employees (HCEs) do not disproportionately benefit and that no plan participant exceeded certain contribution limits. Often, these tests are completed as soon as possible following a year-end so correction and deduction deadlines are not missed. For calendar-based 401(k) plans, that means now.

What percentage of 401(k) plans fail these tests? We studied 3,217 small business plans to find out. Results from our study of 2020 data - including key findings - can be found below.

High 401(k) Fees

The 401(k) Nondiscrimination Tests Studied

  • ADP/ACP Test – the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests measure the elective deferrals and matching contributions of Highly-Compensated Employees (HCEs) for nondiscrimination.

    • For 2022, an HCE is defined as an individual that meets one of the following criteria: 

      • They own more than 5% of the employer (either directly or by family attribution) at any time during 2021 or 2022, or

      • They received more than $130,000 in compensation from the employer during 2021. Alternatively, a plan may also limit this group to the top 20% of employees, ranked by compensation.

    • The most common method for correcting a failed ADP/ACP is refunding the contributions made to HCEs in the amount necessary to pass the applicable test.

    • Safe harbor 401(k) plans can automatically pass the ADP/ACP test by meeting certain contribution and participant notice requirements.

  • The Top Heavy Test – A 401(k) plan is considered top heavy for a plan year when the account balances of “key employees” exceed 60% of total plan assets as of the last day of the prior plan year.

    • A “key employee” is defined as any employee (including former or deceased employees), who at any time during the plan year was:

      • An officer making over $185,000, or

      • A 5% owner of the business (a 5% owner is someone who owns more than 5% of the business), or

      • An employee owning more than 1% of the business and making over $150,000 for the plan year.

    • The most common method for correcting a failed top heavy test is allocating a top heavy minimum contribution to non-key employees.

    • Safe harbor 401(k) plans can automatically pass the top heavy test by meeting certain contribution and participant notice requirements.

  • Elective Deferral Limit (IRC §402(g)) – This limit applies to pre-tax and Roth elective deferrals.

  • Annual Additions Limit (IRC §415) – “Annual Additions” represent the sum of employee and employer contributions (including any reallocated forfeitures) made to a participant’s account during the limitation year (generally, the plan year).

Study Results

The following table summarizes the results of our test study. Because automatic enrollment is widely believed to help improve ADP/ACP and top heavy test results, we divided the safe harbor and traditional plans by their automatic enrollment status.

 


Plan Type

 


Plans

Studied

Failure Rate

ADP

ACP

Top Heavy

402(g)

415(c)

Traditional 401(k) - no automatic enrollment

598

25.59%

4.68%

12.04%

3.18%

0.50%

Traditional 401(k) - automatic enrollment

101

31.68%

2.97%

2.97%

0.99%

0.00%

Safe Harbor 401(k) - no automatic enrollment

2,252

N/A

N/A

56.88%

2.58%

0.49%

Safe Harbor 401(k) - automatic enrollment

266

N/A

N/A

39.47%

3.38%

0.38%

All Plans

3,217

26.47%*

3.74%*

45.41%

2.70%

0.47%

*Excluding safe harbor plans

Key Findings

  • It is common for small business plans to fail the ADP/ACP and top heavy tests.
    • Little surprise when you consider their employee demographics. Business owners often represent a high percentage of plan participants.
  • Most top heavy plans are safe harbor.
    • No surprise when you consider a safe harbor 4% matching or 3% nonelective contribution can cost a small business about the same as a top heavy minimum contribution, while helping the business pass the ADP/ACP test automatically.
  • Automatic enrollment doesn’t generally help small plans pass the ADP/ACP tests.
    • While some might be surprised by this finding, I’m not. In my experience, most small business plans have no problem with employee participation.
  • Few plans fail the 402(g) and 415(c) tests.
    • Probably because most payroll systems automatically cap elective deferrals at the 402(g) limit and a Third-Party Administrator (TPA) usually calculates the employer contribution necessary to max out the annual additions of certain plan participants - usually business owners.  

401(k) Nondiscrimination Tests are Important – Attention is Required

401(k) plans offer valuable benefits to employers and employees alike. These benefits are not free, however. A plan must meet IRS qualification requirements to qualify. One of the most technical qualification requirements is annual nondiscrimination and limits testing. Most employers hire a professional 401(k) TPA to complete the testing required by their plan.

Failing this testing is not a big deal – in fact, as our study shows, it’s quite common for small business plans to fail one or more tests. What is a big deal, however, is not correcting a failed ADP/ACP, top heavy, 402(g), or 415(c) test properly. To best ensure test correction deadlines are not missed, employers should get their 401(k) TPA the information they have requested to complete plan testing as soon as possible.

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