Employers sponsoring non-safe harbor 401(k) plans must perform annual ERISA- and IRS-mandated testing to ensure they do not disproportionately favor highly compensated employees (HCEs) over rank-and-file non-HCEs. It is critical businesses understand the formulas for these nondiscriminatory tests and the steps they must take to fix a failure or risk losing their plans’ tax benefits.
Generally, a company is deemed to be operating its plan fairly when the average contribution of HCEs via salary deferral and employer match is within a certain percentage of those made by NHCEs. As NHCEs save more in their accounts, HCEs can defer more to their accounts. However, businesses must first recognize the IRS definition of a highly compensated employee, which for the 2024 tax year includes the following:
The first test is referred to as the Actual Deferral Percentage (ADP) test, which compares HCEs’ average pre-tax and Roth 401(k) elective salary deferrals (excluding catch-up contributions) to that of NHCEs. Essentially, the ADP measures annual plan engagement among all salary groups and is calculated by dividing the amount an employee defers by their total W-2 income (subject to IRS maximums). A company passes this test when the ADP for eligible HCEs does not exceed the greater of:
By contrast, the Actual Contribution Percentage (ACP) test, also required for businesses that make matching contributions, compares the average amount HCEs receive as employer contributions to that of NHCEs based on employees’ W-2 income. For plans that allow employees to make after-tax contributions, these amounts are also included for ACP testing. A company passes this test when the ACP for eligible HCEs does not exceed the greater of:
If an employer’s plan fails either or both ADP and ACP tests, the IRS grants it a limited time to refund contributions made by HCEs and/or make qualified non-elective contributions to all NHCEs plans to bring the average contributions of both groups within the passing requirements.
Alternatively, employers can avoid these nondiscrimination tests by making their plans Safe Harbor 401(k)s for which they must make specific annual contributions that generally are vested immediately.
About the Author: Sean Deviney is a CFP®* professional, a retirement plan advisor and a director with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with PWA Securities, LLC. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or info@provwealth.com.
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Sean Deviney, CFP®*, is a registered representative of and offers securities through PWA Securities, LLC, Member FINRA/SIPC.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Any opinions are those of the advisors of PWA and not necessarily those of PWA Securities, LLC. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of PWAS, we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Prior to making any investment decision, please consult with your financial advisor about your individual situation.
* Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
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Posted October 2, 2024