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Modern businesses should do everything they can to prevent or reduce fraud, but it can sometimes be found in the strangest places. Breaking nondiscrimination testing rules for your 401(k) could count as fraud to the government, so you should avoid it where possible.
What is 401(k) Nondiscrimination Testing?
401(k) nondiscrimination testing is an assessment used by employers to make sure their 401(k) plans are fair and equitable for all participants. The purpose of the test is to identify any potential discrimination against employees which could impact their ability to access retirement benefits.
The test also ensures that a company’s plan does not favor highly-compensated employees (HCEs). HCEs receive higher wages due to their current position or due to market forces, such as salary caps imposed by government regulations on executive compensation packages.
How Can Employers Make Sure They Pass the Test?
To pass this test, the 401(k) plan must pass certain criteria set out by the IRS. These criteria include limits on employee contributions and employer matching contributions, as well as a requirement that HCEs receive no more than a certain amount of benefits from the plan.
There are several benefits of passing 401(k) nondiscrimination testing, including staying legally compliant. But best of all, employers who pass the Actual Contribution Percentage (ACP) or Actual Deferral Percentage (ADP) test create a fairer workplace for their employees.
What Can You Do If You Didn’t Pass the Test?
Businesses can fail their 401(k) nondiscrimination tests for multiple reasons, but it can be hard to find where they made a mistake. Here’s what you can do to pass the test after a failure.
Try a Different Testing Model
A technically savvy retirement plan may not be able to pass the ADP test, but it could get through the ACP test just fine. But even if your plan barely passes with an alternative testing model, you should still make changes to the plan to ensure better outcomes in the future.
Make Necessary Refunds
You may fail the test because you gave too much money to HCEs. If that’s the case, you need to make necessary refunds. Those who defer the most in dollar terms receive refunds first. If you’re constantly requesting refunds, advise employees to reduce their deferral percentage.
Consider Making a QNEC or QMAC
If you can’t cut back the HCEs contributions, you can try making a qualified non-elective contribution (QNEC) or qualified matching contribution (QMAC). While this approach means employer contributions are 100% vested immediately, it could save your test score.
Build a Case for Retirement Savings
It’s important for businesses to build a case for retirement savings, as non-highly compensated employees can help pass the test. With that said, it can be difficult to encourage lower-paid employees to invest a significant amount, so consider offering raises or financial education.
Make Your Match Go Further
Changing your matching structure without increasing dollar amounts can actually drive contribution behavior. Changing your current match from 50% of the first 4% to 25% of the first 8% can make people move to the latter contribution level if they’re financially savvy.
Institute Automatic Enrollment
If you want to boost participation, then change your 401(k) enrollment strategy from optional to mandatory. They can still opt out if they decide that the plan isn’t for them. Many employers automatically enroll non-participating employees once a year, even after they opt-out.
Institute Automatic Increases
The only consequence of automatic enrollment is that those that are required to enroll have a lower contribution rate than those who wanted to enroll. For this reason, you should institute automatic increases once in a while to keep everyone’s contribution limit on the higher level.
Keep the 401(k) Plan Simple
Employees who tend to avoid signing up for 401(k) plans do so because they’re overwhelmed by the number of options. While automatically enrolling them can fix this problem, it can also cause employees to “set and forget” their plans. Keep plans simple to encourage enrollment.
By understanding what 401(k) nondiscrimination testing is and how to pass it, employers can ensure their retirement plans are equitable for all participants. At the same time, they can reduce their risk of incurring penalties from regulators for failing to meet compliance standards.