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Update Your Plan to Minimize Non-Discrimination Issues   

 

When Congress enacted legislation authorizing 401(k) plans, the legislation included non-discrimination requirements as part of the overall strategy to encourage employers to see that contributions were funded for their rank and file workforce. The tax deduction carrot encouraged businesses to adopt plans and fund contributions, and non-discrimination testing was the vehicle Congress chose for broadening participation. In one way or another, non-discrimination testing affects all 401(k) plans.

Traditional 401(k) plans require a contribution comparison, the Actual Deferral Percentage (ADP) test, between highly compensated employees (generally owners, their family members and employees earning more than $120,000) and non-highly compensated employees (everyone else). If the average contributions or deferrals by the highly compensated exceed those of the non-highly compensated by certain limits, the law requires that those gaps be narrowed, usually by paying out refunds to the highly compensated employees. While this gap may be narrowed by additional employer contributions (Qualified Non-elective Contributions, or QNECs), experience shows that refunds to HCEs are a more common solution.

 

ADP refunds are taxable to the highly compensated when they are paid out. Highly compensated employees therefore have an incentive to minimize or avoid ADP refunds. The most common ways to do this are:

  • Adding safe-harbor 401(k) provisions to a plan,
  • Adding automatic enrollment and auto-increase provisions,
  • Restructuring matching formulas and communicating benefits to employees,
  • Conducting enrollment meetings that lead to signing up more employees.

Adding safe-harbor 401(k) provisions

Safe harbor plans are plans that can be exempt from the ADP test and the related refunds. These plans are ensured to pass testing even when rank and file participation is low. The employer commits to fund a safe-harbor 401(k) contribution each year. The most common formulas are 1) 3% of compensation to all employees, whether or not the employee contributes, or 2) a matching program with a 100% match on the first 3% of compensation and a 50% match from 3% to 5%, for a total maximum employer cost of 4% of compensation. When the match formula stays within certain limits, this approach will ensure no required refunds.

Adding automatic enrollment and increase provisions

Automatic enrollment programs commonly enroll new employees at 3% of salary with an annual increase each year of possibly 1% or 2% per year up to as much as 10%. When added with employer matching or contributions, this can be an effective way to guide employees into sufficient contributions to more adequately prepare for retirement. With more employees participating in the plan, the deferral amount of the non-highly compensated employees increases, allowing highly compensated employees the benefit of deferring more to the plan.

Restructuring matching formulas and communicating benefits

When company budgets seriously limit an employer’s options, considering changes to the match formula can be helpful. Changing a company’s commitment from matching 100% on the first 3% of employee deferrals to matching 50% on the first 6% should not increase employer costs at all and may reduce costs. Yet it encourages increased employee contributions.

Conducting employee enrollment meetings to communicate 401(k) benefits

From time to time, as new employees come in, it’s important to reinforce the benefits of participating in the plan. When an employer offers a match, it can be compelling to take the approach of not leaving money on the table. But even without a match, the benefit of long-term saving plus tax-deferred investment growth over many years can be impactful.

401(k) Plans offer large numbers of Americans a realistic way to build retirement security. The approaches summarized here can help employees take actions that will improve testing results while simultaneously benefiting employees as they prepare for their own futures.