401(k) plans are subject to annual Internal Revenue Service (IRS) nondiscrimination compliance testing, which makes sure a plan is fair to all employees and does not overly favor owners and highly compensated employees (HCEs). While some plan elements may be out of your control, certain business and plan characteristics can increase the likelihood of failing required testing. This article covers common scenarios to watch for and strategies to manage risk through purposeful plan design.
Your company may be subject to these primary nondiscrimination tests after the end of each plan year:
Actual Deferral Percentage (ADP) test — Compares the average deferral (payroll reduction contribution) percentage of highly compensated employees (HCEs) against the average deferral percentage of non-highly compensated employees (NHCEs)
Actual Contribution Percentage (ACP) test — Compares the average employer matching contribution percentage of HCEs against the average of NHCEs
Top-heavy test — Makes sure that if "key employees" hold more than 60% of the total account balances in a 401(k) plan, non-key employees get a minimum contribution
Several business and plan characteristics can increase your risk of failing compliance testing.
Plans with a small number of participants should be especially mindful that low employee participation rates can greatly impact compliance testing results. With fewer participants:
401(k) contributions from key employees (typically officers and owners) are more likely to exceed 60% of plan assets, resulting in a top-heavy testing failure
One HCE contributing a large amount — or one NHCE deciding to unenroll — can have an outsized impact on deferral rates, causing an ADP or ACP test failure
A failed test may mean HCEs need to remove their deferrals or the company needs to make additional contributions to raise testing ratios
Pro tip: Owners can reduce risk by contributing consistently throughout the year, observing NHCE deferral rates, and adjusting their own deferrals accordingly. Adding a safe harbor provision can also address both of these concerns.
S-corporation owners typically have only a portion of their income reported as W-2 wages eligible for 401(k) contributions. The remaining portion is reported on a K-1 (IRS Form 1065). The IRS only permits W-2 wages to count as compensation for plan purposes.
Owners who defer a high portion of their W-2 compensation can end up with a very high Actual Deferral Percentage, putting the plan at risk of failing the ADP test.
For example: Ace is an S-corp owner who reports $70,000 of income on a K-1 and gets $30,000 in wages. If Ace defers $9,000 (only half the annual limit and less than 10% of his total combined income), his actual deferral percentage is 30% because only the $30,000 can be used in the test. Non-owners are unlikely to contribute at a similar deferral percentage, which means the plan would be outside ADP limits and require corrections at year-end.
Important: If you are an S-corp owner who wants to contribute larger amounts to your 401(k), be aware that your W-2 wage deferral percentage is what counts for testing purposes.
Large variations in employee pay can cause compliance issues for your 401(k) plan:
HCEs, owners, and officers may be able to defer a greater percentage of their compensation than rank-and-file employees (NHCEs), leading to compliance testing failures
Large deferrals made by owners and officers (key employees) may cause a plan to be top-heavy
For example: Bad Wolf Inc. has one HCE earning $185,000 annually and deferring 10% to their 401(k). At the same time, the company has nine employees earning an average of $40,000 who can only defer an average of 3%. The ADP disparity of 7% (10% – 3%) exceeds the IRS-allowed 2% difference. The one key employee's 401(k) account would also likely make up more than 60% of total plan assets, making the plan top-heavy.
When a large proportion of a company is made up of partners or owners, it is easy to fall outside the limits for top-heavy testing.
For example: Atmos Law has three partners, three associates, one executive assistant, and two paralegals. Because the partners earn more, save more, and have been with the firm longer than the other employees, the partners' 401(k) account assets exceed 60% of plan assets. As a result, Atmos Law is required to make top-heavy minimum contributions.
Due to ownership attribution rules, family businesses can face the same challenges as businesses with a high proportion of owners. Employees who are the spouses, parents, children, or sometimes even grandchildren of owners can be treated as having the same ownership stake when determining key employee and HCE status.
For example: Alice and Ben own 100% of Family Farms, and their 401(k) assets make up 40% of plan assets. Charles, Diana, and Eric are Alice and Ben's children who work at Family Farms, and together their assets make up 25% of plan assets. Because children are considered key employees due to attribution of their parents' ownership, key employee assets for Family Farms make up 65% of the plan's total assets. As a result, the plan is top-heavy.
Important: If relatives work for your company, they may be considered key employees or highly compensated employees (HCEs) whose deferrals can affect compliance testing results — even if they are modestly compensated and do not hold any ownership in the company.
Many new companies use stock options, grants, or warrants to reward early employees. This can result in a larger number of employee-owners who may be considered key employees or HCEs. If those key employees' 401(k) contribution assets exceed 60% of plan assets, the plan will experience a top-heavy testing failure.
Pro tip: If your company has issued or will issue significant stock options to employees, review them before beginning a 401(k) plan to determine who will be considered a key employee — both now and in the future.
If your plan falls into one or more of the scenarios above, you should be especially diligent about monitoring your plan's compliance scores. You can keep track of your estimated compliance status throughout the year within the Compliance section of your Gusto Retirement administrator dashboard.
Here are plan features that can help reduce risk:
Automatic enrollment — Encourages participation by automatically enrolling eligible employees into the 401(k), which can increase the number of rank-and-file participants and help with compliance testing. All Gusto 401(k) plans include a version of an automatic contribution arrangement.
Employer match — Boosts employees' retirement savings engagement, improves your plan participation rate, and in some cases increases your plan's likelihood of passing annual nondiscrimination testing
Safe harbor plans — Automatically satisfy most IRS nondiscrimination tests, including the ADP and, in some cases, the ACP and top-heavy tests, if certain other conditions are met. Learn more about the types of plans available.
If you are part of a legally related group, not all compliance information will be available.