By Ian Berger, JD
IRA Analyst

If you participate in a 401(k) plan, you probably know about the annual limit on the amount of your deferrals (for 2019, $19,000, or $25,000 if over age 50). But if you are a high-paid employee, another limit may apply.

Welcome to the IRS nondiscrimination rules! These rules are designed to ensure that retirement plans don’t favor “highly compensated employees” (HCEs) at the expense of other employees. In the 401(k) context, the rules limit the amount of deferrals that HCEs can make, depending on the level of deferrals all other employees make. (The nondiscrimination rules don’t apply to solo 401(k) plans.)

HCE’s. You’re an HCE for a particular year if:

• you, or certain family members, own more than 5% of the plan sponsor during that year or the prior year; or
• for the prior year, you received pay of more than an indexed dollar limit ($120,000, if the prior year is 2018).  (Your employer may choose to limit HCEs to employees who are also in the top 20% of employees ranked by pay.)

If you’re not an HCE, you’re considered a non-highly compensated employee (NHCE).

ADP test. There are two 401(k) nondiscrimination tests: the ADP test and the ACP test. Both must be passed annually.

For the ADP test, the plan must first calculate a deferral percentage for each employee. Your deferral percentage is the amount of pre-tax and Roth deferrals (but not age 50 catch-up contributions) you make, divided by your pay for the year. (If you are eligible but don’t defer, your deferral percentage is 0 %.)

Then, the plan must calculate an average deferral percentage for all of the NHCEs and an average for all of the HCEs.

The ADP test works this way:

• If the NHCE average is 2% or less, the HCE average can’t exceed twice the NHCE average.
• If the NHCE average is between 2% and 8%, the HCE average can’t exceed the NHCE average plus 2%.
• If the NHCE average is more than 8%, the HCE average can’t exceed the NHCE average times 1.25.

Example: Company A has 4 NHCEs and 2 HCEs eligible for its 401(k) plan in 2019. Company A performs the ADP test based on the following data:
Employee                           Elective deferrals                      Pay              Deferral Percentage

NHCE1                                    $       0                              $40,000                        0%

NHCE2                                      3,000                                60,000                      5.0

NHCE3                                      4,800                                80,000                      6.0

NHCE4                                      9,000                              100,000                      9.0

HCE1                                       14,000                              140,000                     10.0

HCE2                                       19,000                              158,333                     12.0

In this example, the NHCE average deferral percentage is 5.0% [(0% + 5.0% + 6.0% + 9.0%)/4]. Therefore, to pass the ADP test, the HCE average percentage can’t be more than 7.0%. Since the HCE average percentage is 11.0% [(10.0% + 12.0%)/2], the plan fails the ADP test for 2019.

The November 13 Slott Report will discuss the other nondiscrimination test – the ACP test – as well as ways a plan sponsor can remedy an ADP or ACP test failure.

https://www.irahelp.com/slottreport/how-401k-nondiscrimination-rules-work-part-1