What Is 401(k) Plan Testing?

By Stuart Robertson

What’s that you say – there’s a 401k plan test to pass? Well, it’s not like a test in school at all, and your 401k plan provider should make this simple to manage – or better – you can select a plan design that automatically satisfies these tests.

All 401k plans except Solo 401ks are subject to government tests to help ensure the plan is serving the best interest of employees and not just high earners.

401k Tests Help Ensure Your Plan Is Benefiting All Participating Employees
Yes, 401k plans must be run in the best interest of employees and are meant to benefit all fairly. In particular, the IRS wants to ensure that non-highly compensated employees (NHCEs) are benefiting from the plan, and that highly compensated employees (HCEs) aren’t unfairly benefiting from the plan.

In 2022, NHCEs are defined as those earning less than $135,000 per year, and HCEs are those earning $135,000 or more. HCEs also include any employee who is a 5% or greater owner in the firm and/or immediately family of an owner.

401k Non-Discrimination Tests
There are non-discrimination tests every 401k plan must satisfy. The tests consider salary deferral percentages and employer contributions for both populations to ensure the plan is well managed and needs no corrective actions. These are called:

  1. Actual Deferral Percentage (ADP) Test – this test looks at the employee salary deferral amounts over total compensation by HCEs and NHCEs. There are several ways to pass the test. If the ADP for the eligible HCEs doesn't exceed the greater of:
    • 125% of the ADP for the group of NHCEs, or
    • the lesser of:
      • 200% of the ADP for the group of NHCEs, or
      • the ADP for the NHCEs plus 2%.

Many plans use the last criteria to pass. For example, if NHCEs are deferring 6% of salary on average, an HCE may not contribute more than 8% of their salary to their own 401(k) account.

  1. Actual Contribution Percentage (ACP) Test – this test considers the employer received contributions to the 401k plan by NHCEs and HCEs. The ACP test is met if the ACP for the eligible HCEs doesn't exceed the greater of:
    • 125% of the ACP for the group of NHCEs,
    • or the lesser of:
      • 200% of the ACP for the group of NHCEs, or
      • the ACP for the NHCEs plus 2%.

A company may base the ADP and ACP percentages for NHCEs on either the current or prior year contributions. The election to use current or prior year data is in the plan document that will accompany any 401k plan as it gets established.

How to Automatically Satisfy ADP/ACP 401k Plan Tests
The most common and popular plan design for businesses with less than 100 employees is called a Safe Harbor 401k plan. Safe Harbor 401k plans make it easy for business owners to maximize contributions to their own accounts as they automatically satisfy the required IRS non-discrimination testing.

Businesses that choose a Safe Harbor plan must either:

  • Make a dollar-for-dollar matching contribution for all participating employees on the first 4% of each employee's compensation (this is the most popular option), OR
  • Contribute 3% of the employee's compensation for each eligible employee, regardless of whether the employee chooses to participate in the plan.

All matching contributions are vested immediately. Safe Harbor plans work particularly well for firms that have consistent revenue streams. Businesses that don’t want to provide this kind of match or find it difficult to maintain matching levels year-round may prefer a Traditional 401k plan design.

If you don’t prefer a Safe Harbor 401k plan design, another savvy way to pass these tests is to setup automatic enrollment with an employee salary deferral level of 10% or more (15% is the highest you may set it). This way, many of your employees will be participating given they are automatically enrolled (they can always opt out) and will be contributing at a deferral level that can help them build a meaningful nest egg. Meanwhile, HCEs are able to contribute a high percentage as well often up to the 401k personal limit.

Know that these tests are not really very daunting at all and many, many businesses of all shapes and sizes offer 401k plans. While at first blush, these tests may seem complicated, they can be simple to satisfy and manage with either the right plan design or features no matter your business size or need.

Meet the Author

Our low-cost 401k plans are easy to setup online and are supported by our 401k advisors and specialists. ShareBuilder 401k serves small business and medium-sized companies, as well as the self-employed. We offer Roth 401k, Safe Harbor 401k, Traditional 401k, and Solo 401k options. Your 401k plan is paired with investment management expertise and employee education to help you save more.