In order to retain tax-favored status, the IRS Code requires that section 125, 105(h) and 129 plans pass a series of nondiscrimination test each year.
Standard Nondiscrimination Testing: ADP, ACP, and Top Heavy Tests
- Step #1: Calculate Annual HCE Deferral Rate.
- Step #2: Calculate Annual NHCE Deferral Rate.
- Step #3: Compare and Make Your Determination.
- Step #1: Calculate Annual HCE Contribution Rate.
- Step #2: Calculate Annual NHCE Contribution Rate.
The Internal Revenue Code (IRC) allows pretax contributions to FSAs as long as the benefit does not favor highly compensated employees (HCEs). You are considered "highly compensated" if your gross earnings are above the annual amount set by the Internal Revenue Service (see the IRS website for details).
What is non-discrimination testing? Non-discrimination testing requires that employees of a certain status (highly compensated employees and key employees) stay within a specific contribution rate, as determined by the contribution rate of NHCEs.
A Section 125 premium-only-plan (POP), is a cafeteria plan which allows employees to pay their health insurance premiums with tax-free dollars. However, employees can also use POP plans to pay individual health insurance premiums with tax-free dollars.
125 plan is required for employers who want to allow employees to choose the qualified benefits they want and avoid paying income taxes on the amount of wages they contribute to obtain those benefits. Flexible spending account (FSA) benefits for the employee: FSAs can only be offered through a Sec. 125 plan.
In order for employers to implement an HRA they must have a written plan document in place. Considered a self-insured health plan, the employer must annually pass non-discrimination testing to remain in compliance with Plan requirements.
The Section 125 rules specifically prohibit the following individuals from participating: • Self-employed individuals; • Partners within a partnership; and • More than 2 percent shareholders in a subchapter S corporation (S corporation).
A cafeteria plan, also known as a section 125 plan, is a written plan that offers employees a choice between receiving their compensation in cash or as part of an employee benefit. Employer contributions toward an employee's cafeteria-plan benefits are not taxed.
Nondiscrimination tests make sure everything is fair by looking at how much of their income different employees defer, how much the company contributes to employee accounts, and what percentage of assets in the plan belong to the HCEs and key employees.
In a section 125 plan or cafeteria plan, employees can pay qualified medical, dental, or dependent-care expenses on a pretax basis, which has the effect of reducing their taxable income as well as their employer's Social Security (FICA) liability, federal income and unemployment taxes, and state unemployment taxes
A Section 125 plan must offer employees a choice between at least one taxable benefit (such as taxable compensation) and one or more qualified benefits. Benefits that are not qualified benefits cannot be offered under a Section 125 plan.
A section 125 plan is the only means by which an employer can offer employees a choice between taxable and nontaxable benefits without the choice causing the benefits to become taxable. A plan offering only a choice between taxable benefits is not a section 125 plan.
4 For the 2021 plan year, an employee who earns more than $130,000 in 2020 is an HCE. For the 2022 plan year, an employee who earns more than $130,000 in 2021 is an HCE.
They are considered self-employed. Only employees can participate in pre-tax benefits through a Section 125 cafeteria plan. So, owners may generally participate in the plan, but certain owners cannot participate on a pre-tax basis under Section 125.
What is a 401k discrimination testing? The Federal Government issues nondiscrimination tests to evaluate the benefits plans of highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). These tests are meant to confirm NHCEs are not being excluded from the same benefits that HCEs receive.
Many employers have asked us whether they can take this approach a step further, and offer different levels of benefits to different employees. The short answer is yes, as long as the employer does not make these decisions on a discriminatory basis.
While the DOL's HIPAA Nondiscrimination Requirements describes what is allowed by law, California medical insurance companies often only allow an employer to designate a single employer contribution amount on the master application for group medical insurance.
One of the benefits of a qualified Section 403(b) retirement plan is that elective deferrals are not subject to nondiscrimination testing. All employer contributions, on the other hand, must demonstrate that contributions do not discriminate in favor of highly compensated employees (HCE).
When a plan document failure is discovered in a 401k plan audit, it's usually required that the plan documents be modified and that a correction be issued to plan participants. This will only be completed if the correction will be favorable to the plan participant.
The failed ADP and/or ACP test can be corrected by:
- returning the excess HCE contributions that are causing the plan to fail the test back to the HCEs, or.
- contributing additional amounts to the NHCEs.
The Major 401(k) Nondiscrimination TestsFor 2020, an HCE is defined as an individual that meets one of the following criteria: They own more than 5% of the employer (either directly or by family attribution) at any time during 2019 or 2020. They received more than $125,000 in compensation from the employer during 2019
Since employees are classified based on the income from the previous year's tax return, make sure you're looking at the requirements for the right year. In 2019, the HCE threshold will increase to $125,000 (from $120,000 in 2018).
401(k) Contribution Limit Rises to $19,500 in 2020
| Defined Contribution Plan Limits | 2020 | 2019 |
|---|
| Key employees' compensation threshold for nondiscrimination testing | $185,000 | $180,000 |
| Highly compensated employees' threshold for nondiscrimination testing**** | $130,000 | $125,000 |
For 2020 and 2021, a 401(k) participant filing single can contribute up to $19,500. . If you're at least age 50, you can direct an additional $6,500 in “catch-up” contributions. Factor in an employer match and you could be looking at major tax-advantaged savings.
Here's how the calculation works:
- Count the number of NHCE's benefiting from the plan. Divide by the total number of NHCEs.
- Count the number of HCE's benefiting from the plan. Divide by the total number of HCEs.
- Divide the #1 by #2. The ratio must be 70% or greater for a plan to pass.
To correct a top-heavy allocation failure, the employer must make a corrective contribution on behalf of the employee who received an insufficient allocation in an amount equal to the insufficiency, adjusted for earnings. There is more than one way to correct a vesting failure under EPCRS.
