An employee benefits attorney explains in plain language nondiscrimination tests for employee retirement plans.
A fundamental requirement for every qualified retirement plan is that the benefits or contributions be provided in a manner that does not discriminate in favor of highly compensated employees (HCEs). The IRC requires a qualified plan to demonstrate its compliance with this nondiscrimination requirement by satisfying a particular test. Some tests are specific to the type of contribution. For example, a 401(k) plan demonstrates its compliance by having its salary reduction contributions satisfy the actual deferral percentage (ADP) test and its matching contributions satisfy the actual contribution percentage (ACP) test.
Other types of contributions or benefits must demonstrate compliance by passing other tests. Typically, profit sharing or discretionary contribution plans will prove their contribution or benefits are nondiscriminatory by allocating the contributions as an equal percentage for all participants. This formula satisfies a regulatory "safe harbor" test.
The effect of using the general test or cross-testing described below is to permit a plan to target HCEs for what could be relatively large contributions (the maximum of $49,000 for 2009 for a defined contribution plan) and make significantly lower contributions to non-highly compensated employees (NHCEs).
The General Test for Contributions
A discretionary contribution plan can show that its contributions or benefits do not discriminate in favor of HCEs by satisfying a fairly complex objective test described in the regulation. The basic test or what the regulation describes as the "general test" for defined contribution plans, works as follows (see Treas. Reg. § 1.401(a)(4)-2(c)):
This article has been excerpted from the Journal of Accountancy. View the full article here.