What is nondiscrimination testing?

As an employer or human resources professional for a small or medium-sized business (SMB), there are many compliance considerations to be aware of, especially regarding employee benefits and taxation. One such consideration is nondiscrimination testing (NDT) for certain benefits offerings.

This blog post will explain what nondiscrimination testing is, when you should complete it, why it’s important for your organization, and what happens if you encounter testing failures.

Takeaways from this blog post:

• Nondiscrimination testing (NDT) evaluates the fairness of an organization's fringe benefits to ensure they are accessible to all eligible employees, not just highly-compensated employees.
• >NDT applies to retirement plans, flexible spending accounts, health savings accounts, and health reimbursement arrangements (HRAs).
• You should conduct NDT annually and helps to ensure that an organization's benefits plans are fair and in compliance with IRS guidelines.

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What is non-discrimination testing?

NDT is a series of tests established by the Internal Revenue Service (IRS) to evaluate how fair an organization’s fringe benefits are. NDT aims to ensure your organization’s benefits plans are accessible to all eligible current employees, not just highly-compensated employees (HCEs)¹.

The federal government initially established these additional tests for 401(k) plans² but now they apply to certain Section 125 cafeteria plans and Section 105 plans.

Pre-tax benefits that require NDT include:

• Retirement plans
• Flexible spending accounts (FSAs)
• Health savings accounts (HSAs)
• Health reimbursement arrangements (HRAs)

There are a few different tests for determining if your current plan is discriminatory toward non-highly-compensated employees (NHCEs) in favor of key employees. First, let’s look at the difference between HCEs and NHCEs.

Who is considered a highly-compensated employee?

NDT relies on comparing HCEs and NHCEs. The IRS has clear guidelines on which employees should be considered HCEs.

Employees eligible as an HCE must meet the following criteria:

• They own more than 5% of the interest in the organization at any time during the current or preceding year
• They receive more than $155,000 in annual compensation from the organization in the current or preceding year (as of 2024)

The IRS permits you to consider any eligible employees in the top 20% of workers by compensation as HCEs, but this is optional. All other workers are considered NHCEs.

When should non-discrimination testing be done?

NDTs are annual tests. These reports are due to the IRS by the final day of the plan year. It’s a good idea to conduct your tests before this date so that you have time to take corrective action to comply with IRS guidelines. Otherwise, you won’t have time to correct any errors that are found.

Why is nondiscrimination testing performed?

NDT ensures that your retirement and Section 125 plans are fair to all employees. Since these plans have tax advantages, the IRS enforces NDT so that an organization’s benefits don’t unfairly compensate employers and certain key employees.

What nondiscrimination tests are required?

Depending on the type of benefits your organization offers, there may be different annual testing methods you need to complete.

Retirement plans and Section 105(h) health plans³ such as HRAs, dental and vision insurance, and FSAs that provide tax-free benefits are subject to NDT.

Eligibility test

The eligibility test determines whether enough NHCEs benefit from the plan compared to HCEs. You must include all employees in the current year testing group except those who have been with your organization for fewer than three years, those younger than 25, and part-time and seasonal employees.

To pass, your plan needs to satisfy one of three tests:

• 70% test: Your plan benefits 70% or more non-excludable employees
• 70%/80% test: Your plan benefits 80% or more of your non-excludable workers who are eligible for the plan if at least 70% of your non-excludable workers are eligible
• Non-discriminatory classification test: Your plan benefits a class of employees that doesn’t discriminately favor HCEs. You’ll need to use bona fide employee classes, and your plan must have an acceptable ratio of benefiting NHCEs to HCEs.

HRAs, such as individual coverage HRAs (ICHRAs), have special rules and can be offered to different classes of employees as long as those classes aren’t discriminatory.

Benefits test

Under the benefits test, Section 105 health plans must provide the same additional benefits offered to HCEs to all other participants. This only reflects the actual benefits employees can be reimbursed for, not the amount.

To pass, your health plan needs to satisfy the following if they include HCEs:

• Employee contributions test: Employee contributions, such as for FSAs, must be the same for HCEs and NHCEs
• Benefit limits test: Benefit contribution limits must be uniform for all participants and free from modification based on age or years of employment. For example, if you offer a $6,000 annual ICHRA allowance to your employees but a $10,000 allowance to your executives only, your benefit would fail the NDT.
• Waiting periods: Requiring a longer waiting period for NHCEs than HCEs is cause for failure of the test

Section 105 allows for an exception for NDT for medical diagnostic procedures, such as blood tests, physical exams, and X-rays.

Actual deferral percentage (ADP) test

Actual deferral percentage (ADP) looks at elective deferrals and divides that amount by the plan participant’s compensation. This is used for retirement plans like 401(k)s.

First, you’ll need to find the annual contribution rate for both HCEs and NHCEs. Divide the average elective deferrals for each type of employee by their average compensation. Now, you’ll compare the two values.

To pass, the ADP for HCEs can’t exceed the greater of:

• 125% of the ADP for the NHCEs
• 200% of the ADP for the NHCEs
• The ADP of the NHCEs plus an additional 2%

Actual contribution percentage (ADP) test

This test is similar to ADP, but it includes employer-matched contributions as well, including any employer contributions through a nonelective contribution model. Divide each participant’s matching contributions and after-tax contributions by compensation, much like with ADP.

To pass, the ACP for HCEs can’t exceed the greater of:

• HCEs can’t exceed 125% of the ACP for the NHCEs
• HCEs can’t have less than 200% of the ACP for the NHCEs

Top-heavy test

The top-heavy test⁵ is used to determine if your current retirement benefits have a greater value for key employees.

These key employees are defined by the IRS as:

• An employee making more than $200,000 per year
• Anyone with a 5% or more ownership stake in the organization
• Any employee who owns more than 1% of the organization and makes more than $150,000 in annual compensation

If the value of the plan assets in key employees’ retirement accounts is greater than 60% of all assets from the overall employer-sponsored plan, including non-key employees, it fails the test.

Key employee concentration test

With the key employee concentration utilization test, no more than 25% of the combined tax-free benefits may be provided to key employees. This includes all pre-tax contributions for HSAs, FSAs, HRAs, and life or disability insurance premiums combined.

Dependent care tests

There are two unique utilization tests for dependent care benefits: the 55% of average benefits test and the 5% owners test.

Under the 55% average employer contribution test, dependent care plans must provide at least 55% of the average company contributions to eligible NHCEs.

With the 5% ownership test, you may give no more than 25% of the additional contributions for dependent care assistance to a 5% shareholder or a business owner.

What happens if you fail nondiscrimination testing?

If your benefits fail NDT, your tax-free benefits will become taxable income for HCEs on all excess reimbursements. You must include these excess contributions on employees’ W-2s as gross income, but they aren’t subject to income tax withholding.

Excess reimbursements are determined by dividing the total reimbursements to HCEs by the total reimbursed to all employees for the plan year. Then, multiply this by the total reimbursed to a single HCE.

The tax-free status of your benefit for NHCEs isn’t affected.

Conclusion

By completing non-discrimination testing during each plan year, you can ensure that your employee benefits continue to receive tax benefits from the IRS. You’ll also ensure that all your employees see the benefits of your compensation package regardless of their overall income or position.

If any of the IRS tests fail, be sure to review your benefits to determine whether your employees are properly classified and where you can enhance your benefits for your NHCEs. That way, you can make any corrections to your plan design before the results are due to the IRS.

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1. https://www.irs.gov/retirement-plans/identifying-highly-compensated-employees-in-an-initial-or-short-plan-year#:~:text=Highly%20Compensated%20Employees%20%E2%80%93%20In%20General&text=Generally%2C%20an%20employee%20is%20an,known%20as%20the%20lookback%20year).

2. https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-the-plan-failed-the-401k-adp-and-acp-nondiscrimination-tests

3. https://www.law.cornell.edu/uscode/text/26/105

4. https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview#:~:text=Safe%20harbor%20401(k)%20plans,-A%20safe%20harbor&text=These%20contributions%20may%20be%20employer,whether%20they%20make%20elective%20deferrals.

5. https://www.irs.gov/retirement-plans/is-my-401k-top-heavy