403(b) Plans: Required Nondiscrimination Testing

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).

To test for nondiscrimination, contributions or benefits (divided into pay) of the highly paid group are compared to those of the non-HCEs. The averages for each group must not favor the HCEs beyond a specified range. The allowable range is defined by the type of plan and the HCE concentration (HCE vs. total eligible employees).

Plans can be designed to avoid nondiscrimination testing. For example, a plan that does not cover any HCEs, or that allocates employer contributions to all participants directly in proportion to compensation would be deemed to be automatically nondiscriminatory.

403(b) plan sponsors that match elective deferrals are generally required to test the matching contributions via the actual contribution percentage test (ACP). Matching contributions are divided into pay to determine the contribution ratio for each employee. Employees who do not receive a match would be included in the testing with a ratio of zero. The average of the HCE and non-HCEs are compared. If the non-HCE group is not within the specified allowable range below the HCE group (generally less than 1.25%), then a correction is required. The correction methods involve either distributing or forfeiting matching contributions from HCEs or providing an additional employer contribution to the non-HCEs. Plans with an employer match can adopt safe harbor provisions to avoid testing.

Employer contributions other than matches are subject to a different nondiscrimination test. Plans using an allocation method that is not in proportion to pay (such as a discretionary amount to each individual) must pass general nondiscrimination testing. This is a complicated area with many variables and options, but these plan designs can be very beneficial to an organization’s key employees.

The plan’s compensation definition may also require annual nondiscrimination testing. There are safe harbor definitions of compensation that are automatically nondiscriminatory, such as W-2 compensation, and other all-inclusive definitions. Plans that want to eliminate a portion of compensation, such as bonuses or overtime, must perform a test under Section 414(s) of the IRC. The non-excluded pay is divided into total pay to determine the “exclusion ratio” for the HCE and non-HCE groups. The average ratio for the HCE group cannot be more than a small amount above the non-HCE average, which has informally been defined as 3%.

Another area that may involve nondiscrimination is the “benefits, rights and features” of the plan. This can include the ability to take a loan from the plan, distribution alternatives, or investment options. Anything available under the plan cannot be preferential to HCEs. For example, if the right to self-direct investments or even the availability of a specific investment is restricted under the plan to accounts of a certain size, then the feature must be tested to ensure that it does not predominantly favor HCEs.

Nondiscrimination is an important consideration for plan sponsors, and failure of the nondiscrimination standards can lead to plan disqualification. Please contact us with any questions about your plan’s compliance with these requirements.

For questions or more information, please contact Richard Green at rgreen@windes.com or 844.4WINDES (844.494.6337).