Discrimination Testing for 401k Retirement Plans

IRS guidelines require all employees to make equal contributions to 401k retirement plans, regardless of their income. Discrimination testing is used to determine whether a company’s 401k plan meets these guidelines.

Discrimination testing checks whether the 401k plan is top heavy by determining whether the contributions made by employees who earn over 100,000 dollars a year are more than 2 percent higher than those made by employees earning under this amount. If the discrimination test shows a difference of over 2 percent, then the deferrals of the higher earners must be reduced. The excess contributions will be returned to these employees and penalties may be imposed upon the company.

Employers have two options for avoiding this problem. First, they may convince their lower earning employees to make larger contributions. This can be achieved through education and offering incentives. Secondly, they may convert their 401k plan into a Safe Harbor 401k plan.

A Safe Harbor 401k retirement plan requires the employer to match their employee’s contributions. They may either do so by contributing a fixed amount of 3 percent or as a percentage of the employee’s salary, which may be up to 4 percent. The employer is required to make contributions to the retirement plan of every employee aged 21 or over who has worked for at least 1000 hours in the previous year. They must make contributions even if the employee does not contribute. Employees can choose how much they want to contribute to their plan, up to a maximum limit. Matched contributions are 100 percent vested.
Matching for a Safe Harbor 401k plan will increase costs for the employer, but it will also excuse them from discrimination testing. Employer contributions to the 401k Safe Harbor plan must continue in order to avoid discrimination testing. Employees must be given 30 days notice before contributions are stopped.
The risk of failing discrimination testing increases as a company grows. It is important to ensure that your employees are educated about their retirement plans. Employees who understand the need to prepare for retirement and the benefits of contributing to their retirement plans will be more likely to make the necessary contributions to prevent the plan from becoming top heavy. Your retirement plan provider can supply you with information packets, brochures and software to help you keep your employees informed. It is possible to encourage employees of all ages to make contributions into their retirement plans. Younger employees can be educated about the benefits of beginning to invest early in order to save more for their retirement. Employees who are nearing retirement age can be educated about the possibility of catching up on their contributions in order to compensate for missed years.

Related posts:

1. The 401k Employee Retirement Plan
2. Introduction to Employee Retirement Plans

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