Most know just enough about nondiscrimination testing (NDT) to be dangerous! This is not an unusual feeling, as many of the regulations are vague and the Internal Revenue Service (IRS) has provided little guidance. This Q&A blog provides key highlights to know to provide more clarity and understanding.
1. What exactly is nondiscrimination testing and why must it be done?
Answer: NDT is required by law and overseen by the IRS.
It’s conducted for one primary reason: to make sure highly compensated and certain key employees are not receiving a better benefit than other employees in regards to their Code Section 125/cafeteria plan benefits**, Code Section 105(h)/self-insured group health plan benefits, Code Section 129/Dependent Care FSA benefits, and Code Section 79/Group Term Life benefits. These benefits use pre-tax dollars, which equates to saving on income taxes and social security taxes. If highly compensated and/or key employees are receiving favoritism, they have more savings on their taxes than others.
Definitions: Below are generalities; some tests performed may have a slightly modified version.
Highly Compensated Employee:
- An officer during the preceding plan year (or current plan year in the case of the first year of employment)
- >5% owner of the employer during the preceding or current plan year
- An employee with annual compensation more than the “highly compensated employee” specified dollar threshold for the preceding year (or current plan year in the case of the first year of employment)
- A spouse or dependent of any of the above
- For purposes of Code Section 105(h) tests, 25% of the employer’s top-paid employees
- An officer of the employer with annual compensation in excess of a specified dollar threshold ($180,000 for 2019; $185,000 for 2020)
- >5% owner of the employer
- >1% owner of the employer with annual compensation in excess of $150,000 (not indexed)
**Cafeteria plan benefits may include: Premium only plans (POPs) and health and dependent care flexible spending accounts (FSAs), which all need to be tested together under Code Section 125. The FSAs need to be tested again separately under Code Sections 105(h) and 129.
2. Why bring up nondiscrimination testing at the end of May?
Answer: To test midyear gives the Plan Administrator a chance to fix any detected failures. If conducted at the end of the year (the mandated deadline), there is no means to amend. See Question 5 for more details. Overall, the Plan Administrator has more flexibility to handle issues. Note that employers who laid off a large population of non-highly-compensated employees during the COVID-19 National Emergency may see plans fail that usually pass. In addition, employers who adopted the allowable mid-year election changes may see non-highly-compensated employees dropping more coverages than highly compensated employees.
3. What are the tests to be conducted for Section 125, Section 129 and 105h?
|Eligibility Test||Contributions and Benefits Test||Key Employee Concentration Test||>5% Owners Concentration Test||55% Average Benefits Test|
|Section 125 /POP||x||x||x|
|Section 129 Dependent Care FSA (most vulnerable for failing)||x||x||x||x|
|Section 125 Health FSA||x||x|
|Section 105(h): Self-funding and HRA||x||x|
4. What does each test entail?
Answer: Typically, a detailed census is required to run a test, as well as a completed worksheet to provided needed plan information, such as the aggregate premium pre-tax collected for all employees vs highly compensated employees.
See below for specifics:
|Test Description of the Test|
|Eligibility Test||Section 125 and Section 129: Nondiscriminatory employee classification
Section 105(h): Must pass at least one of the following three tests:
1. 70% of all employees
2. 80% of eligible employees if 70% of all employees are eligible
3. Nondiscriminatory employee classifications
|Contributions & Benefits Test||Section 125: Benefits or contributions cannot favor highly compensated participants in availability or actual elections
Section 129: Benefits or contributions cannot favor highly compensated employees
Section 105(h): Benefits to highly compensated employees must be provided on the same basis to other participants
|Key Employee Concentration Test||Section 125: Aggregate nontaxable benefits and taxable benefits provided to key employees (employee plus employer contributions) cannot exceed 25% of the total nontaxable and taxable benefits provided to all employees|
|More than 5% Owners Concentration Test||Section 129: Not more than 25% of the amounts paid or incurred by an employer for dependent care assistance may be provided for 5% shareholders or owners of the employer|
|55% Average Benefits Test||Section 129: Average non-highly compensated employees benefits must be greater than 55% of average benefit for highly compensated employees.|
5. How does employer-paid group term life insurance come into play?
Answer: Group Term Life, on the life of the employee, can be paid with pre-tax contributions up to a $50,000 maximum. If there is more than $50,000, it could be deemed as gross income and taxed. NDT is required to ensure that key employees are not receiving favored benefits (this is not applicable to highly compensated individuals). As a result, an eligibility test is to be run, as well as a benefits test. The NDT regs are in Code Section 79.
6. What if the tests fail?
Answer: If testing is done early in the plan year, corrections can be made prior to the end of the plan year and the plan will retain tax-favored status. If corrections are not made, “discriminatory benefits” must be included in the gross incomes of highly compensated and key employees. This may mean a revision of the employee’s W2s.
7. Who receives the results besides the Plan Administrator?
Answer: Test results and other documentation should be kept on file. The data would be required during an IRS audit.
In all this type of testing is a challenge to get one’s mind wrapped around the details. If you have any questions or need to have NDT run for your groups, please contact Aubrey Box from Wrangle. Her email address is firstname.lastname@example.org.
To keep track of special extension deadlines due to federally-declared natural disasters, click here to be redirected to our blog piece that keeps a running list of the information for you.