Employer 401k Plans: How Does the Non-Discrimination Test Work?

If you are investing in an employer 401k, you need to understand how all of the rules work, as they can affect you. For example, if you are a highly compensated employee, you need to understand how the non-discrimination test works. Here are the basics of the non-discrimination test and how it is used.

Non-Discrimination Test

According to federal regulations, every employer 401k has to go through a non-discrimination test in order to make sure that the retirement plan is not too highly weighted towards upper-level employees. If only the highly compensated employees are contributing to the plan, the IRS will change the rules of the plan, and it could potentially lose its tax-exempt status.

How the Test Works

In order to complete this test, they will look at the percentage of deferral rates for every employee. They are going to compare how much money is deferred into the account by highly compensated employees and how much money is deferred by those that are not highly compensated. If there is larger than a 2 percent difference between the deferral rates of the highly compensated and the non-highly compensated employees, then the plan is said to be unfair for the lower-level employees. 

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