The Importance of Discretionary Testing: ACP and ADPIf you’re a business owner who is interested in offering retirement benefits like a 401k, you may have heard of the words nondiscrimination or discretionary testing. These tests were designed to ensure fairness when it comes to employer contributions. U.S. Congress established these tests in order to make sure that retirement benefits did not only benefit high earners or core employees, and that everyone was able to get a fair percentage of employer contributions. Discretionary testing ensures that business owners and other business stakeholders are not able to take advantage of the system by putting in large and disproportionate amounts of money into their retirement plans. Typically, discretionary testing involves reviewing the average benefits provided to two groups of employees – highly compensated employees and key employees. Before we proceed to the kinds of compliance tests that businesses may be subjected to, we’ll first go into the differences between highly compensated employees and key employees.
What Kinds of Employees Are Being Reviewed for Compliance?As mentioned above, there are two kinds of employees that will be looked at for compliance testing. So what exactly makes an employee highly compensated or key?
Highly Compensated Employee (HCE)According to the IRS, an employee can be considered highly compensated if they have achieved any of the following within the business:
- Owns 5% or more of the business during the year or the preceding year.
- Received compensation of more than $130,000 in 2021 or more than $135,000 in 2022 or was in the top 20% of employees when ranked by compensation.
Key EmployeeKey employees are those with major decision-making roles within a business. Some of them own huge shares in the business, are very highly compensated or have excellent benefits and incentives. Based on IRS guidelines, key employees are considered as such if or when they meet the following criteria:
- They are officers of the company with gross compensation of more than $180,000
- Employees of the company in the current year who:
- Own 5% or more of the company in the current or previous year.
- Own 1% or more of the company with an annual pay of more than $150,000.