Congress concocted special Non-Discrimination rules for 401(k) Plans because they felt that, without them, some employers would adopt the Plans, allow their Highly Compensated Employees to defer the maximum allowed by the law, and not bother to explain the Plan to the low paid employees. Here is a brief rundown on the rules.
Employees are separated into two groups - Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NCE). An HCE is someone making over $0 in the prior year and (optionally) in the top 20% of employees by pay. Owners of 5% or more of the company are also HCEs. Everyone else is an NCE.
Deferral percentages are calculated for each eligible NCE. If your pay is $30,000 and you defer $1,500, your deferral percentage is 5%. Someone that doesn't defer has a 0% rate. The deferral rates are then averaged. This is called the Average or Actual Deferral Percentage (ADP).
The two employees in the above example have an ADP of 2.5% (5% + 0% / 2).
The ADP of the HCEs cannot be more than the greater of either:
If the above example, the HCEs are limited to 4.5%, on average. (2x but not more than 2% more).
If the HCE's average deferrals are higher than the NCE's average deferrals, refunds must be made. The limit for a year can be known before it starts, but the average of the HCE's deferrals generally can not be known until after the year closes. So, it is usual to let the HCE's maximize their deferrals, with a caveat that some might have to be returned.
You have the choice of either looking back at the prior year's ADP of the Non-Highly Comp'd or using the current year. Generally, once the choice is made, you have to stick with it.
In the first year of the Plan, you can automatically assume that the NCEs deferred 3%, so the HCEs deferrals can average 5% (2% more).
New "Safe Harbor" rules have become effective. You can either agree to make Matching contributions or an across the board contribution.
The Safe Harbor Contributions must be 100% vested when made. If you agree to either scheme, there is no Non-Discrimination testing.
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