Nondiscrimination Rules

Nondiscrimination rules limit the extent to which employers can target tax-favored retirement benefits toward "highly compensated employees"--a term with a precise legal definition that includes most owners of firms and employees earning over $95,000. Such rules are intended to help low- and middle-income workers accumulate retirement savings and to support higher standards of living for future retirees from among the rank and file. The cost of complying with such rules, however, may deter some firms from offering plans.

Specific nondiscrimination rules include the following:

• A plan may not make participation conditional on an employee's reaching an age greater than 21. Furthermore, it may make participation conditional on an employee's completing more than one year of service (if the employee is over 21) only if it complies with stricter vesting requirements.



• A plan must meet one of two balanced-coverage requirements. The ratio percentage test requires that the number of rank-and-file employees who benefit from a plan be at least 70 percent of the number of highly compensated employees who benefit. The average benefit test requires that the average ratio of plan benefits to compensation for rank-and-file employees be at least 70 percent of the ratio for highly compensated employees.



• Defined-benefit plans must cover a minimum number of employees, depending on the size of the firm. Plans in firms with 200 or more employees must cover at least 50 workers. Plans in firms with between five and 199 workers must cover at least 40 percent of them. Plans in firms with two, three, or four employees must cover at least two workers.



• Ordinary 401(k) plans must meet a test involving the "actual deferral percentage" (ADP). The ADP is the percentage of compensation that employees actually choose to defer. As originally designed, the test limits the ADP calculated for highly compensated employees as a group to no more than twice the corresponding measure for rank-and-file employees. Furthermore, as the rank-and-file ADP rises above 2 percent, the multiple allowed for highly compensated employees declines until it reaches 1.25 for a rank-and-file ADP of 8 percent. The ratio remains fixed above 8 percent. The table below summarizes the allowable ADP for the highly compensated based on that of the rank and file:

Since 1998, 401(k) plans have had alternatives to the ADP test. One option requires employers to match 100 percent of the contributions by rank-and-file employees up to 3 percent of compensation and 50 percent of such contributions between 3 percent and 5 percent of compensation. In addition, the matching rate that applies at any given percentage of compensation may not be higher for the highly compensated than for the rank and file. The other alternative requires employers to contribute 3 percent of compensation on behalf of all eligible rank-and-file employees without regard to the level of employee contributions.

Alternative tests are available for nonqualified tax-favored plans such as SEPs and SIMPLEs.