Chapter 17
401(k) Tax Code Nondiscrimination Rules
As we discussed in Chapter 16, the Tax Code’s retirement savings tax incentives inevitably provide the most incentive to high paid/high income taxpayers. In Chapter 5, we discussed how the Tax Code nondiscrimination rules, the compensation limit and the limits on benefits and contributions work together to “flatten out” benefits provided under a firm’s tax qualified retirement plan. Generally, to provide the maximum benefit to the high paid, similar retirement benefits must also be provided to some reasonably broad group of low paid employees.
Because the DB system is, from the participant’s point of view, “involuntary,” it is (relatively) easy to implement the Tax Code nondiscrimination rules under it: in a DB plan, there is (generally) just one plan benefit formula—everyone gets the same benefit, regardless of their preferences (e.g., for cash vs. savings).
In contrast, in the 401(k) system, individuals can choose the level at which they want to save. That opportunity to choose the level of savings is perhaps the most important innovation of the 401(k) system. No one is forced to save anything. So, as we have said, different employees at the same employer can save at different rates.
This element of “voluntarism” presents a challenge for policymakers intent on using the Tax Code to encourage retirement benefits for low paid individuals, who in many cases prefer current cash to retirement savings. How do you implement nondiscrimination rules in such a system without violating the 401(k) system’s commitment to participant choice?
The ADP Test
To address this issue, a special set of rules—called the ADP test—were developed. Under these rules, the percentage that high paid employees (called highly compensated employees or HCEs) may contribute is limited by the percentage low paid employees (NHCEs) contribute. Thus, the amount that high paid employees can voluntarily save is limited by the voluntary saving choices of low paid employees.
The ADP test is very technical and not very intuitive and we’re not going to treat it in detail. The following is a brief and oversimplified (aka “quick and dirty”) description.
You begin by calculating the actual deferral percentage (ADP) for NHCEs. The ADP here is not the average contribution but rather the average of the ratios, calculated separately for each NHCE, of NHCE 401(k) contributions divided by the NHCE’s compensation.
To illustrate: assume there are three low paid employees:
–Employee 1, who is paid $50,000 and contributes $1,500, has a ratio of 3%
–Employee 2, who is paid $25,000 and contributes $2,500, has a ratio of 10%
–Employee 3, who is paid $20,000 and contributes $1,000, has a ratio of 5%
The average of these ratios is (18%/3) 6%.
Once the ADP for NHCEs is determined, the ADP for HCEs is then limited as set forth in Table 17.1.
Table 17.1: Maximum HCE 401(k) Contributions Under the ADP Test
| If the NHCE ADP is | The maximum HCE ADP is |
| Less than 2% | The NHCE ADP x 2 |
| Between 2% and 8% | The NHCE ADP + 2% |
| Above 8% | The NHCE ADP x 1.25 |
Thus, in our example, with an NHCE ADP of 6%, the average of the contribution/compensation ratios for HCEs could not exceed 8%.
The point of the ADP test is to make sure that high paid employees are not contributing significantly more (as a percent of compensation) than low paid employees.
There is, obviously, some dissonance between the Tax Code’s nondiscrimination principle—pursuant to which employers are, in effect, forced to provide retirement benefits to low paid employees (who may in many cases simply prefer cash)—and a system that lets every employee choose how much to save. The ADP test is, in effect, a compromise between these two principles—it lets high paid employees save a little bit more than low paid employees, on average.
The Dollar Limit on 401(k) Contributions
In addition, in 1986, Congress radically reduced the dollar amount that an employee could contribute to a 401(k) plan, from $30,000 (the dollar limit then applicable to all contributions for an employee to a DC plan) to $7,000. Since then, this limit has been increased—in 2018 it is $18,500. But it is still significantly lower than the current (2018) dollar limit on regular, employer contributions to a DC plan—$55,000.
This restriction on voluntary contributions is, in effect, the result of the discomfort, among some lawmakers at least, with the idea of tax incentives for voluntary savings.
Passing the ADP Test
Let’s keep our eye firmly fixed on the policies at stake in these very technical rules. Policymakers are trying to reconcile the voluntary nature of the 401(k) system—which in many respects is appealing—with one of the two fundamental retirement savings tax policy principles we described in Part I: using tax policy to provide retirement income to low paid workers when they can’t work anymore.
The (not irrational) intuition was that if you let individuals decide voluntarily whether or not to save for retirement, then many high paid employees—in high tax brackets and with disposable, save-able income—will save. And many low paid employees—in low tax brackets and with a high preference for cash—won’t.
The purpose of the ADP test was to, in effect, require plan sponsors to figure out a way, without violating 401(k)’s principle of voluntary saving, to incentivize low paid employees to save. For a very long time, sponsors used two principle tools to do this: “education” and matching contributions.
Participant Education
The first tool was talk.
In connection with the development of the 401(k) system an entire industry developed to, in effect, sell the idea of retirement savings, especially to low paid employees. These were, very much, “ad campaigns,” with (in many cases) videos, targeted communications (for identified under-savers) and lots of face-to-face persuasion.
No doubt these programs had some effect.
Matching Contributions
The second tool was money: matching contributions. The idea was, in effect, to tease employees into saving by offering a financial incentive: e.g., for the first 3% of pay an employee contributed, the sponsor might contribute (up to) 3% as a matching contribution.
Matching contributions are, typically, provided to all employees, subject to the contribution and compensation limits (discussed in Chapter 5). And because, as we said, high paid employees generally have more disposable income and a greater incentive to save, Congress ultimately imposed a separate nondiscrimination test—called the “actual contribution percentage” (ACP) test—for matching contributions, modeled on the ADP test.
Safe Harbors
ADP testing is one of the two major issues (the other, as we’ll discuss, is fiduciary risk) preventing smaller businesses from adopting 401(k) plans. To address this issue, beginning in 1996 Congress added “design-based” safe harbors: if the sponsor provided for a minimum level of matching and/or sponsor contributions to a 401(k) plan, then it did not have to run the ADP/ACP tests.
Generally, safe harbor minimums are set fairly high, and the sponsor contributions have to be vested when made. As a result, opting out of ADP testing, and into a safe harbor, has for many employers been prohibitively expensive.
Defaults
After exhausting the potential for increasing (especially low-paid) employee 401(k) participation by education and matching contributions, sponsors began considering the possibility of using defaults to increase contribution rates.
Soon, and (interestingly) in the beginning at least without any legal encouragement, employers began to adopt auto-enrollment policies, generally defaulting new employees into 401(k) plan participation at a 3% contribution rate. And, while as we said in Chapter 15, the data on the relative effectiveness of defaults vs. matching contributions is not altogether clear, there is no question that matching contributions-plus-defaults is more effective at increasing participant 401(k) contributions than matching contributions without defaults.
Regulators followed this trend with guidance making it clear that, generally, defaulting employees into a 401(k) plan did not violate the principle that the decision by an employee to contribute to a 401(k) plan must be voluntary. And then Congress, in the PPA, adopted a new automatic enrollment safe harbor with (marginally) more relaxed sponsor matching and employer contribution requirements.
There is, at this point, bipartisan consensus that using defaults to increase contributions is a good thing. Indeed, as we’ll talk about in Part III, Democrats (and some Republicans) enthusiastically support the idea of requiring all US employers to implement some sort of automatic enrollment retirement savings program.
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What is happening here? What is all the education, different (and sometimes very complicated) matching contribution schemes and finally automatic enrollment (and then automatic increases in participant contributions) about?
To repeat what we said at the beginning of this chapter: the 401(k) concept was, in the first instance, one of voluntary savings. If you think about the two retirement savings policy objectives we discussed in Chapter 12, tax benefits for voluntary savings takes care of Objective 1—not taxing savings.
But how, in a voluntary system, do you address Objective 2—using tax policy to provide retirement income for low paid workers, who, because they are in a lower tax bracket (or pay no income taxes) and have a high (and understandable) preference for cash, are unlikely to save at the same rates as high-paid employees? By using education, matching contributions and defaults to get low paid employees to voluntarily use 401(k) plans to save for retirement. And to get employers where necessary to subsidize retirement benefits for low paid employees.
Critically, as we observed in Chapter 12, in all of this the employer is the locus of policy implementation. Motivated by a desire to provide tax savings for all its employees, the employer is the one that undertakes to educate low paid employees about the need to save for retirement. The employer is the one that finances the match (but, see our discussion in Chapter 12, “Who Pays for Retirement Benefits?”). And the employer is the one that implements defaults and administers the automatic contribution program.