Requirements for tax-qualified retirement plans, such as 401(k) plans, that limit participation by executives and other highly paid employees (HCEs) if their participation would otherwise result in contributing too much relative to contributions by lower-paid employees. These rules limit the extent to which elective contributions of highly compensated employees can exceed those of lower-paid employees, and are among the reasons your company might set up a nonqualified deferred compensation plan.

This determination requires what is known as average deferral percentage (ADP) testing and other types of tests. (See A Guide To Common Qualified Plan Requirements from the IRS.) When lower-paid employees as a group do not have enough saved in the plan, either this reduces the amount that HCEs can save or the company must return some of the savings by HCEs with corrective distributions. For more on this see a brief summary from Newport Group on the ADP, ACP, and top-heavy year-end-plan tests, the IRS guide to fixing 401(k) plans that failed the nondiscrimination tests, and a commentary from the firm Guideline.

Newport also predicts that the Covid-19 crisis could lead lower-paid employees to lower or discontinue deferrals. That will have a direct impact on plan testing, “particularly if HCEs continue to defer or have front-loaded their deferrals early in the year.” The firm recommends an NQDC plan as a less expensive option than traditional plan testing defensive strategies.