IRS Non-Discrimination Testing for Retirement Plans

The Internal Revenue Service (IRS) requires company-sponsored retirement plans to undergo annual non-discrimination testing. These tests confirm that a plan does not unfairly benefit a company’s owners or highest-paid employees over the general workforce, ensuring the tax advantages of these plans are distributed equitably.

Passing these annual tests is required for a plan to maintain its tax-qualified status, which allows employer contributions to be tax-deductible and for employee contributions and investment earnings to grow tax-deferred. Failure to comply can lead to financial penalties and jeopardize these favorable tax treatments.

Key Employee Classifications for Testing

To conduct non-discrimination testing, employees are categorized into specific groups based on compensation, ownership, and officer status. The primary groups are Highly Compensated Employees (HCEs), Non-Highly Compensated Employees (NHCEs), and Key Employees.

Highly Compensated Employee

A Highly Compensated Employee (HCE) is an individual who meets either an ownership or compensation test. The ownership test is met if the person owned more than 5% of the business during the current or preceding year, which includes ownership attributed from a spouse, child, parent, or grandparent.

The compensation test identifies an HCE if they received compensation above a specific threshold in the preceding “lookback year.” For 2025 testing, the 2024 lookback year compensation threshold is $155,000. Some plan documents may also include a provision that limits the HCE group to the top 20% of employees ranked by pay.

Non-Highly Compensated Employee

A Non-Highly Compensated Employee (NHCE) is any employee who does not meet the criteria to be classified as an HCE. This group comprises the majority of the workforce in most companies and serves as the benchmark against which the benefits of HCEs are measured in several non-discrimination tests.

Key Employee

The Key Employee classification is used for the Top-Heavy test and has a different definition than an HCE. An employee is considered a Key Employee if they meet any one of three criteria during the plan year. The first is owning more than 5% of the business.

The second is owning more than 1% of the business while also earning more than $150,000 in compensation for the year. The third criterion defines a Key Employee as an officer of the company who earns above a certain compensation level. For 2025, the officer compensation threshold is $230,000.

Required Non-Discrimination Tests

Retirement plans must pass a series of annual tests to demonstrate compliance with IRS regulations. The primary tests are the Actual Deferral Percentage (ADP) test, the Actual Contribution Percentage (ACP) test, the Coverage Test, and the Top-Heavy Test.

Actual Deferral Percentage (ADP) Test

The ADP test compares the average salary deferral rates of HCEs with those of NHCEs. An employee’s deferral percentage is calculated by dividing their total salary deferrals for the year by their gross compensation. The individual percentages for all eligible employees are then averaged to arrive at a single ADP for each group.

To pass, the HCE group’s average deferral rate must not exceed the NHCE group’s rate by a specified margin. If the NHCE ADP is between 0% and 2%, the HCE ADP can be no more than double. If the NHCE ADP is between 2% and 8%, the HCE ADP can be up to 2 percentage points higher. For an NHCE ADP over 8%, the HCE ADP is limited to 1.25 times the NHCE rate.

Actual Contribution Percentage (ACP) Test

The ACP test operates similarly to the ADP test but focuses on employer matching contributions and any after-tax employee contributions. The calculation and passing requirements for the ACP test mirror those of the ADP test. A plan must satisfy both the ADP and ACP tests independently.

The Coverage Test

The Coverage Test, under Internal Revenue Code section 410, ensures a plan benefits a broad cross-section of the workforce. The most common method for passing this test is the ratio percentage test, which requires the plan’s coverage ratio to be at least 70%.

This ratio is calculated by dividing the percentage of NHCEs benefiting from the plan by the percentage of HCEs benefiting. For example, if a plan benefits 100% of HCEs, it must benefit at least 70% of NHCEs to pass.

The Top-Heavy Test

The Top-Heavy test determines if plan assets are concentrated with Key Employees. A plan is considered “top-heavy” if the total account balances of all Key Employees exceed 60% of the total assets in the plan on the last day of the preceding plan year.

If a plan fails this test, the employer must make a minimum contribution to the accounts of all non-key employees. This contribution is generally equal to 3% of the employee’s compensation. However, if the highest contribution rate for any Key Employee is less than 3%, the required contribution for non-key employees is lowered to match that rate.

Information Required for Testing

To perform non-discrimination tests, plan sponsors must compile a comprehensive set of data for every employee, including:

• Employee census data: Full names, Social Security numbers, dates of birth, dates of hire, and termination dates for anyone employed during the year.
• Compensation information: Gross compensation for each employee, including base salary, wages, bonuses, commissions, and overtime pay.
• Contribution data: Specific dollar amounts of employee salary deferrals (pre-tax and Roth) and all employer contributions, such as matching funds and profit-sharing.
• Ownership and officer information: A list of every individual with an ownership stake and their percentage, along with a list of all company officers.

Correcting Failed Tests

When a plan fails a non-discrimination test, the sponsor must take corrective action to maintain its tax-qualified status. The IRS provides specific methods and deadlines for fixing failures, which usually involve returning excess contributions to HCEs or making additional contributions to NHCEs.

Correction Deadlines

For failed ADP and ACP tests, a plan has 2.5 months after the plan year ends to make corrective distributions without incurring a 10% excise tax on the excess amount. For a calendar-year plan, this deadline is March 15. The final deadline to make corrections and preserve the plan’s qualified status is the last day of the plan year following the year of the failure.

Corrective Distributions

One method for correcting a failed ADP or ACP test is to make corrective distributions. This involves refunding excess contributions to the affected HCEs to lower their group’s average rate to a passing level. These refunds are reported as taxable income to the HCEs in the year they are received, and the plan administrator will issue a Form 1099-R to report the distribution.

Making Additional Employer Contributions

An alternative is for the employer to make additional contributions to the NHCEs. These are known as Qualified Nonelective Contributions (QNECs) or Qualified Matching Contributions (QMACs). A QNEC is given to all eligible NHCEs, even those who did not contribute, while a QMAC is an additional match made only to NHCEs who made their own deferrals. Both QNECs and QMACs must be 100% vested immediately.

Safe Harbor Plan Design

Employers can adopt a Safe Harbor plan design to bypass certain annual tests. This requires the employer to commit to specific contribution levels, and in return, the plan is automatically deemed to have passed the ADP and ACP tests, and often the Top-Heavy test. This is a strategic choice for employers who want predictability and to allow HCEs to maximize their contributions without being limited by NHCE savings rates.

Required Employer Contributions

An employer can choose from several contribution formulas to satisfy Safe Harbor requirements. A popular option is the basic match, where the employer matches 100% of employee deferrals on the first 3% of compensation, plus 50% on the next 2% of compensation. Alternatively, an employer can make a non-elective contribution of at least 3% of compensation to every eligible employee’s account, regardless of whether the employee contributes.

Vesting and Notice Requirements

Safe Harbor contributions must be 100% vested immediately, unlike typical employer contributions that may be subject to a vesting schedule. Employers must also provide an annual notice to all eligible employees at least 30 days before the start of the plan year. This notice must describe the plan’s Safe Harbor provisions, including the contribution formula and the employee’s rights and obligations.