What Is IRS Nondiscrimination Testing?

Employer-sponsored retirement plans offer tax advantages to encourage saving. To ensure these benefits are distributed equitably, the Internal Revenue Service (IRS) requires annual nondiscrimination tests. These tests are a requirement for plans like 401(k)s to maintain their tax-qualified status. The purpose is to verify that a plan does not disproportionately favor business owners or high-earning employees over the general workforce. The government provides tax incentives for these plans, and in return, requires proof that they promote broad retirement savings. If the disparity in benefits is too great, the plan fails and the employer must take corrective action.

Key Employee Classifications for Testing

To conduct nondiscrimination testing, the IRS requires employers to categorize their workforce into specific groups. The primary groups are Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs), with a separate category for Key Employees used in a specific test.

An individual is defined as an HCE based on an ownership test or a compensation test. The ownership test identifies anyone who owned more than 5% of the business at any point during the current or preceding year. An employee who owns exactly 5% is not an HCE, but owning 5.01% triggers the classification. This stake is determined by company shares or voting power and includes interest held by a spouse, parents, children, and grandparents.

For testing in 2025, an employee is an HCE if they earned more than $155,000 in 2024. This threshold is indexed for inflation and will increase to $160,000 for the 2025 look-back year when determining HCEs for 2026. Some plans may also include a provision that limits the compensation-based HCE group to the top 20% of employees ranked by pay. Any employee who does not meet either the ownership or compensation test is an NHCE.

A separate classification is that of a “Key Employee,” which is used for the Top-Heavy test. An employee is a Key Employee if, during the prior plan year, they met any of the following conditions:

• An officer of the company who earned more than $230,000.
• An individual who owned more than 5% of the business.
• An individual who owned more than 1% of the business and earned over $150,000.

Required Nondiscrimination Tests

Retirement plans must pass a series of annual tests that measure fairness to maintain a tax-qualified status. These evaluations use the established employee classifications to compare the benefits received by HCEs and Key Employees against those received by the rest of the workforce.

Coverage Test

The Coverage Test ensures the plan benefits a broad cross-section of the workforce. The ratio percentage test is the most common method, which compares the percentage of NHCEs who benefit from the plan to the percentage of HCEs who benefit. To pass, the ratio must be at least 70%. For example, if 100% of HCEs benefit, then at least 70% of NHCEs must also benefit. If a plan covers only 80% of HCEs, it would need to cover at least 56% of NHCEs to pass.

Actual Deferral Percentage (ADP) Test

The ADP test is specific to 401(k) plans and focuses on the elective deferrals made by employees. It compares the average percentage of salary deferred by HCEs to the average percentage deferred by NHCEs. Each eligible employee’s deferral percentage is determined, and then these percentages are averaged for both the HCE and NHCE groups. Catch-up contributions made by employees age 50 and over are excluded from this calculation.

A plan passes if the HCEs’ average deferral rate does not exceed the NHCEs’ rate by a specified margin. The HCE average cannot be more than 125% of the NHCE average. Alternatively, it can be up to 2 percentage points higher than the NHCE average, as long as it is not more than two times the NHCE average. For instance, if the NHCE group’s average deferral rate is 3%, the HCE group’s average can be no more than 5%.

Actual Contribution Percentage (ACP) Test

The ACP test operates similarly to the ADP test but scrutinizes employer matching contributions and any after-tax contributions made by employees. It compares the average contribution rates for HCEs to those of NHCEs using the same mathematical limits as the ADP test. To calculate the averages, each employee’s total matching and after-tax contributions are divided by their plan compensation.

Top-Heavy Test

The Top-Heavy test examines the concentration of plan assets. A plan is “top-heavy” if more than 60% of its total assets are held in the accounts of Key Employees as of the last day of the preceding plan year. If this ratio is exceeded, the plan is deemed top-heavy for the year. This triggers a requirement for the employer to contribute at least 3% of compensation to the accounts of all non-key employees who are employed on the last day of the plan year.

Information Required for Testing

Performing accurate nondiscrimination testing requires employers to compile a comprehensive census of their workforce and financial information related to the plan. This data is foundational for ensuring the tests are performed correctly and the results are reliable. The necessary information includes:

• Employee census data: Full legal name, Social Security number, date of birth, and date of hire for every individual employed during the plan year. For former employees, their termination date and hours worked are also needed to determine eligibility.
• Compensation data: Gross wages, the definition of “plan compensation” as outlined in the plan document, and a breakdown of any compensation types excluded from plan calculations.
• Contribution data: A detailed accounting of each employee’s pre-tax or Roth 401(k) deferrals, any after-tax contributions, and all employer contributions broken down by type, such as matching or profit sharing.
• Ownership and officer information: A list of all business owners with their exact percentage of ownership and family relationships to apply attribution rules. A list of all company officers and their compensation is also required to identify Key Employees.

Correcting a Failed Test

Failing one or more nondiscrimination tests requires the employer to take corrective action within a set timeframe to bring the plan back into compliance. To avoid a 10% employer excise tax on excess amounts from failed ADP or ACP tests, corrections must be made within 2.5 months following the end of the plan year. Plans with an automatic enrollment feature may have an extended six-month deadline. The final deadline to make corrections and avoid plan disqualification is 12 months after the plan year ends.

A common correction method for a failed ADP or ACP test is to refund the “excess contributions” to the affected HCEs until the test passes. These refunds, which include investment earnings, are taxable income to the HCEs in the year they are received. This method lowers the HCEs’ average contribution rate to the required level.

Alternatively, the employer can make additional contributions to the NHCEs. A Qualified Nonelective Contribution (QNEC) is an employer contribution made to all eligible NHCEs, regardless of whether they deferred their own money. A Qualified Matching Contribution (QMAC) involves the employer making extra matching contributions to NHCEs who made their own deferrals.

If an employer fails to correct a test within the 12-month window, the plan risks losing its tax-qualified status. This would make all contributions and earnings immediately taxable for all participants, not just HCEs. The employer would also face significant penalties, making timely correction a primary responsibility for plan sponsors.