What Is the 410(b) Coverage Test for 401(k) Plans?

The Internal Revenue Service requires 401(k) plans to undergo annual testing, known as coverage testing, to ensure they do not unfairly favor business owners or high-earning employees. Mandated by Internal Revenue Code Section 410(b), this test verifies that a retirement plan benefits a broad cross-section of the workforce. Passing this annual evaluation is necessary for a plan to maintain its tax-qualified status, which allows for tax-deductible employer contributions and tax-deferred growth for participants.

The test compares the proportion of lower-paid employees benefiting from the plan to the proportion of higher-paid employees who benefit. Failing this requirement can lead to significant consequences, including costly corrections or plan disqualification.

Identifying the Testing Groups

Before performing the test, a company must categorize its workforce into groups defined by the IRS. The primary distinction is between a Highly Compensated Employee (HCE) and a Non-Highly Compensated Employee (NHCE). An individual is classified as an HCE for a given year if they meet either an ownership or a compensation test. The ownership test is met if the person owned more than 5% of the business at any point during the current or preceding year.

The compensation test is based on earnings from the preceding year. For testing performed in 2025, an employee is an HCE if they earned more than $155,000 in 2024. A plan document may also include a provision that limits the compensation-based HCE group to only the top 20% of earners. Any employee who does not meet the HCE definition is classified as an NHCE.

After separating employees into HCE and NHCE groups, the employer must identify any employees who can be legally excluded from the test. These excludable employees are not counted for testing purposes and may include:

• Employees who have not met the plan’s minimum age and service requirements, such as being 21 years old with one year of service.
• Union employees whose retirement benefits were subject to good-faith bargaining.
• Nonresident aliens who have no income from U.S. sources.
• Employees who terminated during the year with 500 or fewer hours of service and did not receive a benefit.

The Ratio Percentage Test

The most direct path to satisfying the 410(b) coverage rules is through the Ratio Percentage Test. The test compares the rate at which NHCEs benefit from the plan to the rate at which HCEs benefit. To pass, the coverage percentage of the NHCE group must be at least 70% of the coverage percentage of the HCE group.

The first step is to determine the coverage percentage for each group. This is calculated by dividing the number of employees in a group who are benefiting from the plan by the total number of non-excludable employees in that same group. An employee is considered “benefiting” if they are eligible to make 401(k) deferrals, even if they choose not to contribute.

Once the coverage percentages are found, the NHCE coverage percentage is divided by the HCE coverage percentage. For example, a company has 10 non-excludable HCEs and 80 non-excludable NHCEs. If all 10 HCEs are benefiting (a 100% HCE coverage rate) and 60 NHCEs are benefiting (a 75% NHCE coverage rate), the plan’s ratio is 75%. Since 75% is greater than the required 70%, the plan passes the test.

The Average Benefit Test

If a plan does not pass the Ratio Percentage Test, it has a second opportunity to comply by using the more complex Average Benefit Test. This alternative consists of two separate sub-tests, both of which must be passed. The first part is the Nondiscriminatory Classification Test, which ensures the group of employees eligible for the plan is based on a reasonable, objective business classification.

To satisfy the Nondiscriminatory Classification Test, a plan’s ratio percentage is compared against a safe harbor percentage from Treasury Regulations. This safe harbor is determined by the plan’s NHCE concentration percentage. If the plan’s ratio meets or exceeds the safe harbor percentage, this part of the test is passed, while falling below an unsafe harbor percentage results in automatic failure.

If the Nondiscriminatory Classification Test is passed, the plan must then satisfy the Average Benefit Percentage Test. This test shifts the focus from who is covered to the actual value of the benefits received. It requires that the average benefit percentage for the NHCE group is at least 70% of the average benefit percentage for the HCE group.

Calculating this involves determining the benefit for each employee as a percentage of their compensation, including all employer contributions and employee deferrals. These individual benefit percentages are then averaged for the HCE and NHCE groups to determine if the 70% threshold is met.

Correcting a Failed Test

Discovering a 410(b) coverage test failure requires prompt action to maintain the plan’s qualified status. The deadline to correct a failure by retroactively amending the plan is 9 ½ months after the close of the plan year in which the failure occurred. For a calendar-year plan that fails testing for 2024, the correction must be completed by October 15, 2025, to avoid more costly procedures under the IRS’s Employee Plans Compliance Resolution System (EPCRS).

The most common method to fix a coverage failure is to retroactively amend the plan to expand coverage. This involves amending the plan document to include enough additional NHCEs to pass either the Ratio Percentage Test or the Average Benefit Test for the failed year. This amendment must be effective as of the first day of the year of the failure.

Since these newly covered NHCEs were not able to make their own 401(k) deferrals, the employer must make a Qualified Nonelective Contribution (QNEC) to the plan on their behalf. This contribution compensates for the missed deferral opportunity and is often based on the average deferral rate of the NHCE group. Any missed employer matching or profit-sharing contributions for these employees must also be made, with earnings.