What Is the 70/50 Rule for Retirement Plans?

IRS nondiscrimination tests for qualified retirement plans are designed to ensure plans do not disproportionately benefit business owners or highly compensated employees at the expense of the general workforce. Adhering to these standards is an aspect of maintaining a plan’s tax-qualified status. This article will dissect two components: the minimum participation standard and the minimum coverage test, explaining how they function and what is required for compliance.

Understanding the Minimum Participation Standard

The minimum participation standard is a requirement primarily for defined benefit plans. This rule is outlined in Internal Revenue Code (IRC) Section 401 and sets a baseline for the number of employees a plan must cover. Its purpose is to prevent employers from establishing pension plans that benefit only a select few, such as top executives.

The core of the rule is a calculation: the plan must benefit the lesser of either 50 employees or 40% of the employer’s total workforce. For example, a company with 300 employees must have at least 50 employees benefiting from its defined benefit plan. In contrast, a smaller business with 100 employees must cover at least 40 of them (40% of 100), as this is less than 50.

For an employee to be considered “benefiting” under a defined benefit plan, they must be actively accruing a benefit for the plan year. This means their potential retirement payout is growing based on the plan’s formula, which involves factors like salary and years of service. Simply being eligible to participate is not sufficient; there must be an actual increase in their accrued benefit.

Navigating the Minimum Coverage Test

The minimum coverage test, governed by IRC Section 410, applies broadly to qualified retirement plans, including 401(k)s. This test ensures that the plan covers a broad cross-section of the workforce and doesn’t just favor the highest earners. To apply this test, employees are first categorized as either Highly Compensated Employees (HCEs) or Non-Highly Compensated Employees (NHCEs). An HCE is an individual who owns more than 5% of the business or earned above a specific compensation threshold in the preceding year. For 2025, this threshold is compensation of more than $155,000 in 2024.

The most common way to satisfy the minimum coverage requirement is through the Ratio Percentage Test. This involves a three-step calculation. First, an administrator determines the percentage of all non-excludable HCEs who are benefiting from the plan. Second, they calculate the same percentage for all non-excludable NHCEs.

An employee is considered “benefiting” in a 401(k) plan if they are simply eligible to make elective deferrals, even if they choose not to contribute. The final step is to divide the NHCE benefiting percentage by the HCE benefiting percentage. To pass the test, this resulting ratio must be at least 70%. For instance, if a plan benefits 100% of HCEs, it must also benefit at least 70% of NHCEs. If a plan fails this test, it may still pass under the more complex Average Benefit Test.

Determining Which Employees to Include

Before applying either the minimum participation or minimum coverage tests, an employer must first identify the total workforce and then determine which employees can be legally excluded from the calculation. The law permits the exclusion of specific groups of employees, which can simplify the testing process and help a plan satisfy the requirements.

Commonly excluded categories include employees who have not yet met the plan’s minimum age and service requirements. A plan can require an employee to be at least 21 years old and have completed one year of service before becoming eligible to participate.

Other excludable groups are employees covered by a collective bargaining agreement, provided their retirement benefits were a subject of good-faith negotiation between the employer and the union. Certain nonresident alien employees who have no income from U.S. sources can also be left out of the testing pool.

Consequences of Non-Compliance

Failing to meet the minimum participation or coverage standards can result in the disqualification of the retirement plan. This outcome has serious tax consequences for the employer, the plan’s trust, and the employees.

For the employer, plan disqualification means the loss of tax deductions for any contributions made to the plan during the non-compliant years. This can result in a substantial and unexpected tax liability. The plan’s trust, which is a tax-exempt entity, loses that status, and its investment earnings become subject to taxation. This erodes the value of the assets held for all participants.

The impact is on the employees. Upon disqualification, all vested benefits become immediately taxable to the employees as income, even if the money has not been distributed from the plan. This can push employees into higher tax brackets and create a significant financial hardship. While the IRS has established correction programs, such as the Employee Plans Compliance Resolution System (EPCRS), to help plan sponsors fix these errors, the process can be complex and costly.