410(b) Coverage Testing: The Three Tests, Fixes, and Penalties

Section 410(b) coverage testing is the annual check that a qualified retirement plan benefits enough rank-and-file employees, not just owners and top earners, to keep its tax-advantaged status.¹ A plan has to pass one of three statutory tests each year. Fail all three and go uncorrected, and the plan can be disqualified, with immediate tax bills for highly compensated employees and the loss of the employer’s deduction. The mechanics look intimidating, but they come down to four questions: who counts, who’s an HCE, who’s benefiting, and does the resulting ratio clear one of the three tests.

Who Counts in the Testing Population

Every employee of the employer goes into the testing pool unless they fit an excludable category. Miscount here and the whole test can flip.

The main excludable categories:

Employees who haven’t met the plan’s minimum age or service conditions (up to age 21 and one year of service, the statutory maximum), as long as the plan also excludes them from benefits.¹
Nonresident aliens with no U.S.-source earned income, plus nonresident aliens whose U.S.-source income is fully exempt under a tax treaty.²
Collectively bargained employees, when testing a plan that covers only non-union employees.²
Employees of a different qualified separate line of business, when the plan being tested benefits only one line’s workforce.²
Certain short-service terminees: employees who leave during the year with 500 or fewer hours, aren’t employed on the last day, and don’t get a benefit solely because of a last-day or minimum-service rule.

Everyone else is a nonexcludable employee and stays in the pool. Watch a common trap: if your plan is more generous than the statutory maximums (say, age 18 and six months of service), employees who benefit but haven’t hit the statutory age-21-and-one-year mark cannot be ignored. They’re in.

If the employer is part of a controlled group or an affiliated service group, employees across every entity in the group are treated as working for a single employer.³ A plan that looks fine when you count one subsidiary can fail once the full group is on the roster.

Classifying HCEs and NHCEs

Every nonexcludable employee is either a highly compensated employee or a non-highly compensated employee. An employee is an HCE if either test is met:

Ownership: the employee owned more than 5% of the business at any time during the current or preceding plan year. Pay level is irrelevant.⁴
Compensation: the employee earned more than $160,000 from the employer during the preceding plan year. That threshold applies to 2025 compensation when determining HCE status for the 2026 plan year.⁵

Employers can narrow the compensation-based HCE group with a top-paid group election, which limits HCEs on the pay side to those also in the top 20% by compensation during the lookback year. The election has to be written into the plan document and, once made, sticks until revoked.⁴ Everyone who isn’t an HCE is an NHCE.

What “Benefiting” Actually Means

The coverage tests measure the percentage of HCEs and NHCEs who benefit under the plan, and benefiting is narrower than being eligible.

In a defined contribution plan such as a profit-sharing plan, an employee benefits only if they actually receive an allocation for the year.⁶ Zero allocation, no benefit for testing purposes. In a defined benefit plan, the employee needs to accrue a benefit during the year.

The important exception: in a 401(k) plan or matching contribution arrangement, an employee is treated as benefiting simply by being eligible, whether or not they defer or receive a match.⁶ That’s a big reason 401(k) plans generally clear coverage more easily than profit-sharing plans, where discretionary allocations may be skipped.

The Three Coverage Tests

You only need to pass one. Administrators usually try them in order of complexity.

The Percentage Test

The simplest option: the plan benefits at least 70% of all NHCEs.¹ If you hit that, you’re done. HCE participation doesn’t matter. Plans with broad eligibility and automatic enrollment usually pass here.

The Ratio Percentage Test

If you can’t reach 70% of NHCEs outright, the plan can still pass by showing NHCE coverage is proportional to HCE coverage. The NHCE percentage benefiting must be at least 70% of the HCE percentage benefiting.¹

If 100% of HCEs benefit, the plan needs to cover at least 70% of NHCEs. If only 80% of HCEs benefit, required NHCE coverage drops to 56%. The regulation treats the flat 70% test and the ratio test as one “ratio percentage test,” because the flat test is just the special case where every HCE participates.⁷

The Average Benefit Test

Plans that fail the ratio percentage test have one more path. The average benefit test has two components, and both must be satisfied.

First, the nondiscriminatory classification test. The plan must cover a group of employees defined by a reasonable classification based on objective business criteria, such as salaried employees or employees at a particular location. Whether the classification is nondiscriminatory turns on how the plan’s ratio percentage compares against a safe harbor and unsafe harbor that shift with the NHCE concentration of the workforce. Above the safe harbor, the plan passes automatically; below the unsafe harbor, it fails; in between, the IRS applies facts and circumstances.⁸

Second, the average benefit percentage test. The average benefit percentage for NHCEs must be at least 70% of the average benefit percentage for HCEs.⁹ To calculate it, take each employee’s employer-provided contributions or benefit accruals as a share of compensation, then average those percentages separately for HCEs and NHCEs. Every nonexcludable employee is included, even those who don’t participate in any plan.¹

Combining Plans to Pass

Employers with more than one plan can sometimes aggregate them and test as a single unit. This helps when one plan skews HCE and another skews NHCE. Together they may pass the ratio percentage test where neither would alone. Aggregated plans must share the same plan year.¹⁰

The other direction is mandatory. The 401(k) elective deferral portion of a plan is tested separately from the 401(m) matching and after-tax portion, and collectively bargained employees are split off from non-union employees for their own test. Mandatory disaggregation overrides any voluntary aggregation.

Fixing a Failed Test

Because testing is done after the plan year closes, failures always come to light in hindsight. The standard fix is a retroactive plan amendment that expands the group of NHCEs treated as benefiting for the failed year. In practice, the employer makes corrective contributions to those NHCEs, often Qualified Nonelective Contributions, which must be fully vested when made and carry the same distribution restrictions as elective deferrals.

The deadline for the corrective amendment is generally the 15th day of the 10th month after the plan year ends — nine and a half months out. A calendar-year plan that fails 410(b) for 2025 needs the amendment in place by October 15, 2026. The corrective increase in benefits must independently pass nondiscrimination, which is automatic if only NHCEs receive it.

Here’s a critical wrinkle: 410(b) failures are demographic failures, not operational ones, so the IRS self-correction program is not available. Miss the retroactive amendment window and you’re left with the Voluntary Correction Program, which requires a formal application and a user fee. For submissions on or after January 1, 2026, VCP fees are based on total net plan assets:¹¹

$0 to $500,000 in assets: $2,000
$500,001 to $10,000,000: $3,500
Over $10,000,000: $4,000

The IRS can impose a higher sanction for failures it considers egregious or intentional. If the failure surfaces during an audit rather than through voluntary disclosure, the employer enters the Audit Closing Agreement Program, where penalties are steeper and negotiated case by case.¹²

What Disqualification Costs

Let a coverage failure ride and the plan loses qualified status, with tax consequences hitting from three directions.

HCEs must include their entire vested account balance (to the extent not already taxed) in gross income for the year of disqualification.¹³ That can produce a very large single-year tax bill. NHCEs generally aren’t hit immediately; their benefits are taxed under the nonexempt trust rules, typically at distribution.

The employer can’t deduct contributions to a disqualified plan until the amounts are includible in the employees’ income.¹³ For a defined benefit plan without separate participant accounts, the deduction can be lost entirely. On top of that, the trust loses its own tax-exempt status, so investment earnings become currently taxable inside the trust. Between the HCE income inclusion, the lost employer deduction, and the trust-level tax, plan disqualification is one of the most expensive compliance failures in employee benefits. Even the top-tier VCP fee looks cheap next to it.

1
Office of the Law Revision Counsel. 26 USC 410 – Minimum Participation Standards
2
eCFR. 26 CFR 1.410(b)-6 – Excludable Employees
3
Office of the Law Revision Counsel. 26 USC 414 – Definitions and Special Rules
4
Internal Revenue Service. Identifying Highly Compensated Employees in an Initial or Short Plan Year
5
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs
6
GovInfo. 26 CFR 1.410(b)-3 – Employees and Former Employees Who Benefit Under a Plan
7
GovInfo. 26 CFR 1.410(b)-2 – Minimum Coverage Requirements
8
GovInfo. 26 CFR 1.410(b)-4 – Nondiscriminatory Classification Test
9
eCFR. 26 CFR 1.410(b)-5 – Average Benefit Percentage Test
10
eCFR. 26 CFR 1.410(b)-7 – Definition of Plan and Rules Governing Plan Disaggregation and Aggregation
11
Internal Revenue Service. Voluntary Correction Program (VCP) Fees
12
Internal Revenue Service. Timing of Retirement Plan Self-Correction
13
Internal Revenue Service. Tax Consequences of Plan Disqualification