IRS Testing for 401(k) Plans: ADP, ACP, Coverage, and Top-Heavy

A traditional 401(k) plan has to clear a set of annual IRS checks known as 401(k) nondiscrimination testing: the ADP test on employee deferrals, the ACP test on employer matching and after-tax contributions, a coverage test, and a top-heavy test. Each one compares what owners and highly paid employees get out of the plan against what everyone else gets. Fail, and the plan sponsor faces corrective distributions, excise taxes, or in the worst case, loss of the plan’s tax-qualified status altogether.¹

Who the Tests Sort Employees Into

Every test starts by sorting employees into groups. The main dividing line is between Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). You’re an HCE if you owned more than 5% of the company at any point during the current or preceding plan year, regardless of pay.² You’re also an HCE if your compensation in the preceding year exceeded an indexed threshold. For the 2026 plan year, that means earning more than $160,000 in 2025.³

The 5% ownership rule reaches further than most owners expect. Under constructive ownership, stock held by your spouse, children, grandchildren, and parents is treated as if you held it yourself.⁴ An owner’s adult child who works at the company and personally owns nothing can still be classified as an HCE because of a parent’s shares. This catches family businesses more than any other rule.

Employers have one optional tool to narrow the HCE group: they can elect to count only the top 20% of employees ranked by pay when applying the compensation threshold.² For a company where many mid-level employees cross the $160,000 line, this election can meaningfully shrink the HCE group and improve test results.

Key Employees are a separate category that matters only for the Top-Heavy Test. You’re a Key Employee if you’re an officer earning more than $235,000 in 2026, a more-than-5% owner, or a more-than-1% owner earning over $150,000.⁵ The officer threshold is adjusted for inflation each year; the $235,000 figure for 2026 is up from $230,000 in 2025.⁶

The ADP Test on Employee Deferrals

The Actual Deferral Percentage (ADP) test is the central nondiscrimination check on salary deferrals. Each eligible employee’s deferral percentage equals their elective deferrals divided by their compensation. Those individual percentages are averaged separately for the HCE group and the NHCE group. Employees who chose not to defer count as 0%, which pulls the NHCE average down.¹

The plan passes if the HCE average clears the more generous of two alternative limits:¹

Under the 125% test, the HCE average cannot exceed 125% of the NHCE average.
Under the 2%/200% test, the HCE average cannot exceed the NHCE average plus 2 percentage points, and it also cannot exceed 200% of the NHCE average. Both caps apply, so the binding limit is whichever is lower.

Catch-up contributions by employees aged 50 and older are excluded from the ADP calculation entirely.¹ That includes the standard $8,000 catch-up for 2026 and the enhanced $11,250 catch-up for participants ages 60 through 63 introduced by SECURE 2.0.⁷ Both pre-tax and Roth deferrals count toward the test; catch-up amounts sit outside it.

The ACP Test on Matching and After-Tax Contributions

The Actual Contribution Percentage (ACP) test applies the same math to employer matching contributions and any employee after-tax contributions. Each participant’s matching and after-tax amounts are divided by their compensation, then averaged within the HCE and NHCE groups. The same two-limit structure applies: the HCE average must not exceed the greater of 125% of the NHCE average or the NHCE average plus 2 percentage points, with that figure capped at 200% of the NHCE average.¹

Because the ACP test captures employer matching, the matching formula itself can cause a failure. A common scenario: the company offers a generous match, but lower-paid employees don’t defer enough to earn it. The NHCE contribution percentage stays low, which tightens the cap on HCEs. An overly complex or back-loaded formula can make this worse. Plans that consistently fail the ACP test often find the root cause is low participation among rank-and-file workers rather than anything the HCEs are doing.

The Coverage Test

The IRS also requires that a plan cover a broad enough slice of the workforce. The most straightforward way to satisfy this is the Ratio Percentage Test. It passes if the percentage of eligible NHCEs who participate is at least 70% of the percentage of eligible HCEs who participate.⁸ If every HCE is in the plan, at least 70% of eligible NHCEs must be in it too.

When a plan can’t clear the Ratio Percentage Test, it can fall back on the Average Benefit Percentage Test. This more complex calculation looks at the value of all contributions and benefits NHCEs receive and compares it to what HCEs receive. The NHCE average benefit must be at least 70% of the HCE average benefit.

The Top-Heavy Test

The Top-Heavy Test measures whether plan assets have become too concentrated among Key Employees. A plan is top-heavy when Key Employee account balances exceed 60% of total plan assets as of the last day of the prior plan year.⁹ This test catches small-company plans especially hard. When the business has only a handful of employees and the owner has been saving for decades, the owner’s balance can easily dwarf everyone else’s.

A top-heavy determination triggers two obligations. First, the employer must make a minimum contribution for all non-key employees who were employed on the last day of the plan year. That minimum is 3% of each non-key employee’s compensation, unless the highest contribution rate for any Key Employee was less than 3%, in which case non-key employees receive that lower rate instead.⁹

Second, the plan must use an accelerated vesting schedule for employer contributions. Top-heavy plans must offer either full vesting after three years of service, or a six-year graded schedule that starts at 20% after two years and increases by 20% each year until reaching 100% at six years.¹⁰ The faster vesting applies to all employer contributions in the plan, even amounts that accrued before the plan became top-heavy.

Fixing a Failed Test

A failed ADP or ACP test doesn’t automatically disqualify a plan, but it starts a clock on mandatory corrections. Plan sponsors have two basic strategies: reduce what HCEs received, or increase what NHCEs received.

Distributing Excess Contributions to HCEs

The most common fix is returning excess contributions to HCEs. The plan calculates how much the HCE group deferred (or received in matching) beyond the allowable limit, then distributes those amounts plus investment earnings back to the affected HCEs. To avoid a 10% excise tax, these corrective distributions must go out within two and a half months after the close of the plan year. For a calendar-year plan, that deadline is March 15.¹ Plans that use an Eligible Automatic Contribution Arrangement (EACA) covering all eligible employees get a longer six-month window.

Missing the excise-tax deadline doesn’t end the correction opportunity, but it makes it expensive. The employer must file Form 5330 and pay the 10% excise tax on the uncorrected amounts. The hard deadline is 12 months after the plan year closes. If corrections aren’t completed by then, the plan’s salary deferral arrangement is no longer qualified, and the entire plan risks losing its tax-exempt status.¹

Adding Employer Contributions for NHCEs

Instead of pulling money back from HCEs, the employer can put more money in for NHCEs through Qualified Nonelective Contributions (QNECs) or Qualified Matching Contributions (QMACs). QNECs are employer-funded contributions that must be fully vested when allocated and are subject to the same withdrawal restrictions as salary deferrals.¹¹ Adding these contributions raises the NHCE average, which lifts the ceiling for HCEs and allows the plan to pass retroactively.

The QNEC/QMAC route costs the employer real dollars, but it avoids tracking down excess contributions, recalculating earnings, and processing distributions. It also avoids telling highly paid employees that part of their retirement savings is being returned. For plans that fail by small margins year after year, building a modest QNEC into the annual budget can be a practical answer.

Skipping the Tests With a Safe Harbor Plan

A safe harbor 401(k) plan skips the ADP test entirely, and in most cases the ACP test as well, by committing upfront to a minimum level of employer contributions. The trade-off is simple: guaranteed employer dollars for all employees in exchange for freedom from annual testing.

Traditional Safe Harbor

The traditional safe harbor offers two contribution formulas. The matching option requires a dollar-for-dollar match on the first 3% of compensation an employee defers, plus a 50-cent-on-the-dollar match on the next 2%, producing a maximum employer match of 4% of pay. The nonelective option requires the employer to contribute at least 3% of each eligible employee’s compensation regardless of whether that employee defers anything at all.¹² Under both formulas, employer contributions must be 100% vested immediately.

QACA Safe Harbor

A Qualified Automatic Contribution Arrangement (QACA) combines safe harbor status with automatic enrollment. The employer must either match 100% of the first 1% of pay deferred plus 50% of the next 5%, or make a 3% nonelective contribution for all participants.¹³ Unlike the traditional safe harbor, QACA employer contributions don’t need to be immediately vested; the plan can use a two-year cliff vesting schedule instead.

Notice and Mid-Year Adoption

Safe harbor plans require an annual written notice to each eligible employee. The notice must go out at least 30 days but no more than 90 days before the start of each plan year.¹⁴ It must explain the matching or nonelective formula, how to make deferral elections, vesting and withdrawal rules, and how to get more information about the plan.

An employer that didn’t start the year as a safe harbor plan can still adopt safe harbor status mid-year by amending the plan to include a nonelective contribution of at least 3% at least 30 days before the plan year ends. If the employer bumps the nonelective contribution to 4%, the amendment can be adopted any time before the end of the following plan year.¹⁵ This gives plan sponsors a late-year escape hatch when test projections look bad.

If a Plan Loses Qualified Status

Disqualification is the nuclear option, and the IRS doesn’t impose it lightly, but the stakes clarify why timely correction matters. Once a plan is disqualified, the consequences hit everyone involved.

For employees, the damage depends on classification. NHCEs must include in income any employer contributions made during the disqualified years, but only to the extent they’re vested in those amounts. HCEs face a harsher outcome: if the disqualification stems from a coverage or participation failure, an HCE must include the entire vested account balance that hasn’t already been taxed in income for that year.¹⁶ Distributions from a disqualified plan cannot be rolled over to an IRA or another retirement plan, so participants lose the ability to defer that tax hit.

For the employer, the plan trust loses its tax-exempt status and must begin filing income tax returns and paying tax on investment earnings. The employer’s deduction for contributions is delayed until the amounts are included in employees’ income, and the contributions become subject to FICA and FUTA taxes at the time of contribution or vesting.¹⁶

Fixing Errors Through EPCRS

The IRS maintains the Employee Plans Compliance Resolution System (EPCRS) to give plan sponsors a path to fix problems without losing qualified status. The system has three tiers:¹⁷

The Self-Correction Program (SCP) allows correction of certain failures without contacting the IRS or paying a fee. It is generally available for operational errors caught and fixed promptly.
The Voluntary Correction Program (VCP) requires the plan sponsor to apply to the IRS before any audit, pay a user fee, and receive written approval of the correction. User fees for 2026 range from $2,000 for plans with up to $500,000 in assets to $4,000 for plans over $10 million.¹⁸
The Audit Closing Agreement Program (Audit CAP) is available when errors are discovered during an IRS audit. The plan sponsor pays a negotiated sanction that is typically larger than a VCP fee.

VCP matters directly for nondiscrimination failures. If a plan sponsor discovers a testing error from a prior year that wasn’t corrected within the normal 12-month window, VCP may be the only way to preserve the plan’s qualified status. The fees are modest relative to the tax consequences of disqualification, so early voluntary correction is almost always the right financial decision.

1
Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
2
Internal Revenue Service. Retirement Plans Definitions
3
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
4
Office of the Law Revision Counsel. 26 U.S. Code 318 – Constructive Ownership of Stock
5
Office of the Law Revision Counsel. 26 USC 416 – Special Rules for Top-Heavy Plans
6
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs, as Adjusted
7
Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500
8
Internal Revenue Service. EPCRS Handbook Chapter 7 – 401(k) Determination Issues
9
Internal Revenue Service. Is My 401(k) Top-Heavy?
10
Internal Revenue Service. Top-Heavy Plans – Employee Plans Issue Resource Guide
11
Internal Revenue Service. Issue Snapshot – Plan Forfeitures Used for Qualified Nonelective and Qualified Matching Contributions
12
eCFR. 26 CFR 1.401(k)-3 – Safe Harbor Requirements
13
Internal Revenue Service. FAQs – Auto Enrollment – Are There Different Types of Automatic Contribution Arrangements for Retirement Plans
14
Internal Revenue Service. Notice Requirement for a Safe Harbor 401(k) or 401(m) Plan
15
Internal Revenue Service. Mid-Year Changes to Safe Harbor 401(k) Plans and Notices
16
Internal Revenue Service. Tax Consequences of Plan Disqualification
17
Internal Revenue Service. EPCRS Overview
18
Internal Revenue Service. Voluntary Correction Program (VCP) Fees