Is Non-Discrimination Testing Required for Your Plan?

If your organization sponsors a 401(k), a cafeteria plan, a self-funded health plan, a dependent care assistance program, or group-term life insurance, non-discrimination testing requirements almost certainly apply to you every year. The IRS uses these tests to confirm that tax-advantaged benefits don’t flow disproportionately to the highest earners. Skip the testing, or fail it and don’t correct the problem in time, and the plan can lose its tax-favored status entirely.

Which specific tests you owe depends on the plan type. The short list:

Traditional 401(k) plans: ADP, ACP, and top-heavy tests.
403(b) plans: universal availability for deferrals; ACP if there’s an employer match.
Section 125 cafeteria plans: eligibility, contributions and benefits, and key employee concentration tests.
Self-funded health plans: Section 105(h) eligibility and benefits tests.
Dependent care assistance programs: Section 129 eligibility, benefits, ownership concentration, and the 55% average benefits test.
Group-term life insurance: Section 79 eligibility and benefits tests.

Fully insured group health plans sit outside this list for now. The Affordable Care Act added similar non-discrimination rules under Section 2716, but the IRS has indefinitely delayed enforcement pending further guidance, so fully insured plans currently face no penalty for non-compliance. That could change if final regulations are issued.

Who Counts as a Highly Compensated Employee

Every test compares what highly compensated employees (HCEs) get against what everyone else gets, so the definition matters. You’re an HCE if either of two things is true:

You owned more than 5% of the business at any point during the current or prior year, regardless of pay.¹
You earned more than a set dollar threshold in the preceding year. For plan years beginning in 2026, the threshold is $160,000 in 2025 compensation.²

Employers may elect to narrow the HCE group to the top 20% by pay. Everyone who isn’t an HCE is a non-highly compensated employee (NHCE). A separate category, “key employees,” governs top-heavy and some welfare plan tests: officers earning above a set compensation level, 5% owners, and 1% owners earning over $150,000.

Retirement Plan Tests

401(k) Plans

Traditional 401(k) plans face three potential tests. The Actual Deferral Percentage (ADP) test compares the average percentage of pay that HCEs defer against the NHCE average. The Actual Contribution Percentage (ACP) test runs the same comparison for employer matching contributions and after-tax employee contributions. Both tests impose a mathematical ceiling on how far the HCE average can exceed the NHCE average, and HCEs tend to save at higher rates, which is where most plans run into trouble.

A 401(k) is also top-heavy when more than 60% of its total assets belong to key employees. A top-heavy plan generally must make a minimum employer contribution for all non-key employees.

403(b) Plans

Plans offered by nonprofits and public schools under Section 403(b) get a partial pass. They’re generally exempt from the ADP test and from top-heavy rules for elective deferrals. If the plan includes employer matching contributions, those matches must still pass the ACP test.³

In place of ADP testing, 403(b) plans must satisfy a universal availability requirement: every eligible employee must have the opportunity to make elective deferrals. Participation can’t be limited to certain departments or job classifications.

Health and Welfare Plan Tests

Section 125 Cafeteria Plans

Cafeteria plans that let employees choose between taxable cash and pre-tax benefits must pass an eligibility test (are enough rank-and-file employees eligible?), a contributions and benefits test (do HCEs get a disproportionate share?), and a key employee concentration test (do key employees receive more than 25% of total plan benefits?). If the plan fails, HCEs lose pre-tax treatment and must include the value of their benefits in taxable income.

Self-Funded Health Plans

Self-insured medical reimbursement plans are tested under IRC Section 105(h). The eligibility test checks whether a broad enough group of employees can participate. The benefits test checks whether the same benefits available to HCEs are available to other participants.⁴ When a plan fails either test, HCEs must include in taxable income the amount of discriminatory benefits they received. The plan itself keeps its tax status; the HCE tax break is what disappears.

Dependent Care Assistance Programs

A dependent care assistance program (DCAP) that lets employees set aside pre-tax dollars for childcare or eldercare must pass testing under IRC Section 129. That includes an eligibility test, a contributions and benefits test, and an ownership concentration test capping benefits going to more-than-5% owners at 25% of the total.⁵

DCAPs also face a 55% average benefits test: the average benefit provided to NHCEs across all of the employer’s dependent care plans must equal at least 55% of the average benefit provided to HCEs.⁵ Failure means HCEs lose the exclusion and their dependent care benefits become taxable income.

Group-Term Life Insurance

Employer-provided group-term life insurance up to $50,000 in coverage is normally tax-free. Section 79 requires that the plan pass both an eligibility test and a benefits test, or key employees lose the exclusion.⁶

The eligibility test offers several paths: cover at least 70% of all employees, keep at least 85% of participants as non-key employees, or use a classification the IRS doesn’t consider discriminatory. The benefits test requires that any coverage available to key employees also be available to everyone else. A plan won’t fail just because coverage amounts are tied to salary, since that creates a uniform relationship to compensation.⁶

Plans That Don’t Need Annual Testing

Safe Harbor 401(k) Plans

The most common way employers avoid annual ADP and ACP testing is to adopt a safe harbor 401(k). These plans automatically satisfy both tests by committing to a specific minimum employer contribution. The typical options are a dollar-for-dollar match on the first 3% of pay deferred plus 50 cents on the dollar for the next 2%, or a flat 3% non-elective contribution to all eligible employees regardless of whether they defer.⁷

A full safe harbor plan also satisfies top-heavy minimum contribution requirements. The tradeoff is cost: the employer must contribute for all eligible employees, and those contributions vest immediately (or on a two-year cliff schedule under a qualified automatic contribution arrangement). For many small and mid-sized employers, that guaranteed cost is cheaper than the risk of failed testing and corrective distributions.

Government and Church Plans

Government-sponsored plans are broadly exempt from ERISA and from most non-discrimination testing under the Internal Revenue Code. A 403(b) plan run by a public school or government entity only needs to meet the universal availability requirement for elective deferrals.

Church plans go further. Plans sponsored by churches or qualified church-controlled organizations aren’t subject to ERISA unless the church affirmatively elects coverage.⁸ A 403(b) plan of a “steeple” church or qualified church-controlled organization is not subject to any non-discrimination testing at all.

No Small Employer Exemption

There is no blanket exemption based on headcount. A 401(k) with 10 participants faces the same testing obligations as one with 10,000. Small employers often find safe harbor designs especially attractive because the cost of correcting a failed test on a small plan can be disproportionately painful compared to just making the safe harbor contribution from the start.

What a Failed Test Costs

For a 401(k) that fails ADP or ACP, the employer generally has 12 months after the close of the plan year to distribute or recharacterize excess contributions to HCEs. Miss that window and the cash or deferred arrangement can lose its qualified status entirely, which would be a tax disaster for every participant.⁹

Even inside the 12-month window, timing matters. If the employer doesn’t distribute or recharacterize excess contributions within 2½ months after the plan year ends (6 months for plans with an eligible automatic contribution arrangement), the employer owes a 10% excise tax on the excess.⁹

HCEs who receive corrective distributions pay tax on them in the year distributed, reported on Form 1099-R. Those distributions can’t be rolled over into an IRA or another retirement plan.⁹ Any employer matching contributions tied to the excess deferrals are forfeited back to the plan.

For cafeteria plans, DCAPs, and group-term life insurance, the penalty structure differs but the theme is the same: HCEs or key employees lose their tax-favored treatment, and the value of their benefits becomes taxable income.

How to Fix a Failed 401(k) Test

There are two main correction paths. The first is distributing excess contributions back to HCEs, which lowers the HCE percentage until the test passes. This is the most common approach, though HCEs understandably dislike getting money kicked out of their retirement accounts.

The second is making qualified non-elective contributions (QNECs) for NHCEs. The employer contributes the same percentage of compensation to all eligible NHCEs, raising the NHCE average enough to pass. If these corrective contributions are made within 12 months after the plan year ends, the 10% excise tax doesn’t apply.⁹

If the correction deadline passes without action, the employer can still fix the problem through the IRS Voluntary Correction Program by filing an application, paying a user fee, and proposing a correction method. It’s more expensive than correcting on time, but it beats disqualification. If the IRS discovers the failure during an audit before any self-correction, the employer may need to negotiate a closing agreement under the Audit Closing Agreement Program, which carries steeper sanctions based on the facts.⁹

Testing Deadlines

Testing must be completed within 12 months after the end of the plan year. For a calendar-year plan, that outer deadline is December 31 of the following year. But the corrective distribution clock runs much faster: the 2½-month excise tax deadline for a calendar-year plan falls on March 15. Most plan administrators aim to complete testing by late February or early March so there is time to process corrections before that excise tax triggers.

1
eCFR. 26 CFR 1.414(q)-1T – Highly Compensated Employee (Temporary)
2
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs (Notice 2025-67)
3
eCFR. 26 CFR 1.403 – Tax-Sheltered Annuity Regulations
4
Internal Revenue Service. Technical Assistance Request – Section 105(h)
5
Office of the Law Revision Counsel. 26 USC 129 – Dependent Care Assistance Programs
6
Office of the Law Revision Counsel. 26 USC 79 – Group-Term Life Insurance Purchased for Employees
7
Internal Revenue Service. Notice Requirement for a Safe Harbor 401(k) or 401(m) Plan
8
Internal Revenue Service. Issue Snapshot – Church Plans, Automatic Contribution Arrangements, and the Consolidated Appropriations Act, 2016
9
Internal Revenue Service. 401(k) Plan Fix-it Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests