Nondiscrimination Testing for Qualified Retirement Plans

Nondiscrimination testing for qualified retirement plans is the annual set of federal checks that proves a 401(k) or similar plan doesn’t disproportionately benefit owners and top earners. The main tests are coverage under Section 410(b), the ADP and ACP tests on deferrals and matching contributions, the top-heavy test under Section 416, and the broader 401(a)(4) rule on contributions and benefits. Failing any of them can force corrective refunds, extra employer contributions, or, at worst, loss of the plan’s tax-qualified status.

Who Counts as a Highly Compensated Employee

Every test begins by sorting the workforce into highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). Under Internal Revenue Code Section 414(q), you are an HCE if you owned more than 5 percent of the business at any point in the current or preceding year, or if your prior-year compensation exceeded the indexed threshold, which is $160,000 for the 2026 plan year.¹² Everyone else is an NHCE.

Only the first $360,000 of any individual’s pay counts for 2026 plan purposes, no matter how much the person actually earns.¹

One boundary worth flagging: you cannot split employees across separate legal entities to avoid testing. When a parent owns at least 80 percent of a subsidiary, or five or fewer people control two or more companies (a brother-sister group), the IRS treats the combined workforce as one employer. Professional service firms with shared ownership and service ties can also be pulled together as an affiliated service group under Section 414(m).³

The Coverage Gate Under Section 410(b)

Before a plan looks at contribution rates, it has to show it covers enough of the workforce. Section 410(b) offers two ways to pass.

The ratio percentage test is the usual route. The percentage of NHCEs who benefit under the plan must be at least 70 percent of the percentage of HCEs who benefit.⁴ If 100 percent of HCEs participate, at least 70 percent of NHCEs must participate too.

Plans that miss can fall back on the average benefit test. The covered group must qualify as a reasonable, nondiscriminatory classification, and the average benefit percentage for NHCEs across all the employer’s plans must be at least 70 percent of the average benefit percentage for HCEs.⁵ This second test looks only at employer-provided contributions or benefits; employee deferrals do not count.

The ADP and ACP Tests

The actual deferral percentage (ADP) test compares the average deferral rate of HCEs against the average deferral rate of NHCEs. The HCE average passes if it satisfies whichever of these two limits is more favorable:

The HCE average is no more than 1.25 times the NHCE average, or
The HCE average is no more than 2 percentage points above the NHCE average and no more than twice the NHCE average.

If NHCEs defer an average of 4 percent, the first limit caps HCEs at 5 percent while the second caps them at 6 percent, and the plan uses the 6 percent cap.⁶

The actual contribution percentage (ACP) test uses the same math but on employer matching contributions and any voluntary after-tax employee contributions. A plan can pass ADP and still fail ACP, or vice versa, so both must be run every year.⁶

The plans that struggle most are those where NHCE participation is low. When the NHCE average sits at 2 percent, HCEs are capped at 4 percent under either formula, which frustrates owners who want to defer more.

The Top-Heavy Test

Section 416 asks a different question: where has the money in the plan accumulated? A plan is top-heavy when more than 60 percent of total account balances belong to key employees.⁷

Key employees are a narrower group than HCEs. You are a key employee for a plan year if any one of the following applies:

You are an officer of the employer with annual compensation over $235,000 for 2026.¹
You own more than 5 percent of the business.
You own more than 1 percent and earn over $150,000.⁷

A top-heavy defined contribution plan must make a minimum contribution for every non-key participant, generally 3 percent of that person’s compensation. If no key employee received a contribution rate above 2 percent, the required minimum drops to that lower rate.⁷

Small employers get caught here most often. When only a few employees participate and the owner has been maxing out for years, the owner’s balance can easily push the plan past 60 percent.

The General 401(a)(4) Requirement

On top of the specific tests, every qualified plan must show that contributions or benefits, viewed as a whole, do not discriminate in favor of HCEs.⁸ A plan needs to prove either its contributions or its benefits are nondiscriminatory in amount, not both.

Traditional 401(k) plans with a uniform allocation formula usually pass without difficulty, and many safe harbor designs are deemed to satisfy this rule automatically. It matters most for plans with tiered employer contributions, Social Security integration, or cross-tested profit-sharing formulas where different employee groups receive different rates.

Safe Harbor Plans and Skipping ADP/ACP

An employer can bypass the ADP and ACP tests by adopting a safe harbor design under Section 401(k)(12). The price is a required employer contribution that vests immediately. Two standard formulas qualify:

A safe harbor match of 100 percent of each NHCE’s deferrals up to 3 percent of compensation, plus 50 percent of deferrals from 3 to 5 percent. Alternative match formulas work if they are at least as generous overall and the match rate does not rise as an employee defers more.⁹
A safe harbor nonelective contribution of at least 3 percent of compensation for every eligible NHCE, whether or not the employee defers anything.⁹

Both require full and immediate vesting and an annual participant notice before the plan year begins. Safe harbor status exempts a plan from ADP and ACP testing but does not automatically exempt it from top-heavy rules; a safe harbor plan can still be top-heavy, though its safe harbor contributions may satisfy the minimum required for non-key employees. Coverage testing under Section 410(b) applies regardless.

Correcting a Failed Test

When ADP or ACP fails, the calendar matters as much as the correction method.

Corrective Distributions

The most common fix is to refund excess contributions, along with allocable earnings, to the HCEs whose deferrals or contributions caused the failure. Refunds must go out within two and a half months after the plan year ends to avoid a 10 percent excise tax on the excess. For a calendar-year plan that means March 15 of the following year, or March 16 when the 15th falls on a weekend. Plans with an eligible automatic contribution arrangement get a six-month window instead.¹⁰

Even if the employer misses that deadline and owes the excise tax, the correction still has to be completed by the end of the following plan year. Otherwise the failure becomes an operational defect that threatens the plan’s qualified status.

Qualified Nonelective Contributions

Rather than take money back from HCEs, the employer can lift the NHCE average by depositing qualified nonelective contributions (QNECs) into NHCE accounts. QNECs vest immediately and are subject to the same withdrawal restrictions as regular plan assets. When NHCE participation is thin, this route can be expensive because the employer is funding accounts for workers who aren’t contributing on their own.

Self-Correction Under EPCRS

The IRS Employee Plans Compliance Resolution System (EPCRS) allows self-correction of failed ADP and ACP tests. If the plan had reasonable compliance procedures and the failure is insignificant, the employer can self-correct without filing with the IRS or paying a fee.¹¹ Correction methods include making QNECs to NHCEs or using a one-to-one approach, where amounts distributed from HCEs are matched by equivalent contributions allocated to NHCEs. For significant failures, self-correction must be completed by the end of the third plan year following the year that includes the last day of the normal correction period.¹²

What Losing Qualified Status Costs

Disqualification hits everyone connected to the plan. The employer loses its deduction for contributions. Employees face immediate income tax on their vested account balances, even without a withdrawal. The plan’s trust loses tax-exempt status, so investment earnings inside the trust become taxable.

The IRS prefers correction to disqualification, which is why EPCRS exists, but the programs only help employers who identify problems and act. Plans that skip testing for years or ignore known failures are the ones that end up disqualified. Professional testing typically costs a few hundred to a few thousand dollars a year depending on plan complexity, which is small next to the tax fallout of losing qualified status.⁶

1
Internal Revenue Service. Notice 2025-67 – 2026 Amounts Relating to Retirement Plans and IRAs
2
eCFR. 26 CFR 1.414(q)-1 – Highly Compensated Employee
3
Internal Revenue Service. Controlled and Affiliated Service Groups
4
Office of the Law Revision Counsel. 26 USC 410 – Minimum Coverage Requirements
5
eCFR. 26 CFR 1.410(b)-5 – Average Benefit Percentage Test
6
Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
7
Office of the Law Revision Counsel. 26 USC 416 – Special Rules for Top-Heavy Plans
8
eCFR. 26 CFR 1.401(a)(4)-1 – Nondiscrimination Requirements of Section 401(a)(4)
9
Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
10
Office of the Law Revision Counsel. 26 USC 4979 – Tax on Certain Excess Contributions
11
Internal Revenue Service. The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
12
Internal Revenue Service. Revenue Procedure 2021-30