Section 410(b) Nondiscriminatory Classification Test: Prongs and Fixes

The Section 410(b) nondiscriminatory classification test is the fallback path a retirement plan uses to prove it covers a broad enough slice of the workforce when it cannot pass the simpler 70% ratio percentage test. It is the first of two prongs inside the “average benefit test,” and a plan has to clear both prongs (plus a threshold reasonableness check) to keep its qualified status. Passing the classification test means the group of employees eligible for the plan was chosen using an objective business standard and that the plan’s coverage ratio lands at or above a safe harbor percentage that shifts with the makeup of the workforce.

Where the Classification Test Fits

Section 410(b) gives employers three ways to satisfy the minimum coverage requirement. The first is the ratio percentage test: the percentage of non-highly compensated employees (NHCEs) benefiting under the plan must be at least 70% of the percentage of highly compensated employees (HCEs) benefiting. Most plans pass here and stop.

When a plan cannot meet the 70% ratio, it turns to the average benefit test. That test has two independent requirements, and both must be satisfied. The first is the nondiscriminatory classification test. The second is the average benefit percentage test, which compares actual benefit rates between NHCEs and HCEs across all of the employer’s plans. A third option exists for plans that benefit zero HCEs, but that scenario is uncommon.

So the classification test never stands alone. Passing it is necessary but not sufficient.

Sorting Employees Before You Test

Every number in the calculation depends on correctly sorting the workforce into HCEs, NHCEs, and employees the plan is allowed to ignore.

Who Is a Highly Compensated Employee

Under IRC Section 414(q), an employee is highly compensated if either of two conditions applies:

  • The employee owned more than 5% of the business at any time during the current or preceding year, regardless of pay. This uses the 5% owner definition in IRC Section 416(i)(1).1Office of the Law Revision Counsel. 26 U.S. Code 414 – Definitions and Special Rules
  • The employee earned more than $160,000 from the employer during the preceding year. Employers may optionally narrow this further to those who also ranked in the top 20% by pay.

The $160,000 threshold applies for 2026 plan years, based on preceding-year compensation.2Internal Revenue Service. Notice 2025-67 Everyone who does not meet either definition is an NHCE.

The “employer” for this purpose is not always the plan sponsor. Under IRC Sections 414(b), (c), (m), and (o), all employees of companies in a controlled group, affiliated service group, or other related-employer arrangement are treated as working for a single employer.3Internal Revenue Service. Controlled and Affiliated Service Groups A parent company that runs a plan for headquarters staff still has to count subsidiary employees when calculating its coverage ratio and concentration percentage.

Employees the Plan Can Strip Out

Before running any coverage math, the sponsor removes “excludable employees” from both sides of the equation so they do not skew the results. The regulation at 26 CFR § 1.410(b)-6 lists the categories:

  • Employees who have not reached age 21 or completed a year of service (typically 1,000 hours in 12 months), if the plan document imposes those entry conditions.
  • Employees covered by a collective bargaining agreement where retirement benefits were the subject of good-faith negotiation, when testing a non-union plan (and vice versa).
  • Nonresident aliens with no U.S.-source earned income from the employer.
  • Employees of a qualifying separate line of business under IRC Section 414(r), when testing a plan that covers a different line.
  • Terminated employees who did not benefit for the year solely because they failed a last-day-of-year or minimum-service requirement in the plan.

Each exclusion has to be supported by the plan document and applied consistently.4eCFR. 26 CFR 1.410(b)-6 – Excludable Employees Miscounting these categories is one of the most common testing errors, because adding a handful of employees to the wrong side of the ratio can flip a passing result into a failure.

Reasonable Classification: The First Prong

The classification test asks first whether the group of employees eligible for the plan was chosen using a reasonable, objective business standard. Under 26 CFR § 1.410(b)-4(b), the classification must be based on identifiable business criteria, not a hand-picked list of names.

IRS guidance identifies job categories, salaried versus hourly pay status, and geographic work-site location as acceptable classification criteria.5Internal Revenue Service. Chapter 10 Coverage and Nondiscrimination Other groupings work when they reflect genuine operational divisions. Covering all salaried employees at a Chicago office while excluding hourly warehouse workers at the same location draws on two recognized criteria. Listing 14 individuals by name and calling them “the management team” is not a reasonable classification, even if every listed person is a manager. Naming employees, or using criteria that effectively single out specific individuals, automatically fails this threshold.6eCFR. 26 CFR 1.410(b)-4 – Nondiscriminatory Classification Test

Consistency matters too. If an employer says it excludes “all hourly workers” but quietly includes the hourly workers who happen to be highly compensated, regulators will treat the classification as pretext. During an audit, the IRS will want to see that the classification was written into the plan document before the testing date, not reverse-engineered afterward.

Safe Harbor and Unsafe Harbor Percentages: The Second Prong

Once the classification passes the reasonableness check, the plan’s coverage ratio is measured against a regulatory table that slides with the workforce’s makeup. The NHCE concentration percentage is the number of NHCEs divided by the total number of non-excludable employees. The higher the concentration of lower-paid workers, the lower the coverage threshold the plan needs to hit.

Selected benchmarks from the table:

  • NHCE concentration 0–60%: safe harbor 50.00%; unsafe harbor 40.00%.
  • NHCE concentration 70%: safe harbor 42.50%; unsafe harbor 32.50%.
  • NHCE concentration 80%: safe harbor 35.00%; unsafe harbor 25.00%.
  • NHCE concentration 90%: safe harbor 27.50%; unsafe harbor 20.00%.
  • NHCE concentration 99%: safe harbor 20.75%; unsafe harbor 20.00%.

For each percentage point of NHCE concentration above 60%, both the safe harbor and unsafe harbor drop by 0.75 percentage points, except that the unsafe harbor floors at 20.00% once concentration reaches 87%.6eCFR. 26 CFR 1.410(b)-4 – Nondiscriminatory Classification Test

The plan’s coverage ratio (the percentage of NHCEs benefiting divided by the percentage of HCEs benefiting) is compared against the applicable thresholds. Three outcomes are possible:

  • At or above the safe harbor: the classification is automatically nondiscriminatory.
  • Below the unsafe harbor: the classification automatically fails, and no business justification can save it.
  • Between the safe and unsafe harbor: the plan enters a facts-and-circumstances review.

These figures should be recalculated every year. A round of layoffs that hits lower-paid workers changes the concentration percentage and shifts the applicable thresholds. An acquisition that brings in a large non-covered workforce can push a passing plan below the line.

The Facts and Circumstances Middle Zone

A plan whose ratio lands between the safe and unsafe harbor is evaluated qualitatively under 26 CFR § 1.410(b)-4(c)(3). No single factor decides the outcome; the IRS weighs several considerations together:

  • The strength of the business rationale behind the classification. The regulation states outright that reducing the employer’s cost of providing retirement benefits is not a relevant business reason.
  • The overall percentage of employees who benefit.
  • Whether coverage rates are distributed at roughly similar levels across salary ranges. A plan covering 90% of high earners but only 30% of the lowest-paid workers faces an uphill battle.
  • How close the ratio sits to the safe harbor. A ratio barely below the safe harbor needs far less justification than one hovering just above the unsafe harbor floor.
  • The extent to which the plan’s average benefit percentage under § 1.410(b)-5 exceeds the required 70%.

These factors come directly from the regulation.6eCFR. 26 CFR 1.410(b)-4 – Nondiscriminatory Classification Test Plans in the middle zone should document the business rationale before the plan year ends rather than assembling it during an audit. Written records showing why certain job categories were excluded, along with census data demonstrating broad coverage across pay levels, can decide a borderline case.

The Other Half: Average Benefit Percentage Test

Clearing the classification test is not enough on its own. The plan must also satisfy the average benefit percentage test under 26 CFR § 1.410(b)-5.7eCFR. 26 CFR 1.410(b)-5 – Average Benefit Percentage Test

The average benefit percentage is calculated by dividing the average actual benefit percentage of all NHCEs by the average actual benefit percentage of all HCEs. The result must be at least 70%. Each employee’s actual benefit percentage generally includes employer contributions, allocated forfeitures, and in some cases elective deferrals, expressed as a percentage of compensation. Unlike the classification test, this calculation looks across all qualified plans the employer maintains, not just the plan being tested.

A plan can cover a nondiscriminatory group on paper and still fail 410(b) here if benefit rates across the employer’s entire plan lineup tilt too heavily toward HCEs.

Aggregating Plans to Pass

Employers with more than one retirement plan can aggregate two or more plans and test them as a single plan. Under 26 CFR § 1.410(b)-7(d), this permissive aggregation is available for both the ratio percentage test and the classification test. A plan covering salaried employees that would fail on its own may pass when combined with a separate plan for hourly employees.8eCFR. 26 CFR 1.410(b)-7 – Definition of Plan and Rules Governing Plan

The catch is meaningful. Once aggregated for 410(b) purposes, the plans must also be treated as a single plan for nondiscrimination testing under Section 401(a)(4). Aggregation can solve a coverage problem while creating a benefits-level nondiscrimination problem. Plans can only be aggregated if they share the same plan year, ESOPs generally cannot be combined with other ESOPs, and an employer cannot mix Plan A with Plan B for one test and Plan A with Plan C for another.

Fixing a Failure After Year-End

If a plan fails 410(b) coverage for a plan year, the employer has a limited window to fix it retroactively. Under 26 CFR § 1.401(a)(4)-11, a corrective amendment can be adopted up to 9½ months after the close of the plan year (the 15th day of the 10th month). The amendment must be effective as of the first day of the plan year being corrected and cannot reduce any employee’s existing benefits.9eCFR. 26 CFR 1.401(a)(4)-11 – Additional Rules

The typical fix is expanding eligibility or increasing contributions for NHCEs so the coverage ratio clears the threshold. When the amendment is adopted after year-end, any additional allocations must independently satisfy Sections 401(a)(4) and 410(b), unless the employer is conforming the plan to one of the regulatory safe harbors.

Employers who miss the 9½-month deadline, or who discover the failure years later, can seek relief through the IRS Employee Plans Compliance Resolution System. Self-correction is available for certain operational failures if the plan has favorable determination letter coverage and the correction is made within a reasonable period. Larger or older failures typically require a submission under the Voluntary Correction Program, which involves an IRS filing and a compliance fee.

What Happens If the Plan Is Disqualified

The stakes for a persistent 410(b) failure are severe. When a plan loses its qualified status, three things happen at once.10Internal Revenue Service. Tax Consequences of Plan Disqualification

Employees must include employer contributions in gross income. For coverage-related disqualifications specifically, the impact falls hardest on HCEs, who must include the full value of their previously untaxed vested account balance in income, not just the contributions from the disqualified year. If the only reason for disqualification is a coverage failure, NHCEs do not have to include employer contributions from the disqualified years in income until those amounts are actually distributed.

The employer loses the deduction for its contributions in the year they were made. Instead, the deduction is deferred to the year the contribution becomes taxable income to the employee. If the plan does not maintain individual accounts for each participant, the employer may lose the deduction entirely.

The plan trust itself loses its tax-exempt status and must begin filing Form 1041 and paying income tax on investment earnings. For a plan with substantial assets, that tax drag compounds quickly, which is why sponsors treat 410(b) testing as an annual exercise rather than a one-time compliance check.