401(k) Nondiscrimination Tests: How to Stay Compliant

Does your company's 401(k) plan benefit all your employees equally, or does it favor owners and executives who make more money? That's what the 401(k) nondiscrimination tests try to assess each year.

What do you need to do to pass the tests? Well, our friends at the IRS have made that piece of the equation a little more complex, so let's take a closer look at what each nondiscrimination test measures, how to apply them, and what it means if your plan fails.

As you read this, remember it's possible to set up a Safe Harbor 401(k) plan, which automatically satisfies most nondiscrimination testing.¹

What are the nondiscrimination tests?

To give everyone an opportunity to save for the future, a 401(k) plan can't overly favor highly compensated employees (HCEs) or key employees (such as owners) over non-highly compensated employees (NHCEs) or non-key employees.

Nondiscrimination tests help make sure the operation of the 401(k) plan is fair by looking at:

• How many employees are eligible or benefit under the plan

• What percentage of their income employees defer

• How much the company contributes to employee accounts

• What percentage of assets in the plan belong to Key Employees

According to the IRS 401(k) Plan Overview: "[These tests] verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees."

There are several annual nondiscrimination tests a 401(k) sponsor must pass:

• The Coverage (410(b)) test

• The Actual Deferral Percentage (ADP) test

• The Actual Contribution Percentage (ACP) test

Generally, plans must also determine their Top-Heavy status and if they are Top-Heavy they may be required to make additional employer contributions to non-key employees to keep the plan's qualified status.

Ultimately, whether a plan passes discrimination testing is a combination of how many employees benefit from the plan, which employees participate by deferring income to their 401(k) accounts, how much they defer, and how much a company contributes each plan year.

Employee participation

Participation by employees in their employer's 401(k) plan is optional. However, one of the more successful ways for an employer to increase employee participation is by adding an automatic enrollment feature to the plan. In fact, research found that when small businesses offered automatic enrollment, 81% of employees participated. When automatic enrollment was offered to large-plan employees, 94% of large-plan employees participated.

If employees don't have the extra money to set aside, don't see the value in saving for their future, or don't know about their plan, they may not choose to participate. This lack of participation, coupled with high participation among HCEs and Key Employees, may make the plan more likely to fail a nondiscrimination test. It's up to the plan sponsor to offer a plan that includes features that encourage employee participation.

Employer contributions

How much a company contributes to its employees' 401(k) savings can also have a big impact on whether the plan will pass nondiscrimination testing. We'll get into it below, but here are two types of contributions:

• Matching contributions, which are company contributions that are made based on how much employees choose to defer.

• Nonelective (profit sharing) contributions, which are made whether or not an employee defers income to their 401(k) account.

Sometimes employer contributions are also subject to a vesting schedule. That means an employee accrues a percentage of ownership in employer contributions based on how long they have worked and potentially how many hours they earned in that time until they reach 100% vesting. Unvested employer contribution balances are forfeited if an employee leaves the company before they're fully vested.

While employees appreciate matching contributions because it means they'll get additional money in their retirement nest egg, these contributions also benefit employers. Nice perks keep employees happier, contributions qualify as tax-deductible business expenses,³ and they tend to help 401(k) plans avoid discrimination issues when structured correctly.

Defining "highly compensated employees"

Nondiscrimination testing of a 401(k) plan looks for discrimination by comparing the average benefits received and the participation rates of the "highly compensated employees" (HCEs) to the average benefits received and the participation rates of the non-highly compensated employees (NHCEs).

But how do you know if someone is an HCE? The IRS defines an HCE as an individual who:

• Is a more than 5% owner of the sponsoring business at any time during the current year or the preceding year (including certain family members via attribution rules), regardless of how much compensation that person earned, OR

• Received compensation from the business of more than $160,000, during the preceding year (2025) ($155,000 for 2024). If the plan is using the top paid group election, only individuals who made more than the compensation limit in the preceding year who are also in the  top 20% of employees when ranked by compensation are considered HCEs.

If someone doesn't meet either of those conditions, they are an NHCE.

The two different criteria are determined separately. This means that if an individual is an HCE based on ownership (including attribution) but is not in the top 20% based on compensation, they are still an HCE. The top paid group election only limits the number of HCEs included solely due to compensation.

The nondiscrimination tests in action

This is all a little complex, so let's look at an example to keep this from turning into an acronym salad. Let's say that a company called Winterfell Consulting offers to make a matching contribution of 50% of the income an employee defers to their 401(k) account, until the deferral amount reaches 5% of the employee's compensation.

Here's how their employees chose to participate last year:

These are hypothetical examples for illustrative purposes only and do not represent any current or past client accounts.²

Is this arrangement discriminatory? Here's a closer look at the tests the IRS applies.

Coverage Testing (410(b) test)

Coverage testing compares how many HCEs are eligible to benefit under the plan to how many NHCEs are eligible. This test is run for each contribution type made to the plan for that plan year (e.g., elective deferrals, employer match, etc.). When compared to the number of HCEs eligible, at least 70% of the NHCEs must also be eligible for that contribution type.

When an employer uses a plan design that reduces the number of employees eligible to participate in the plan by, 1) excluding certain classes of employees, 2) having an age or service requirement for eligibility, or (3) requiring an employee to meet certain conditions in order to receive a contribution each year, they run the risk of failing coverage testing. The only way to correct a failed coverage test is to amend the plan design to include enough employees to pass the test.

Using the Winterfell Consulting information provided in the grid above, let's calculate the coverage test for this plan. Note that Sansa is excluded because the plan design excludes interns.

• 100% of the HCEs are eligible to make deferrals and receive employer match (HCE ratio = eligible HCEs/total nonexcludable HCEs)

• 66.67% of the NHCEs are eligible to make deferrals and receive employer match (NHCE ratio = benefitting NHCEs/total nonexcludable NHCEs)

Coverage ratio = 66.67% (66.67%/100%)

The sample plan fails the ratio percentage test because the coverage ratio is less than 70%. There is also a slightly more complex test called the average benefits test that also comes out to less than 70%. The plan will be required to add Sansa as a benefiting employee in order to pass coverage testing.

Keep in mind that currently Gusto 401(k) plans are designed to automatically pass coverage testing for deferrals and match but may need to test for profit sharing contributions.⁴

The Actual Deferral Percentage (ADP) test

The annual ADP test compares the average salary deferral rate of HCEs to that of the NHCEs. Each employee's deferral percentage is calculated by dividing the amount an employee defers into the plan each plan year by their total compensation for that plan year.

Continuing to use the Winterfell Consulting information provided in the grid above, let's calculate the coverage test for this plan.

These are hypothetical examples for illustrative purposes only and do not represent any current or past client accounts.²

In this case, Jon, the HCE, defers 10% of his compensation, while Sansa, Arya, and Bran — all NHCEs — contribute an average of 3%.

As an HCE, Jon can defer the greater of (i.e. whichever percentage is larger):

1. (NHCE average deferral) x (1.25%) — in this case, that is: (3%)(1.25%) = 3.75% OR

2. The lesser of the (NHCE deferral average) x (2) or +2% — in this case, that is: (3%)(2) = 5% or 3%+2%=5%

The greater of these two calculations is 5%, meaning Jon can defer 5%.

Since Jon is deferring 10%, the plan fails the ADP test. The plan will need to either refund Jon’s excess 5% of deferrals plus earnings to correct the ADP testing failure or he could make a Qualified Nonelective Contribution (QNEC) to the NHCEs in the plan to raise their deferral rates to the level where the test is passing - or a combination of both. Because only amounts over 5% of compensation are being refunded, no match needs to be removed at this step.

The Actual Contribution Percentage (ACP) test

The ACP test is similar to the ADP test, but it compares the average employer matching contribution received by HCEs and NHCEs, rather than how much they defer. ACP is calculated by dividing the company's matching contribution to an employee by their compensation:

These are hypothetical examples for illustrative purposes only and do not represent any current or past client accounts.²

Here, Winterfell Consulting gives the HCE, Jon, a 2.5% total contribution, while NHCEs Sansa, Arya, and Bran receive an average contribution of 1.5%.

Using the same calculation formulas for the ACP test as with the ADP test, the NHCE's match contribution average is 1.5% (0+2.5+2 / 3). Applying the 2 x test (1.5 x 2) = 3, which is the HCE average match contribution, the plan passes the ACP test.

If the ACP test is failing, the same corrective action for the ADP test can be applied to the ACP test — distribute the vested portion of the excess match plus earnings and/or forfeiture of unvested match plus earnings. If the plan is using current year testing and permits QNECs and/or QMACs, the employer could make an additional contribution to NHCE employees in an amount equal to pass the test.

Top-Heavy Test

The fourth nondiscrimination test is the top-heavy test. This test measures the adjusted total value of account balances held by "Key Employees" against the total value of all account balances in the plan as of the last day of the prior plan year (or current year, if it's the plan's first year).

To determine the total value of the accounts, distributions taken in the prior four years must be added back in and unrelated rollover balances must be subtracted for both Key and Non-Key employees. A plan is top-heavy if the Key Employees own more than 60% of the total plan assets.

Key Employees are defined by the IRS as:

• Anyone who owns more than 5% of the business (including certain family members via attribution rules), OR

• An employee owning more than 1% of the business (including certain family members via attribution rules) whose compensation exceeds $150,000 for the plan year (not indexed for cost of living adjustment (COLA)).

• An officer making over $235,000 in the plan year for 2026 (indexed for COLA annually). There is a maximum number of officers who can be treated as key employees. The maximum is the greater of 10% of total employees or 3, but cannot exceed 50.

Returning to the example, let's assume this is the first year of Winterfell Consulting's plan and the value of each account as of 12/31 is shown below. Jon Snow owns 100% of the company, which makes him the only key employee. Here's what their assets add up to at the end of the year:

These are hypothetical examples for illustrative purposes only and do not represent any current or past client accounts.²

There are total assets of $25,905 in the Winterfell plan, and the key employee has assets of $21,450 — about 83% of the total plan assets. Because more than 60% of the plan assets belong to the key employee, this plan is top-heavy for the initial plan year and the following year.

When a plan is top-heavy for a given year, each non-key employee must receive a top-heavy minimum contribution which is the lesser of (1) 3% or (2) the highest contribution percent of any key employee (including deferrals that are not catch-up contributions). This top-heavy minimum contribution can be met by matching, profit sharing, safe harbor, or qualified non-elective contributions (QNECs).

In Winterfell’s case, the top-heavy minimum contribution is 3% (the lesser of 3%, or Jon’s total contribution of 12.5%). This 3% contribution can be offset by other employer contributions (but not deferrals). Because both Arya and Brans’ total match is below the 3% they will need to receive an additional contribution.

Correcting a failing 401(k) plan

If your plan fails any one of the above tests, it's okay — it happens — but you must take steps to fix it in a timely manner. There are major consequences if you don't take corrective action and certain correction options are no longer available past the deadline. The IRS 401(k) Fix-It Guide has useful information on all kinds of situations you may encounter.

There's another way to stay compliant

Passing annual nondiscrimination tests is a crucial part of a 401(k) plan's administration. And, as you can see in the examples above, correcting a failure can have unwelcome consequences for employees — or require making employer contributions you may not have budgeted for. To address any risk early, it's highly advisable to conduct interim testing throughout the year to stay in front of things.

However, there is another way to stay compliant — adding a Safe Harbor Provision to the plan. This feature automatically satisfies most of these annual tests as it requires a mandatory employer contribution each year, using minimum contribution formulas for an employer match or nonelective contribution. Bottom line, a little planning can go a long way toward keeping your 401(k) plan compliant.

This content is for informational purposes only and is not intended to be taken as tax advice. Please contact a tax professional for further information.

FAQs

What are 401(k) nondiscrimination tests?

Nondiscrimination tests are annual IRS-required assessments that ensure a company's 401(k) plan doesn't unfairly favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs). The main tests include the coverage (410(b)) test, ADP test, ACP test, and top-heavy test.

What happens if my 401(k) plan fails nondiscrimination testing?

If your plan fails, you must take corrective action. This typically involves refunding excess contributions to HCEs, making additional contributions to NHCEs, or amending the plan design. Failure to correct nondiscrimination testing failures can result in plan disqualification.

How can I avoid 401(k) nondiscrimination testing?

The most common way to automatically satisfy most nondiscrimination tests is to establish a Safe Harbor 401(k) plan, which requires making minimum employer contributions. This automatically satisfies the ADP and ACP tests and may exempt the plan from top-heavy minimum contributions.

Who is considered a Highly Compensated Employee (HCE)?

An HCE is someone who owns more than 5% of the business at any time during the current or preceding year, or received compensation over $160,000 in the preceding year in 2025 for 2026 (or was in the top 20% by compensation, if that election is made).

What is the top-heavy test?

The top-heavy test measures whether Key Employees (owners and certain officers) own more than 60% of total plan assets. If the plan is top-heavy, employers must contribute up to 3% of compensation for Non-Key Employees.

Disclosures

¹ Making a profit sharing contribution in addition to your safe harbor contribution could remove the exemption from the top-heavy minimum contribution requirement. This may require additional employer contributions to the plan. By choosing to make a profit sharing contribution, you are assuming this risk and the responsibility to make additional contributions if the plan exceeds top heavy limits.

² These are hypothetical examples for illustrative purposes only and do not represent any current or past client accounts.

³ This content is for informational purposes only and is not intended to be taken as tax advice. Please contact a tax professional for further information.

⁴ All plans of related entities must be administered by Gusto Retirement Services, LLC in order to have Gusto complete compliance testing.