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 is exempt from 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 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 features chosen for the 401(k) plan are fair by looking at:

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

Generally, plans must also pass a fourth compliance test each year, the Top-Heavy test, or they will 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 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 in 2023 found that plans with automatic enrollment had a 94% participation rate, compared with a participation rate of 67% for plans with voluntary enrollment.

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:

Sometimes employer contributions are also subject to a vesting schedule. That means an employee accrues a percentage of ownership in employer contributions each plan year 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, 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:

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

Note that if an HCE based on ownership (including attribution) is not in the top 20% based on compensation, they must be added back to the HCE group, without dropping any employee from the top 20% based on 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 6% of the employee’s W-2 income.

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

This example is for illustrative purposes only. This is not investment or tax advice.

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 benefiting from the plan to how many NHCEs are benefiting. 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 benefiting, at least 70% of the NHCEs must also benefit from 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, or 2) 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.

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

The sample plan fails the ratio percentage test because the coverage ratio is 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 most Guideline 401(k) plans are designed to automatically pass coverage testing.

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 W-2 income 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.

This example is for illustrative purposes only. This is not investment or tax advice.

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):

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

Since Jon is deferring 10%, the plan fails the ADP test. Jon will need to either refund his 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.

The Actual Contribution Percentage (ACP) test

The ACP test is similar to the ADP test, but it compares the average employer contributions received by HCEs and NHCEs, rather than how much they defer. ACP is calculated by dividing the company’s contribution to an employee by their W-2 income:

This example is for illustrative purposes only. This is not investment or tax advice.

Here, Winterfell Consulting gives the HCE, Jon, a 3% 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 a plan must pass is the top-heavy test. This test measures the total value of account balances owned 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 fails the top-heavy test if the key employees own more than 60% of the total plan assets.

Key employees are defined by the IRS as:

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:

This example is for illustrative purposes only. This is not investment or tax advice.

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 fails the top-heavy test for the initial plan year and the following year.

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. There are major consequences if you don’t take corrective action. The IRS 401(k) Fix-It Guide has useful information on all kinds of situations you may encounter.

Correcting a combined ADP and Top Heavy Failure

Going back to the examples above, the Winterfell 401(k) failed the ADP and top-heavy tests. The plan failed the ADP test because, on average, the NHCEs deferred 3% of their W-2 income, which meant the HCE was only allowed to defer up to 5% of his income under the test. In this case, he deferred 10%.

The correction could be made two different ways. Winterfell Consulting could refund half of the HCE’s 10% deferral so that Jon’s rate doesn’t surpass NHCEs by more than 2%. The refund would be distributed to the HCE as ordinary income in the year it is received.

Or, Winterfell could take a two-step approach:

Correcting a Top-Heavy failure

The Winterfell 401(k) failed the top-heavy test because more than 60% of the plan assets belonged to the key employee. The plan will be considered top-heavy for the next plan year (and current year, if it’s the plan’s first year in existence), and certain employer contributions will need to be made — up to 3% of non-key employees’ compensation for each year the plan is top-heavy.

The 3% contribution can be offset by other employer contributions (but not deferrals). If Winterfell’s match equals 3% of compensation paid for each employee at the end of each year, no further contributions will need to be made to correct a top-heavy failure for that year.

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 — a Safe Harbor 401(k) plan lets you skip most of these annual tests by simply providing an employer contribution each year. Bottom line, a little planning can go a long way toward keeping your 401(k) plan compliant.