What Is the Coverage Test?

The Coverage Test is a regulatory standard used to ensure that employer-sponsored retirement plans, such as 401(k) plans, do not disproportionately benefit highly compensated employees (HCEs) at the expense of non-highly compensated employees (NHCEs). Established under Section 410(b) of the Internal Revenue Code (IRC), this test helps uphold the principle of fairness in tax-advantaged retirement savings. To remain compliant, a plan must pass at least one version of the coverage test each plan year.

Purpose of the Coverage Test

The fundamental purpose of the coverage test is to confirm that a retirement plan is inclusive and not designed solely for the benefit of business owners, executives, or high earners. Since retirement plans offer significant tax advantages, the IRS requires that these benefits be broadly available to employees across all income levels.

Without such a safeguard, companies could design retirement plans that provide substantial contributions or deferrals for HCEs while leaving out or offering minimal benefits to NHCEs. The coverage test enforces balance and prevents discriminatory practices.

Who Is an HCE?

To understand how the coverage test works, it’s important to define highly compensated employees. According to the IRS, an HCE is generally someone who meets one of the following criteria:

• Owns more than 5% of the business at any time during the current or preceding year, regardless of compensation.
• Received compensation above a certain IRS-defined threshold in the previous year (for 2025, this threshold is $160,000, though it may adjust annually for inflation).

Employees who do not meet either of these criteria are considered non-highly compensated employees or NHCEs.

How the Coverage Test Works

There are two primary methods for satisfying the coverage test:

1. Ratio Percentage Test

This is the most common test used. It compares the percentage of NHCEs who benefit from the plan to the percentage of HCEs who benefit. The formula is:

Coverage Ratio = (NHCEs Benefiting / Total NHCEs) ÷ (HCEs Benefiting / Total HCEs)

For the plan to pass, the resulting percentage must be at least 70%. This means that if 80% of HCEs benefit from the plan, at least 56% (70% of 80%) of NHCEs must also benefit.

2. Average Benefits Test

If the plan fails the ratio percentage test, the sponsor can attempt to pass using the average benefits test, which has two components:

• Nondiscriminatory Classification Test – This checks whether the classification of employees benefiting from the plan is reasonable and based on objective business criteria (such as job function, location, or tenure).
• Average Benefit Percentage Test – This compares the average rate of employer contributions or benefits between NHCEs and HCEs. The average benefit for NHCEs must be at least 70% of the average benefit for HCEs.

This method is more complex and typically requires additional documentation and calculations, often done by third-party administrators or actuaries.

Who Is Considered a “Benefiting” Employee?

For the purposes of the coverage test, a “benefiting” employee is one who has satisfied the eligibility requirements of the plan and receives an employer contribution, an employer match, or is otherwise entitled to benefits under the plan. Merely being eligible to participate in the plan is not enough unless the employee actually receives a benefit.

It’s also important to note that employees excluded by law — such as those under age 21 or with less than one year of service — can be omitted from the test. Similarly, employees covered by collective bargaining agreements may also be excluded in some cases.

Correcting Coverage Failures

If a plan fails the coverage test, corrective action is required to bring it back into compliance. This can involve:

• Amending the plan to include additional NHCEs,
• Making retroactive contributions for NHCEs who were unfairly excluded,
• Aggregating the plan with another qualified plan to meet the test requirements, or
• Using the average benefits test instead of the ratio test (if applicable).

If no action is taken and the plan remains out of compliance, it risks disqualification, meaning it would lose its tax-advantaged status — a costly outcome for both the employer and participants.

Why the Coverage Test Matters for Employers

Passing the coverage test is a key element of maintaining a qualified plan under ERISA and IRS rules. For employers, this isn’t just a compliance checkbox — it’s a reflection of the company’s commitment to equitable benefit practices. Failing to meet coverage standards can result in reputational harm, regulatory penalties, and additional administrative costs.

Furthermore, consistent failure may require plan redesign or strategy changes, especially for small businesses with uneven workforce demographics (e.g., one owner and a small support staff). In these cases, options like Safe Harbor 401(k) plans are often explored, which automatically satisfy certain nondiscrimination and coverage requirements.

The Bottom Line

The Coverage Test ensures that retirement plans are not skewed to benefit only the highest earners. By requiring employers to include a representative portion of their workforce in retirement benefits, the IRS promotes broader access to tax-favored savings vehicles. For businesses, it’s an essential part of ongoing plan maintenance, compliance, and equitable benefit design.