What Is Nondiscrimination Testing?

Nondiscrimination testing refers to a set of annual compliance tests required by the Internal Revenue Service (IRS) to ensure that qualified retirement plans — such as 401(k) plans — do not disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). These rules are part of the Employee Retirement Income Security Act (ERISA) and are designed to promote fairness in workplace retirement benefits. The tests assess whether contributions and benefits provided by a plan are equitably distributed across all levels of employees.

In essence, a company cannot maintain tax-favored status on its retirement plan unless it can demonstrate that the plan does not unfairly advantage owners, executives, or other highly paid employees. If the plan fails the tests, it must take corrective actions, such as refunding contributions or making additional employer contributions to NHCEs.

Why Nondiscrimination Testing Matters

Qualified retirement plans offer significant tax advantages. Employers can deduct contributions made to employee accounts, and employees can defer income taxes on their contributions and investment earnings until withdrawal. To maintain this favorable tax treatment, the IRS requires that these plans meet certain standards of fairness. Nondiscrimination testing is the mechanism through which these standards are enforced.

Without such testing, companies might be incentivized to use retirement plans primarily as a benefit for top earners, undermining the broader policy goal of encouraging retirement savings across the workforce.

Key Types of Nondiscrimination Tests

Several specific tests apply, depending on the features of the plan. For most traditional 401(k) plans, the main tests include:

1. Actual Deferral Percentage (ADP) Test:
The ADP test compares the average salary deferral percentages of HCEs to those of NHCEs. If HCEs contribute at a significantly higher rate than NHCEs, the plan may fail this test.

2. Actual Contribution Percentage (ACP) Test:
The ACP test measures employer matching contributions and after-tax contributions in a similar way. Again, the goal is to ensure that contributions benefiting HCEs are not excessively higher than those for NHCEs.

3. Top-Heavy Test:
This test checks whether the key employees (generally owners and officers) hold more than 60% of the plan’s total assets. If a plan is considered top-heavy, it must meet minimum contribution and vesting requirements to remain compliant.

Who Is Considered a Highly Compensated Employee?

To determine whether a plan discriminates in favor of certain employees, it’s essential to know who qualifies as an HCE. The IRS defines an HCE as someone who:

• Owned more than 5% of the company at any time during the current or prior year, or
• Earned more than a set compensation threshold in the previous year (e.g., $160,000 for 2025, indexed annually for inflation).

Employees who do not meet either criterion are considered non-highly compensated employees (NHCEs).

Safe Harbor Plans and Testing Relief

Some employers choose to adopt a "safe harbor" 401(k) plan design to avoid the need for ADP and ACP testing. In exchange for committing to minimum employer contributions and immediate vesting on those contributions, a safe harbor plan is automatically deemed to pass certain nondiscrimination requirements.

There are multiple types of safe harbor designs, including basic matching, enhanced matching, and non-elective contributions. While safe harbor plans simplify compliance, they come with increased employer obligations and less flexibility in plan design.

Correcting Test Failures

If a plan fails one or more nondiscrimination tests, the employer must take corrective action within a specific timeframe to avoid penalties and preserve the plan’s qualified status. Common corrective methods include:

• Refunding excess contributions made by HCEs
• Making additional employer contributions to NHCEs to bring the test results into balance
• Recharacterizing contributions or adjusting plan design for future years

Failing to take timely corrective actions can result in disqualification of the plan, causing all contributions to become immediately taxable and subject to penalties.

Administrative Considerations

Plan sponsors must work closely with their third-party administrators (TPAs) or recordkeepers to ensure accurate employee data is collected, categorized, and reported. Testing usually requires detailed information on employee compensation, ownership interest, job classification, and plan participation.

Given the complexity and potential consequences of nondiscrimination testing, it’s common for employers to conduct mid-year checks or projections to identify potential issues before the plan year ends.

The Bottom Line

Nondiscrimination testing plays a critical role in maintaining the integrity and fairness of tax-qualified retirement plans. By requiring that benefits do not disproportionately favor highly compensated employees, these rules support equitable access to retirement savings opportunities. While the rules can be complex and burdensome, proper planning, accurate recordkeeping, and thoughtful plan design can minimize the risk of test failures and maintain compliance. For many employers, considering safe harbor plan structures or working with experienced plan administrators can offer added peace of mind and operational efficiency.