Cash or Deferred Arrangement: Limits, Testing, and Safe Harbor

A cash or deferred arrangement, or CODA, is the feature inside a qualified retirement plan that lets you choose between taking part of your pay in cash now or deferring it into the plan for retirement. Every modern 401(k) is built on one. The election has to be made before the money becomes available to you, and for 2026 the ceiling on what you can defer is $24,500, with extra room for workers age 50 and older.¹

Which Plans Can Contain a CODA

Not every retirement plan can have one. Under IRS rules, a CODA can sit inside a profit-sharing plan, a stock bonus plan, certain pre-ERISA money purchase pension plans, and rural cooperative plans.² It also has to be part of a defined contribution plan that meets the qualification requirements of the Internal Revenue Code.³ Defined benefit pension plans cannot include one.

The favorable tax treatment comes with strings. The plan has to keep its qualified status by hitting contribution limits, passing non-discrimination tests, and honoring distribution restrictions. If the plan loses that status, the tax advantages disappear for every participant, not just whoever caused the failure.

Who the Plan Has to Let In

A CODA cannot make employees wait too long. The longest waiting period allowed for elective deferrals is one year of service, and the plan cannot lock someone out for being older than a certain age. Once you turn 21 and finish a year of service, the plan has to let you defer.⁴

Employer money is treated slightly differently. Matching and profit-sharing contributions can carry an eligibility window as long as two years of service, but only if the employer money vests 100% right away.⁴

Long-Term Part-Time Workers

SECURE 2.0 opened a new path in for part-timers. Starting with plan years that begin in 2025, an employee who works at least 500 hours in each of two consecutive years must be allowed to make elective deferrals. For 2026 eligibility, hours worked in 2024 and 2025 count toward that threshold. Consistent part-time hours are now enough, even without hitting the traditional 1,000-hour year of service.

How Much You Can Defer in 2026

The annual cap on elective deferrals lives in Internal Revenue Code Section 402(g) and gets adjusted for inflation.⁵ For 2026 it sits at $24,500.⁶ That ceiling covers your pre-tax and Roth deferrals added together across every 401(k) you touch during the year. Contributing to two employers’ plans does not double the limit; the $24,500 is shared.

Catch-Up Contributions

Participants aged 50 and older get to add on top. The standard catch-up for 2026 is $8,000, which brings the total deferral for someone 50 to 59, or 64 and older, to $32,500.¹

SECURE 2.0 also built in an enhanced catch-up for the ages between. Participants aged 60 through 63 can put in up to $11,250 as their catch-up for 2026, pushing their total ceiling to $35,750.¹ Once you hit 64, the catch-up drops back to $8,000.

The Overall Annual Additions Cap

There’s a second, separate ceiling. Section 415(c) limits total annual additions to your account from every source combined, meaning your deferrals plus employer matching, profit-sharing, and forfeitures. For 2026 that limit is $72,000.⁶ Catch-up contributions do not count against it, so a 50-year-old could theoretically see up to $80,000 land in the account.

Pre-Tax or Roth

A CODA can offer two versions of the deferral, and many plans offer both. Pre-tax deferrals shrink your taxable income now. Every dollar you pull out in retirement, including growth, gets taxed as ordinary income.

Roth deferrals flip the timing. You pay income tax on the contribution up front, but qualified distributions later come out completely tax-free, contributions and earnings together. A distribution is qualified if you have held the Roth account for at least five years and you are at least 59½, disabled, or the money is going to a beneficiary after your death.⁷

The $24,500 cap covers both types together. You can split however you like, as long as the total stays under the annual limit.

Non-Discrimination Testing

To keep its tax-qualified status, a traditional CODA has to pass two annual tests that prove it isn’t tilted toward higher-paid employees. These are the Actual Deferral Percentage test and the Actual Contribution Percentage test.⁸

Testing splits the workforce into Highly Compensated Employees and Non-Highly Compensated Employees. For the 2026 plan year, an HCE is someone who earned more than $160,000 in the prior year or who owns more than 5% of the business.⁶

How the Tests Work

The ADP test compares the average deferral rate of HCEs against the average for NHCEs. The ACP test runs the same comparison on employer matching contributions and any voluntary after-tax employee contributions. The formula is the same for both: the HCE average cannot exceed the greater of 125% of the NHCE average, or the NHCE average plus 2 percentage points (capped at 200% of the NHCE average).⁸

So when rank-and-file participation rises, HCEs get to defer more. When it falls, HCE contributions get compressed. That’s the recurring headache for small business owners whose employees don’t participate much.

Fixing a Failed Test

If a plan fails, the sponsor has to correct it. The most common fix is returning the excess deferrals to the HCEs. Those corrective distributions are taxable to the HCE in the year they come out, but they are specifically exempt from the 10% early withdrawal penalty that usually applies before 59½.⁹ The returns have to happen within 2½ months after the plan year ends, or six months for plans with eligible automatic contribution arrangements. Miss that window and the employer owes a 10% excise tax on the excess.⁸

The other option is lifting the NHCE side of the equation by making qualified non-elective contributions or qualified matching contributions into NHCE accounts. Those raise the NHCE average enough to pass the test, but they must vest immediately at 100%.

Safe Harbor: Skipping the Tests

Sponsors who don’t want the annual testing risk can use a Safe Harbor design, which lets the plan bypass both the ADP and ACP tests in exchange for mandatory employer contributions. The deal: guaranteed money for the rank and file, and HCEs get to defer up to the statutory maximum without worrying about test results.

The Two Formulas

Two formulas satisfy the Safe Harbor. The first is a non-elective contribution of at least 3% of compensation for every eligible NHCE, regardless of whether the employee defers.¹⁰ Everyone eligible gets it just for being in the plan.

The second is a Safe Harbor match: 100% of the employee’s deferral on the first 3% of pay, plus 50% on the next 2%.¹⁰ Defer at least 5% and you get a 4% match. Either formula requires immediate 100% vesting.

The plan has to send a written notice to eligible employees between 30 and 90 days before each plan year, laying out the Safe Harbor formula and other terms.¹¹

QACA Variation

A Qualified Automatic Contribution Arrangement blends Safe Harbor testing relief with automatic enrollment. Under a QACA, the plan enrolls employees automatically at a default rate starting at 3% of pay and escalates by at least 1% per year up to a minimum of 6%. The default cannot exceed 15%, or 10% during the employee’s first year.¹²

The QACA match formula is 100% of deferrals on the first 1% of compensation, plus 50% on deferrals between 1% and 6%. QACA employer contributions can use a two-year cliff vesting schedule rather than the immediate vesting required for traditional Safe Harbor contributions.¹²

Automatic Enrollment Is Now the Default for Newer Plans

Starting in 2025, SECURE 2.0 requires most new 401(k) plans set up after December 29, 2022, to include automatic enrollment. The default deferral rate has to be at least 3% and no more than 10% of pay, with automatic annual escalation of at least 1% per year. The escalation cap must fall between 10% and 15%. Employees can still opt out or change their rate at any time.

Some employers are exempt from the mandate:

Businesses that normally have 10 or fewer employees
Businesses that have been in existence fewer than three years
Government and church plans, regardless of size or age
SIMPLE IRAs and SIMPLE 401(k) plans

Plans that existed before December 29, 2022, are grandfathered and don’t have to add automatic enrollment, though many add it anyway because higher NHCE participation makes non-discrimination testing easier to clear.

Vesting of Employer Money

Your own elective deferrals are always 100% vested from day one. Employer contributions can follow a vesting schedule that requires you to stick around a few years before the money is fully yours. Leave early and you forfeit the unvested piece.

Employer matching contributions have to use one of two minimum schedules:¹³

Cliff vesting: 0% vested for the first two years, then 100% vested at three years of service
Graded vesting: 20% vested after two years, rising 20% each year to 100% after six years

Safe Harbor contributions are the exception, since both the non-elective and matching versions have to be fully vested immediately. QACA contributions can use the two-year cliff.

Getting Money Out

A CODA is built for retirement, and the tax code enforces that. Money has to stay put until a distributable event: separation from service, death, disability, or hitting age 59½. Distributions before 59½ generally get taxed as ordinary income and hit with an extra 10% tax.¹⁴

Plan Loans

Many plans let you borrow from your own balance while still employed. The maximum is the lesser of $50,000 or 50% of your vested balance, with a floor of $10,000 for small balances.¹⁵ Repayment runs through substantially equal payments made at least quarterly, over no more than five years. Loans used to buy a principal residence can go longer.¹⁶

Keep up with the payments and a loan is not a taxable event. Default and the outstanding balance becomes a deemed distribution, taxable and potentially subject to the 10% early withdrawal penalty.

Hardship Withdrawals

Hardship withdrawals are permanent. You can’t repay the money, and the distribution is taxable. To qualify, you have to show an immediate and heavy financial need, and the withdrawal cannot exceed what it takes to cover that need plus any resulting taxes and penalties. The IRS keeps a safe harbor list of qualifying expenses:¹⁷

Unreimbursed medical expenses for you, your spouse, or dependents
Costs directly tied to buying a principal residence
Tuition and related fees for the next 12 months
Payments needed to avoid eviction or foreclosure on your principal residence
Funeral and burial expenses
Certain casualty repairs to your principal residence
Expenses from a federally declared disaster affecting your home or workplace

Before pulling the money, you have to certify that no other reasonably available resources cover the need. And the plan document has to actually permit hardship withdrawals; not every CODA offers them.

1
Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026
2
Internal Revenue Service. Employee Plans CPE Topics – Cash or Deferred Arrangements
3
Internal Revenue Service. Cash or Deferred Arrangement Listing of Required Modifications
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Internal Revenue Service. 401(k) Plan Qualification Requirements
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eCFR. 26 CFR 1.402(g)-1 – Limitation on Exclusion for Elective Deferrals
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Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs
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Internal Revenue Service. Retirement Topics – Designated Roth Account
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Internal Revenue Service. 401(k) Plan Fix-It Guide – ADP and ACP Nondiscrimination Tests
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Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
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eCFR. 26 CFR 1.401(k)-3 – Safe Harbor Requirements
11
Internal Revenue Service. Mid-Year Changes to Safe Harbor 401(k) Plans and Notices
12
Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
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Internal Revenue Service. Retirement Topics – Vesting
14
Internal Revenue Service. Topic No. 558 – Additional Tax on Early Distributions from Retirement Plans Other Than IRAs
15
Internal Revenue Service. Retirement Plans FAQs Regarding Loans
16
eCFR. 26 CFR 1.72(p)-1 – Loans Treated as Distributions
17
Internal Revenue Service. Retirement Plans FAQs Regarding Hardship Distributions