IRS Testing for 401(k) Plans: ADP, ACP, Top-Heavy, and Safe Harbor

A traditional 401(k) plan has to clear a set of annual IRS checks known collectively as 401(k) nondiscrimination testing: the ADP test on employee deferrals, the ACP test on employer matches and after-tax contributions, a coverage test, and a top-heavy test. The purpose is the same across all four — confirm the plan isn’t tilted toward owners and top earners. Failing doesn’t disqualify a plan on its own, but it starts a strict correction clock. Miss the deadlines and the sponsor faces excise taxes; ignore the failure entirely and the plan can lose its tax-qualified status.

Before any of the tests make sense, you have to know who’s being compared.

Who Counts as Highly Compensated or Key

The main dividing line is between Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). You’re an HCE if you owned more than 5% of the company at any point during the current or preceding plan year, regardless of pay, or if your prior-year compensation crossed an indexed threshold.¹ For the 2026 plan year, that threshold is more than $160,000 earned in 2025.²

The 5% ownership rule reaches further than most people expect. Under constructive ownership rules, stock held by your spouse, children, grandchildren, and parents is treated as if you own it.³ An adult child working at a family business who owns nothing personally can still be an HCE because of a parent’s shares. Employers can also elect to apply the compensation threshold to only the top 20% of employees ranked by pay, which shrinks the HCE group at companies where many mid-level workers cross $160,000.¹

Key Employees are a separate category that only matters for the top-heavy test. You’re a Key Employee if you’re an officer earning more than $235,000 in 2026, a more-than-5% owner, or a more-than-1% owner earning over $150,000.⁴ The officer threshold rose from $230,000 in 2025.⁵

The ADP Test

The Actual Deferral Percentage test compares average salary deferrals between the two groups. For each eligible employee, elective deferrals are divided by compensation; those individual percentages are then averaged separately for HCEs and NHCEs. Employees who choose not to defer count as 0%, which pulls the NHCE average down.⁶

The plan passes if the HCE average clears either of two limits:⁶

The 125% test: the HCE average cannot exceed 125% of the NHCE average.
The 2%/200% test: the HCE average cannot exceed the NHCE average plus 2 percentage points, and it also cannot exceed 200% of the NHCE average.

The plan uses whichever result is more generous. If NHCEs average 3%, the 125% test allows HCEs up to 3.75%, while the 2%/200% test allows up to 5% (3% + 2%, which is under 200% of 3%). At higher NHCE averages the 125% test eventually becomes more favorable: at a 10% NHCE average, HCEs can go to 12.5% under the 125% rule versus only 12% under the 2%/200% rule.

Catch-up contributions by employees aged 50 and older are excluded from the ADP calculation entirely.⁶ That includes the standard $8,000 catch-up for 2026 and the enhanced $11,250 catch-up for participants ages 60 through 63 under SECURE 2.0.⁷ Pre-tax and Roth deferrals both count.

The ACP Test

The Actual Contribution Percentage test runs the same math on employer matching contributions and any employee after-tax contributions. The two-limit structure is identical: the HCE average must not exceed the greater of 125% of the NHCE average or the NHCE average plus 2 percentage points (still capped at 200% of the NHCE average).⁶

Because the ACP test captures the match, the match formula itself can cause a failure. A common pattern: the company offers a generous match, but lower-paid employees don’t defer enough to earn it. The NHCE contribution percentage stays low, which tightens the cap on HCEs. Plans that consistently fail the ACP test often find the root cause is low participation among rank-and-file workers rather than anything the HCEs are doing.

Coverage Test

A plan also has to cover a broad enough slice of the workforce. The simplest way to show this is the Ratio Percentage Test: the percentage of eligible NHCEs who participate must be at least 70% of the percentage of eligible HCEs who participate.⁸ If every HCE is in the plan, at least 70% of eligible NHCEs must be in it too.

When the ratio test fails, the plan can fall back to the Average Benefit Percentage Test, which compares the total value of contributions and benefits going to each group. The NHCE average benefit must be at least 70% of the HCE average benefit.

Top-Heavy Test

The top-heavy test measures whether plan assets have become concentrated among Key Employees. A plan is top-heavy when Key Employee account balances exceed 60% of total plan assets as of the last day of the prior plan year.⁹ Small companies get caught by this most often — when the business has a handful of employees and the owner has been contributing for decades, the owner’s balance can easily dwarf everyone else’s.

A top-heavy plan triggers two obligations. First, the employer must make a minimum contribution for all non-key employees employed on the last day of the plan year. That minimum is 3% of each non-key employee’s compensation, unless the highest contribution rate for any Key Employee was less than 3%, in which case non-key employees receive that lower rate.⁹

Second, employer contributions must vest on an accelerated schedule: either full vesting after three years of service, or a six-year graded schedule that starts at 20% after two years and increases by 20% each year until reaching 100% at six years.¹⁰ The faster vesting applies to all employer contributions in the plan, even amounts that accrued before the plan became top-heavy.

Correcting a Failed ADP or ACP Test

A failure doesn’t disqualify the plan, but it starts a correction clock. Sponsors have two ways out: reduce what HCEs received, or increase what NHCEs received.

Distributing Excess Contributions

The most common fix is returning excess contributions to HCEs. The plan calculates how much the HCE group deferred or received in matching beyond the allowable limit, then distributes those amounts plus investment earnings back to the affected employees. To avoid a 10% excise tax, corrective distributions must go out within two and a half months after the plan year closes. For a calendar-year plan, that’s March 15.⁶ Plans that use an Eligible Automatic Contribution Arrangement covering all eligible employees get six months instead.

Missing the excise-tax deadline doesn’t end the correction opportunity, but it makes it expensive. The employer files Form 5330 and pays the 10% excise tax on the uncorrected amounts. The hard deadline is 12 months after the plan year closes. If corrections aren’t complete by then, the plan’s salary deferral arrangement is no longer qualified, and the entire plan risks losing its tax-exempt status.⁶

Adding Employer Contributions

Instead of pulling money back from HCEs, the employer can put more money in for NHCEs through Qualified Nonelective Contributions (QNECs) or Qualified Matching Contributions (QMACs). Both must be fully vested when allocated and are subject to the same withdrawal restrictions as salary deferrals.¹¹ Adding them raises the NHCE average, which raises the ceiling for HCEs and lets the plan pass retroactively.

The QNEC route costs the employer real dollars but avoids the administrative work of chasing excess contributions and the awkwardness of telling highly paid employees their savings are being refunded. For plans that fail by small margins, building a modest annual QNEC into the budget can be simpler than the refund process.

Skipping the Tests With a Safe Harbor Plan

A safe harbor 401(k) skips the ADP test entirely, and in most cases the ACP test as well, by committing upfront to a minimum level of employer contributions. Guaranteed dollars for everyone, in exchange for freedom from annual testing.

Traditional Safe Harbor

The traditional safe harbor offers two formulas. The matching option requires a dollar-for-dollar match on the first 3% of compensation deferred, plus 50 cents on the dollar on the next 2%, for a maximum match of 4% of pay. The nonelective option requires the employer to contribute at least 3% of each eligible employee’s compensation whether that employee defers anything or not.¹² Under either formula, employer contributions must be 100% vested immediately.

QACA Safe Harbor

A Qualified Automatic Contribution Arrangement combines safe harbor status with automatic enrollment. The employer must either match 100% of the first 1% of pay deferred plus 50% of the next 5%, or make a 3% nonelective contribution.¹³ The default deferral rate must start at least at 3% and gradually increase each year the employee participates. Unlike the traditional safe harbor, QACA employer contributions can use a two-year cliff vesting schedule.

Annual Notice

Safe harbor plans require an annual written notice to each eligible employee, delivered at least 30 days but no more than 90 days before the start of each plan year.¹⁴ The notice explains the contribution formula, deferral elections, vesting, and withdrawal rules. Missing it can jeopardize safe harbor status for the entire year.

What Happens If a Plan Loses Qualified Status

Disqualification is the outcome the whole testing regime exists to prevent. The IRS doesn’t impose it lightly, but the consequences show why timely correction matters.

For NHCEs, employer contributions during disqualified years must be included in income to the extent the employee is vested. HCEs face a much harsher outcome: if the disqualification stems from a coverage or participation failure, the HCE must include the entire vested account balance that hasn’t already been taxed in income for that year.¹⁵ Distributions from a disqualified plan cannot be rolled over to an IRA or another retirement plan, so participants can’t defer that tax hit.

For the employer, the plan trust loses its tax-exempt status and must file income tax returns on its investment earnings. The employer’s deduction for contributions is delayed until the amounts are included in employees’ income, and contributions become subject to FICA and FUTA at the time of contribution or vesting.¹⁵

Fixing Errors Through EPCRS

The IRS maintains the Employee Plans Compliance Resolution System (EPCRS) specifically to let sponsors fix problems without losing qualified status. It has three tiers:¹⁶

The Self-Correction Program allows correction of certain failures without contacting the IRS or paying a fee, generally for operational errors caught and fixed promptly.
The Voluntary Correction Program lets the sponsor apply to the IRS before any audit, pay a user fee, and receive written approval of the correction.
The Audit Closing Agreement Program applies when errors turn up during an IRS audit; the sponsor pays a negotiated sanction that’s typically larger than a VCP fee.

VCP is the route that matters most for old testing failures. If a sponsor discovers a testing error from a prior year that wasn’t corrected inside the 12-month window, VCP may be the only way to preserve the plan’s qualified status. The user fees are modest against the tax consequences of disqualification, which is why early voluntary correction is almost always the cheaper choice.

1
Internal Revenue Service. Retirement Plans Definitions
2
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
3
Office of the Law Revision Counsel. 26 U.S. Code 318 – Constructive Ownership of Stock
4
Office of the Law Revision Counsel. 26 USC 416 – Special Rules for Top-Heavy Plans
5
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs, as Adjusted
6
Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
7
Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500
8
Internal Revenue Service. EPCRS Handbook Chapter 7 – 401(k) Determination Issues
9
Internal Revenue Service. Is My 401(k) Top-Heavy?
10
Internal Revenue Service. Top-Heavy Plans – Employee Plans Issue Resource Guide
11
Internal Revenue Service. Issue Snapshot – Plan Forfeitures Used for Qualified Nonelective and Qualified Matching Contributions
12
eCFR. 26 CFR 1.401(k)-3 – Safe Harbor Requirements
13
Internal Revenue Service. FAQs – Auto Enrollment – Are There Different Types of Automatic Contribution Arrangements for Retirement Plans
14
Internal Revenue Service. Notice Requirement for a Safe Harbor 401(k) or 401(m) Plan
15
Internal Revenue Service. Tax Consequences of Plan Disqualification
16
Internal Revenue Service. EPCRS Overview