Is Non-Discrimination Testing Required for Your Plan?

If your company sponsors a 401(k), a cafeteria plan, a self-funded health plan, a dependent care assistance program, or group-term life insurance, nondiscrimination testing for benefit plans is almost certainly a yearly requirement. The IRS uses these tests to confirm that tax-advantaged plans aren’t tilted toward owners and high earners at the expense of rank-and-file workers. Skipping the tests, or failing them without correction, can strip a plan of its tax-favored status entirely.

A handful of plan designs sidestep testing: safe harbor 401(k)s, most government plans, church plans, and, for now, fully insured group health plans. Everything else needs to be tested each year.

The HCE and NHCE Split Every Test Uses

Every nondiscrimination test compares what highly compensated employees (HCEs) receive against what non-highly compensated employees (NHCEs) receive. You’re an HCE if you owned more than 5% of the business at any point in the current or prior year, regardless of pay.¹ You’re also an HCE if you earned more than a set threshold in the preceding year. For plan years beginning in 2026, that threshold is $160,000 in compensation earned during 2025.² Employers may narrow this further by electing to count only the top 20% by pay. Everyone else is an NHCE.

Some tests also use a related category called “key employees,” which includes officers earning above a set compensation level, 5% owners, and 1% owners earning over $150,000. The two groups overlap but aren’t identical, and which label matters depends on which test you’re running.

401(k) Plans

Traditional 401(k) plans face the most familiar battery of tests. The Actual Deferral Percentage (ADP) test compares the average percentage of pay HCEs defer against the NHCE average. The Actual Contribution Percentage (ACP) test does the same comparison for employer matching contributions and after-tax employee contributions.

Both tests set a mathematical ceiling. If NHCEs average 2% or less, HCEs can average up to double that rate. If NHCEs average more than 2%, HCEs can exceed the NHCE average by no more than 2 percentage points. This is where most plans stumble, because HCEs tend to save at higher rates.

A 401(k) may also be subject to a top-heavy test. A plan is top-heavy when more than 60% of its total assets belong to key employees. When that happens, the employer generally must make a minimum contribution for all non-key employees.

403(b) Plans

Plans offered by nonprofits and public schools under Section 403(b) get a partial pass. They’re generally exempt from the ADP test and from top-heavy rules for elective deferrals. If the plan includes employer matching contributions, though, those matches must pass the ACP test just like a 401(k).³

In place of ADP testing, 403(b) plans use a universal availability requirement: the employer must give every eligible employee the chance to make elective deferrals. Participation can’t be restricted to certain departments or job classifications.

Section 125 Cafeteria Plans

Cafeteria plans that let employees choose between taxable cash and pre-tax benefits (health insurance premiums, FSAs, and similar) must satisfy three tests: an eligibility test, a contributions and benefits test, and a key employee concentration test that caps key employees at 25% of total plan benefits. When a cafeteria plan fails, HCEs lose their pre-tax treatment and must include the value of those benefits in taxable income.

Self-Funded Health Plans

Self-insured medical reimbursement plans have their own testing rules under IRC Section 105(h). The plan must pass an eligibility test that checks whether a broad enough group of employees can participate, and a benefits test that checks whether the same benefits available to HCEs are also available to other participants.⁴

When a self-funded plan fails, HCEs must include in taxable income the amount of discriminatory benefits they received. The plan doesn’t lose its tax status wholesale, but the favorable treatment disappears at the top.

One boundary worth noting: Section 105(h) applies only to self-funded plans. The Affordable Care Act extended similar rules to fully insured group health plans under Section 2716, but the IRS has indefinitely delayed enforcement pending further regulatory guidance. Fully insured plans currently face no penalties for noncompliance with the ACA nondiscrimination provisions. That could change if the IRS issues final regulations.

Dependent Care Assistance Programs

A dependent care assistance program (DCAP) that lets employees set aside pre-tax dollars for childcare or eldercare must pass tests under IRC Section 129. Those include an eligibility test, a contributions and benefits test, and an ownership concentration test limiting employees who own more than 5% of the company to no more than 25% of the program’s total benefits.⁵

DCAPs also face a 55% average benefits test: the average benefit provided to NHCEs across all of the employer’s dependent care plans must equal at least 55% of the average provided to HCEs.⁵ Failure means HCEs lose the exclusion and their dependent care benefits become taxable income.

Group-Term Life Insurance

Employer-provided group-term life insurance up to $50,000 in coverage is normally tax-free. If the plan discriminates in favor of key employees, that exclusion disappears for those key employees. Section 79 requires the plan pass both an eligibility test and a benefits test.⁶

The eligibility test can be met three ways: covering at least 70% of all employees, having at least 85% of participants be non-key employees, or using a classification the IRS doesn’t consider discriminatory. The benefits test requires that whatever coverage is available to key employees is also available to everyone else. A plan won’t fail the benefits test just because coverage amounts are tied to salary, since a uniform relationship to compensation is allowed.⁶

Plans That Don’t Need Testing

Safe Harbor 401(k) Plans

The most common way to skip annual ADP and ACP testing is to adopt a safe harbor 401(k). These plans automatically satisfy both tests by committing to a minimum employer contribution. Typical options are a dollar-for-dollar match on the first 3% of pay deferred plus 50 cents on the dollar for the next 2%, or a flat 3% nonelective contribution to all eligible employees whether they defer or not.⁷

A full safe harbor plan also satisfies top-heavy minimum contribution requirements. The tradeoff is cost: the employer must contribute for all eligible employees, and those contributions must vest immediately (or on a two-year cliff schedule for a qualified automatic contribution arrangement). For many small and mid-sized employers, the guaranteed contribution is cheaper than the risk of failing testing and processing corrections.

Government and Church Plans

Government-sponsored plans are broadly exempt from ERISA and from most nondiscrimination testing under the Internal Revenue Code. A 403(b) plan run by a public school or government entity, for example, only needs to meet the universal availability requirement for elective deferrals.

Church plans get the widest exemption. Plans sponsored by churches or qualified church-controlled organizations are not subject to ERISA unless the church affirmatively elects ERISA coverage.⁸ A 403(b) plan of a “steeple” church or qualified church-controlled organization isn’t subject to any nondiscrimination testing at all.

No Small-Employer Exemption

Headcount doesn’t get you out of testing. A 401(k) with 10 participants faces the same requirements as one with 10,000. Small employers often gravitate toward safe harbor designs precisely because a failed test on a small plan can be disproportionately expensive to fix.

Deadlines

Testing must be completed within 12 months after the end of the plan year. For a calendar-year plan, results should be finalized by December 31 of the following year. That outer deadline is misleading, though, because corrective distribution deadlines hit much earlier. For a calendar-year 401(k), the 2½-month excise tax deadline falls on March 15. Most plan administrators aim to finish testing by late February or early March so they can process any corrections before that trigger.

Running testing early also creates room to adjust. If preliminary results look shaky, the employer can push NHCE participation, tweak matching formulas, or prepare qualified nonelective contributions before the plan year closes.

What Happens When a Plan Fails

For a 401(k) that fails ADP or ACP, the employer generally has 12 months after the close of the plan year to distribute or recharacterize excess contributions to HCEs. Miss that 12-month window and the plan’s cash or deferred arrangement can lose its qualified status entirely, which is a tax disaster for every participant.⁹

Even within that 12 months, timing matters. If the employer doesn’t distribute or recharacterize excess contributions within 2½ months after the plan year ends (6 months for plans with an eligible automatic contribution arrangement), the employer owes a 10% excise tax on the excess.⁹

Corrective distributions to HCEs are taxable in the year distributed and reported on Form 1099-R. They cannot be rolled over into an IRA or another retirement plan.⁹ Any employer matching contributions tied to those excess deferrals are forfeited back to the plan. For cafeteria plans, DCAPs, and group-term life insurance, the mechanics differ but the theme holds: HCEs lose the tax-favored treatment and their benefits become taxable income.

How to Correct a Failed 401(k) Test

Employers have two main paths. The first is distributing excess contributions back to HCEs, which lowers the HCE side of the equation until the test passes. It’s the most common approach, though HCEs understandably dislike having money kicked out of their retirement accounts.

The second path is making qualified nonelective contributions (QNECs) for NHCEs. The employer contributes the same percentage of compensation for all eligible NHCEs, raising the NHCE average enough to pass. Made within 12 months after the plan year ends, these corrective contributions avoid the 10% excise tax.⁹

Miss the correction deadline and the employer can still fix things through the IRS Voluntary Correction Program, which requires an application, a user fee, and a proposed correction. It’s more expensive than correcting within the statutory window, but it beats plan disqualification. If the IRS catches the failure on audit first, the employer may have to negotiate under the Audit Closing Agreement Program, which carries steeper sanctions.⁹

1
eCFR. 26 CFR 1.414(q)-1T – Highly Compensated Employee (Temporary)
2
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs (Notice 2025-67)
3
eCFR. 26 CFR 1.403 – Tax-Sheltered Annuity Regulations
4
Internal Revenue Service. Technical Assistance Request – Section 105(h)
5
Office of the Law Revision Counsel. 26 USC 129 – Dependent Care Assistance Programs
6
Office of the Law Revision Counsel. 26 USC 79 – Group-Term Life Insurance Purchased for Employees
7
Internal Revenue Service. Notice Requirement for a Safe Harbor 401(k) or 401(m) Plan
8
Internal Revenue Service. Issue Snapshot – Church Plans, Automatic Contribution Arrangements, and the Consolidated Appropriations Act, 2016
9
Internal Revenue Service. 401(k) Plan Fix-it Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests