Non-Discrimination Testing

Non-discrimination testing is a mandatory annual evaluation required by the Internal Revenue Service (IRS) to ensure that a company’s retirement plan, such as a 401(k), does not disproportionately benefit business owners and highly compensated employees (HCEs) at the expense of rank-and-file staff. By comparing the participation and contribution rates of different employee groups, these tests confirm that the plan remains "qualified," allowing both the employer and employees to maintain significant tax advantages. If a plan fails to meet these specific fairness standards, it can result in financial penalties, the loss of tax-exempt status, or the requirement to refund contributions to top earners.

The Regulatory Framework of Plan Compliance

Maintaining a qualified retirement plan is not a "set it and forget it" endeavor. The federal government provides tax incentives for retirement savings with the specific intent of encouraging broad-based participation across the American workforce. To prevent these plans from becoming tax shelters for the wealthy, the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC) mandate rigorous oversight.

For 2026, the IRS has adjusted several key thresholds that define who falls into the "Highly Compensated" category. An employee is generally classified as an HCE if they earned more than $160,000 in the preceding year (2025) or owned more than 5% of the business at any time during the current or preceding year, according to IRS Notice 2025-67.

Understanding these definitions is the first step in managing non-discrimination testing effectively. Failure to accurately identify these groups often leads to skewed results that can trigger an audit.

Key Statistics in Retirement Plan Management (2025-2026)

To understand the scale and importance of compliance, consider the following data points from recent industry surveys and federal reports:

The Primary Tests: ADP and ACP

The most common hurdles in the compliance process are the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. These are the core components of the non-discrimination testing cycle for traditional 401(k) plans.

1. The ADP Test

The ADP test focuses on elective deferrals, the money employees choose to take out of their paychecks before taxes. The test averages the deferral percentages of the HCE group and compares them to the average of the non-highly compensated employee (NHCE) group.

Generally, the HCE group’s average cannot exceed the NHCE group’s average by more than two percentage points, or it cannot be more than 125% of the NHCE average. This ensures that if rank-and-file employees are only saving 2% of their income, the executives cannot be saving 10%.

2. The ACP Test

While the ADP test looks at employee money, the ACP test looks at employer money. It evaluates matching contributions and any after-tax employee contributions. The mathematical logic is similar to the ADP test, ensuring that matching formulas do not unfairly favor those with higher salaries.

Top-Heavy Testing: A Different Perspective

A plan is considered "top-heavy" if more than 60% of the total plan assets are held by "key employees." Key employees include certain officers and owners, even if they don't meet the salary threshold for an HCE.

If a plan becomes top-heavy, the employer is legally required to make a minimum contribution (usually 3%) to the accounts of all non-key employees. This serves as a "rebalancing" mechanism to ensure the plan remains beneficial for the entire company.

Why Compliance Fails: Common Pitfalls

Even with the best intentions, organizations often find themselves failing their non-discrimination testing at the end of the year. According to the 2025 PLANSPONSOR Participant Survey, nearly 40% of employees contribute less than 5% of their income. This low participation among NHCEs is the primary driver of test failures.

Typical reasons for failure include:

• Low Enrollment Rates - When the NHCE group does not participate, the mathematical average for that group drops, severely limiting how much HCEs can contribute.

• Inaccurate Census Data - Using the wrong compensation figures or misclassifying an HCE (forgetting the 5% ownership rule, for instance) will invalidate the results.

• High Turnover - Employees who leave mid-year but were eligible to participate still count toward the NHCE averages, often pulling the numbers down.

Consequences of a Failed Test

If the results of the non-discrimination testing are not favorable, the organization must take corrective action. This usually happens in one of two ways:

• Corrective Distributions - The plan must refund the "excess" contributions to the HCEs. While this fixes the plan's status, it is often a source of frustration for top earners who suddenly face a larger tax bill than expected.

• Qualified Non-Elective Contributions (QNECs) - The employer can choose to "pay their way out" of the failure by making additional contributions to the NHCEs. This raises the NHCE average until the test passes. While this keeps HCE money in the plan, it represents an unplanned expense for the company.

For calendar-year plans, these corrections must typically be completed by March 15th of the following year to avoid a 10% excise tax penalty from the IRS.

Strategies to Ensure Future Success

The shift toward non-discrimination testing as a proactive rather than reactive measure is a hallmark of modern benefits administration. Waiting until December to check the numbers is a recipe for non-compliance.

Adoption of Safe Harbor Plans

As noted in the Vanguard 2025 Report, 30% of plans have now adopted a Safe Harbor design. By committing to a specific matching or non-elective contribution for all employees, the employer can bypass the ADP and ACP tests entirely. This provides certainty for HCEs, knowing their contributions will not be refunded at year-end.

Automatic Enrollment and Escalation

The PLANSPONSOR 2025 Participant Survey highlights that 39.7% of participants simply accept the default option. By setting a high default enrollment rate (e.g., 6% instead of 3%) and implementing automatic annual increases, companies can naturally lift the NHCE average deferral percentage. This creates a "rising tide" that allows HCEs more room to contribute without failing tests.

Mid-Year Checkups

Performing a "mock" test in July allows for adjustments before it is too late. If the mid-year data suggests a potential failure, the organization can launch internal communication campaigns to encourage NHCE participation or adjust HCE contribution limits for the remainder of the year.

Conclusion

The integrity of a retirement program relies on its ability to serve all employees equitably. While the technicalities of non-discrimination testing can be complex, the underlying goal is simple: ensuring that tax-advantaged savings are accessible to everyone, not just those at the top of the organizational chart. By leveraging automatic features, monitoring data accurately, and considering Safe Harbor alternatives, organizations can navigate these regulatory requirements while providing a robust benefit for their entire workforce.

Summary Checklist for Annual Compliance:

• Verify 2026 HCE threshold ($160,000).

• Identify all 5% owners and their family members (attribution rules).

• Review NHCE participation rates mid-year.

• Confirm that "compensation" used for testing matches the plan document's definition.

• Ensure all corrective distributions are processed before the March 15 deadline.