Non-discrimination testing (NDT) is a mandatory annual requirement imposed by federal regulators, including the Internal Revenue Service (IRS) and the Department of Labor (DOL), for employers who offer certain benefit plans. The purpose of this testing is to ensure that employer-sponsored plans operate in a manner that is fair and equitable for all employees. These compliance checks prevent the design or operation of a plan from disproportionately favoring a company’s owners, officers, or highly compensated staff. Successfully passing NDT allows the plan and its participants to maintain favorable tax benefits.
The Legal Basis for Non-Discrimination Testing
Non-discrimination testing ensures that benefit plans do not operate to provide better benefits to high-income earners. The tax advantages associated with these plans, such as tax-deferred growth or pre-tax payment of premiums, are intended to encourage broad workforce participation. To maintain the tax-advantaged status of a plan, the Internal Revenue Code (IRC) mandates that employers demonstrate fairness in participation and benefit distribution.
The rules for qualified retirement plans, such as 401(k)s, are governed primarily by IRC Section 401(a)(4), which requires that contributions or benefits must not discriminate in favor of highly compensated employees. Cafeteria plans are subject to separate non-discrimination rules under IRC Section 125. These regulations establish the compliance framework employers must satisfy to retain their tax deductions and the employees’ tax exclusions.
Defining Employee Classifications for Testing Purposes
All non-discrimination testing compares the participation and benefit levels of two distinct employee groups: Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). Accurate classification of every employee is a foundational step in the compliance process.
An employee is classified as an HCE if they meet one of two criteria during the prior year. The ownership test applies to anyone who owned more than 5% of the business at any point during the current or preceding year, regardless of compensation. The compensation test applies if the employee’s compensation exceeded a specific dollar threshold in the preceding year, such as $155,000 for the 2024 testing year, and the employer applies the top-paid group election. Non-Highly Compensated Employees are all employees who do not meet the criteria to be classified as an HCE.
Types of Benefit Plans Subject to Non-Discrimination Testing
Common employee benefit structures are subject to federal non-discrimination rules to ensure equitable access and utilization. Qualified retirement plans, including 401(k) plans, 403(b) plans for non-profits, and profit-sharing plans, must demonstrate that the rates of employee contributions and employer matching do not disproportionately favor highly compensated staff.
Cafeteria Plans (Section 125 plans) require NDT for eligibility, the availability of benefits, and the concentration of benefits elected by key employees. Self-Insured Health Plans also require testing to ensure that the plan’s benefits do not favor HCEs regarding coverage or contribution amounts.
The Primary Non-Discrimination Tests for Qualified Plans
Non-discrimination requirements apply to qualified retirement plans, particularly 401(k)s, to maintain the plan’s tax-favored status. These tests focus on comparing the average contribution rates of the HCE group against the NHCE group. The results of these calculations determine the maximum allowable contribution percentages for HCEs.
Average Deferral Percentage Test (ADP)
The Average Deferral Percentage (ADP) test specifically examines employee elective deferrals, including both pre-tax and Roth contributions. The test calculates the average deferral percentage for the HCE group and compares it to the average deferral percentage for the NHCE group, often using the prior year’s NHCE average. The HCE average is restricted to a maximum determined by a formula based on the NHCE average.
ADP Formula
Under this formula, the HCE average cannot exceed the greater of two limits:
1. 125% of the NHCE average.
2. The NHCE average plus two percentage points (but not more than double the NHCE average).
For example, if the NHCE average deferral is 4%, the HCE average cannot exceed 6% (4% plus 2%). If the NHCE average is 8%, the HCE average cannot exceed 10% (125% of 8%).
Average Contribution Percentage Test (ACP)
The Average Contribution Percentage (ACP) test applies the same mathematical comparison structure as the ADP test but focuses on different types of contributions. This test evaluates employer matching contributions and any voluntary after-tax contributions made by employees. The goal is to ensure that the employer match schedule and the opportunity for after-tax savings do not favor the highly compensated employee group.
The ACP test utilizes the same two-part formula as the ADP test to determine the maximum allowable average contribution rate for the HCE group. A plan must pass both the ADP and ACP tests independently to be considered non-discriminatory regarding employee and employer contributions. Failure of either test requires the plan’s operation to be corrected to rebalance the benefit distribution.
Top-Heavy Test
The Top-Heavy test is distinct from the ADP and ACP calculations, focusing on the allocation of plan assets rather than contribution rates. This test ensures that the total value of assets held by “key employees” does not become too concentrated within the plan. Key employees include any officer earning over a specific amount ($220,000 for 2024) or any owner of more than 5% of the company.
A plan is deemed “Top-Heavy” if the total account balances of key employees exceed 60% of the total assets of the plan as of the last day of the preceding plan year. If classified as Top-Heavy, the employer is required to make a minimum contribution, usually 3% of compensation, to all non-key employees to maintain the plan’s qualified status. This ensures that all employees receive a baseline benefit.
Corrective Actions and Consequences of Failing Testing
When a qualified plan fails the ADP or ACP tests, the employer must take corrective action to re-establish compliance within a specific regulatory window. The most common solution is to refund excess contributions to the Highly Compensated Employees (HCEs). This involves calculating the exact amount of contributions that caused the failure and distributing that amount back to the HCEs, making the distribution taxable income for the recipients.
Alternatively, the employer can make Qualified Non-Elective Contributions (QNECs) or Qualified Matching Contributions (QMACs) to the Non-Highly Compensated Employees (NHCEs). QNECs are 100% immediately vested employer contributions added to NHCE accounts to raise their average contribution percentage to a passing level. Failure to correct the testing within the initial 2.5-month statutory period results in an additional 10% excise tax applied to the excess contributions. Uncorrected failures can lead to plan disqualification, resulting in the loss of tax-favored status and severe tax liabilities for the employer and participants.
Proactive Strategies for Maintaining Compliance
Employers can adopt several proactive strategies to minimize the risk of failing non-discrimination testing and avoid corrective measures. The most effective method for qualified plans is to implement a Safe Harbor provision, which allows a plan to bypass the ADP and ACP testing entirely. This is accomplished by committing to a mandatory minimum employer contribution, such as a 3% non-elective contribution to all eligible employees or a specific matching formula.
Another strategy is to engage in mid-year monitoring of contribution rates for both HCEs and NHCEs. By running checks several times during the plan year, employers can identify an impending failure and proactively adjust HCE contributions or encourage greater NHCE participation before the year-end deadline. Working with a third-party administrator (TPA) to optimize the plan’s design, particularly regarding eligibility and entry dates, can also help maximize the number of participating NHCEs and improve the plan’s chances of passing the tests.