To maintain the tax-advantages of a 401(k) or 403(b) retirement plan, employers must follow the rules established by the Employment Retirement Income Security Act (ERISA) of 1974, including nondiscrimination testing.
401(k) compliance testing ensures that companies administer their 401(k) plans in a fair and equal manner that benefits all employees, rather than just executives and owners. In other words, a 401(k) plan can’t favor one group of employees over another.
Companies must test their plans yearly and address any compliance flaws surfaced by the tests. Often a third-party plan administrator or recordkeeper helps plan sponsors carry out the tests.
Understanding nondiscrimination tests for retirement plans is important both as an employer and as an employee.
401(k) Compliance Testing Explained
Compliance testing is a process that determines whether a company is fairly administering its 401(k) plan under ERISA rules. ERISA mandates nondiscrimination testing for retirement plans to demonstrate that they don’t favor highly compensated employees or key employees, such as company owners. 401(k) compliance testing is the responsibility of the company that offers the plan.
How 401(k) Compliance Testing Works
Companies apply three different compliance tests to the plan each year. These tests look at how much income employees defer into the plan, how much the employer 401(k) match adds up to, and what percentage of assets in the plan belong to key employees and highly compensated employees versus what belongs to non-highly compensated employees.
There are three nondiscrimination testing standards employers must apply to qualified retirement plans.
• The Actual Deferral Percentage (ADP) Test: Analyzes how much income employees defer into the plan
• The Actual Contribution Percentage (ACP): Analyzes employers contributions to the plan on behalf of employees
• Top-Heavy Test: Anayzes how participation by key employees compares to participation by other employees
The Actual Deferral Percentage (ADP) Test
The Actual Deferral Percentage (ADP) test counts elective deferrals of highly compensated employees and non-highly compensated employees. This includes both pre-tax and Roth deferrals but not catch-up contributions made to the plan. This 401(k) compliance testing measures engagement in the plan based on how much of their salary each group defers into it on a yearly basis.
To run the test, employers average the deferral percentages of both highly compensated employees and non-highly compensated employees to determine the ADP for each group. Then the employer divides each plan participant’s elective deferrals by their compensation to get their Actual Deferral Ratio (ADR). The average ADR for all eligible employees of each group represents the ADP for that group.
A company passes the Actual Deferral Percentage test if the ADP for the eligible highly compensated employees doesn’t exceed the greater of:
• 125% of the ADP for the group of non-highly compensated employees
OR
• The lesser of 200% of the ADP for the group of non-highly compensated employees or the ADP for those employees plus 2%
The Actual Contribution Percentage (ACP) Test
Plans that make matching contributions to their employees’ 401(k) must also administer the Actual Contribution Percentage (ACP) test. Companies calculate this the same way as the ADP test but they substitute each participant’s matching and after-tax contributions for elective deferrals when doing the math.
This test reveals how much the employer contributes to each participant’s plan as a percentage, based on their W-2 income. Companies pass the Actual Contribution Percentage test if the ACP for the eligible highly compensated employees doesn’t exceed the greater of:
• 125% of the ACP for the group of non-highly compensated employees
OR
• The lesser of 200% of the ACP for the group of non-highly compensated employees or the ACP for those employees plus 2%
Companies may run both the ADP and ACP tests using prior year or current-year contributions.
Top-Heavy Test
The Top-Heavy test targets key employees within an organization who contribute to qualified retirement plans. The IRS defines a key employee as any current, former or deceased employee who at any time during the plan year was:
• An officer making over $215,000 for 2023 and over $220,000 for 2024
• A 5% owner of the business OR
• An employee owning more than 1% of the business and making over $150,000 for the plan year
Anyone who doesn’t fit these standards is a non-key employee. Top-heavy ensures that lower-paid employees receive a minimum benefit if the plan is too top-heavy.
Under IRS rules, a plan is top heavy if on the last day of the prior plan year the total value of plan accounts for key employees is more than 60% of the total value of plan assets. If the plan is top heavy the employer must contribute up to 3% of compensation for all non-key employees still employed on the last day of the plan year. This is designed to bring plan assets back into a fair balance.
Why 401(k) Compliance Testing Is Necessary
401(k) compliance testing ensures that investing for retirement is as fair as possible for all participants in the plan, and that the plan continues to receive favorable tax treatment from the IRS. The compliance testing rules prevent employers from favoring highly compensated employees or key employees over non-highly compensated employees and non-key employees.
If a company fails a 401(k) compliance test, then they have to remedy that under IRS rules or risk the plan losing its tax-advantaged status. This is a strong incentive to fix any issues with non-compliant plans as it can cost employers valuable tax benefits.
Nondiscrimination testing can help employers determine participation across different groups of their workers. It can also shed light on what employees are deferring each year, in accordance with annual 401k plan contribution limits.
Highly Compensated Employees
The IRS defines highly compensated employees for the purposes of ADP and ACP nondiscrimination tests. Someone is a highly compensated employee if they:
• Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation they earned or received,
OR
• Received compensation from the business of more than $150,000 in 2023 and $155,000 in 2024 or $135,000 (if the preceding is 2022) and was in the top 20% of employees when ranked by compensation
If an employee doesn’t meet at least one of these conditions, they’re considered non-highly compensated. This distinction is important when compliance testing 401(k) plans, as the categorization into can impact ADP and ACP testing outcomes.
Non-Highly Compensated Employees
Non-highly compensated employees are any employees who don’t meet the compensation or ownership tests, as established by the IRS for designated highly compensated employees. So in other words, a non-highly compensated employee would own less than 5% of the interest in the company or have compensation below the guidelines outlined above.
Again, it’s important to understand who is a non-highly compensated employee when applying nondiscrimination tests. Employers who misidentify their employees run the risk of falling out of 401(k) compliance. Likewise, as an employee, it’s important to understand which category you fall into and how that might affect the amount you’re able to contribute and/or receive in matching contributions each year.
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How to Fix a Non-Compliant 401(k)
The IRS offers solutions for employers who determine that their 401(k) is not compliant, based on the results of the ADP, ACP or Top-Heavy tests. When a plan fails the ADP or ACP test, the IRS recommends the following:
• Refunding contributions made by highly compensated employees in order to bring average contribution rates in alignment with testing standards
• Making qualified nonelective contributions on behalf of non-highly compensated employees in order to bring their average contributions up in order to pass test
Employers can also choose to do a combination of both to pass both the ADP and ACP tests. In the case of the Top-Heavy test, the employer must make qualified nonelective contributions of up to 3% of compensation for non-highly compensated employees.
Companies can also avoid future noncompliance issues by opting to make safe harbor contributions. Safe harbor plans do not have to conduct ADP and ACP testing, and they can also be exempt from the Top-Heavy test if they’re not profit sharing plans. Under safe harbor rules, employers can do one of the following:
• Match each eligible employee’s contribution on a dollar-for-dollar basis up to 3% of the employee’s compensation and 50 cents on the dollar for contributions that exceed 3% but not 5% of their compensation.
• Make a nonelective contribution equal to 3% of compensation to each eligible employee’s account.
Safe harbor rules can relieve some of the burden of yearly 401(k) testing while offering tax benefits to both employers and employees.
The Takeaway
A 401(k) is a key way for employees to help save for retirement and reach their retirement goals. It’s important for employers to conduct IRS-mandated 401(k) compliance testing in order to ensure that their 401(k) plans are administered in a fair and equal manner that benefits all employees.
If you don’t have a 401(k) at work, however, or you’re hoping to supplement your 401(k) savings, you may want to consider opening an Individual Retirement Account (IRA) to help save for retirement. Since IRAs are not employer-sponsored, they’re not subject to 401(k) compliance testing, though they do have to follow IRS rules regarding annual contribution limits and distributions.
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FAQ
What is top-heavy testing for 401(k)?
Top-heavy testing for 401(k) plans determine what percentage of plan assets are held by key employees versus non-key employees. If an employer’s plan fails the top-heavy test, they must make qualified, nonelective contributions on behalf of non-key employees in order to bring the plan into compliance.
What happens if you fail 401(k) testing?
If an employer-sponsored plan fails 401(k) compliance testing, the IRS requires the plan to make adjustments in order to become compliant. This can involve refunding contributions made by highly-compensated employees, making qualified nonelective contributions on behalf of non-highly compensated employees or a combination of the two.
What is a highly compensated employee for 401(k) purposes?
The IRS defines a highly compensated employee using two tests based on compensation and company ownership. An employee is highly compensated if they have a 5% or more ownership interest in the business or their income exceeds a specific limit for the year. Income limits are set by the IRS and updated periodically.
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