Non-Discrimination Testing: What It Means for Employers

What it means in practice

What the term means. Federal tax law gives some employee benefits special treatment: pre-tax 401(k) deferrals, salary reductions through a cafeteria plan, excluded dependent care assistance and tax-free medical reimbursements. In exchange, the Internal Revenue Code requires each of these plans to show, usually every plan year, that the benefit is not tilted toward owners and higher-paid staff. The IRS describes the 401(k) version as testing that contributions for rank-and-file employees "are proportional to contributions made for owners and managers." This is an IRS benefit-plan concept, not employment discrimination law; for that, see disparate treatment.

Who counts as highly compensated. For retirement plans, section 414(q) makes an employee an HCE if they were a 5% owner at any time during the current or preceding year, or were paid more than the indexed threshold in the preceding year; the employer may elect to limit the pay group to the top-paid 20% of employees. The IRS COLA table shows $160,000 for both 2025 and 2026, so 2025 pay above $160,000 identifies HCEs for the 2026 plan year. The IRS Fix-It Guide says a spouse, child, grandparent or parent of a 5% owner is treated as a 5% owner, and warns that family members "will have different last names." Each test below uses its own definition, so one employee can be an HCE for one test and not another.

Coverage under section 410(b). A qualified plan must cover enough non-highly compensated employees (NHCEs). Under 26 CFR 1.410(b)-2, the ratio percentage test is met if the percentage of NHCEs benefiting, divided by the percentage of HCEs benefiting, is at least 70%. A plan that fails can instead pass the average benefit test, which combines a nondiscriminatory classification test with an average benefit percentage test. Employees covered by a collective bargaining agreement where retirement benefits were bargained in good faith, and certain nonresident aliens, are excluded from the count. A 401(k) plan applies section 410(b) as of the last day of the plan year, counting everyone who was an employee on any day of the year (26 CFR 1.410(b)-8).

Amounts under section 401(a)(4). Section 401(a)(4) bars contributions or benefits that discriminate in favor of HCEs. The regulations say either the contributions or the benefits must be nondiscriminatory in amount, not both, and that benefits, rights and features and plan amendments must also be nondiscriminatory (26 CFR 1.401(a)(4)-1). A 401(k) arrangement is deemed to satisfy the amounts test because elective deferrals are tested separately under the ADP test.

ADP and ACP tests for 401(k) plans. The actual deferral percentage (ADP) test compares average deferral rates of HCEs and NHCEs; the actual contribution percentage (ACP) test does the same for matching and after-tax contributions. The formulas and a worked limit appear on our 401(k) plan page. If a test fails, 26 CFR 1.401(k)-2 allows only three corrections: qualified nonelective or matching contributions for NHCEs, distribution of excess contributions, or recharacterization. Distributions start with the HCEs who contributed the highest dollar amounts, and excess contributions cannot be held in a suspense account. A corrective distribution is taxable to the HCE in the year distributed.

ADP and ACP deadlines and the 10% excise tax. Section 4979 imposes a tax, paid by the employer, of 10% of excess contributions and excess aggregate contributions, unless they are distributed or forfeited within the first 2 1/2 months of the following plan year (6 months for an eligible automatic contribution arrangement). The IRS Fix-It Guide adds that the plan has 12 months after the plan year to correct; if not, the cash or deferred arrangement is no longer qualified and the entire plan may lose its tax-qualified status. The IRS says an employer paying the tax files Form 5330. For a calendar 2026 plan year, the dates are March 15, 2027, June 30, 2027 for an eligible automatic contribution arrangement, and December 31, 2027.

Top-heavy rules under section 416. Top-heavy testing looks at key employees, not HCEs. Section 416(i) defines a key employee as an officer paid above the indexed amount ($235,000 for 2026), a 5% owner, or a 1% owner paid more than $150,000, and limits the number of officers counted to 50 (or, if less, the greater of 3 or 10% of employees). A defined contribution plan is top-heavy when key employee accounts exceed 60% of all accounts on the determination date, which is the last day of the preceding plan year. A top-heavy 401(k) plan owes non-key employees employed on the last day of the plan year a contribution of up to 3% of compensation, capped at the highest rate any key employee receives, and must use 3-year cliff or 6-year graded vesting.

Safe harbor exemption. The IRS says a safe harbor 401(k) plan is not required to perform the ADP and ACP tests if it meets certain requirements, and SIMPLE 401(k) plans are also exempt from annual testing. Under section 416(g)(4)(H), a plan consisting solely of safe harbor deferrals and qualifying matching contributions is not top-heavy; the IRS says "certain safe harbor 401(k) plans" escape the top-heavy rules, so a plan with extra profit-sharing contributions may not. Section 410(b) coverage still applies to every qualified plan (26 CFR 1.410(b)-2(a)). The same rules reach other plan types; for example, nonelective contributions under a 403(b) plan are subject to section 410(b).

Cafeteria plans under section 125. Section 125 has three tests. Eligibility: the plan cannot favor highly compensated individuals, here officers, more-than-5% shareholders, highly compensated employees, and their spouses and dependents. Contributions and benefits: qualified and total benefits cannot favor highly compensated participants. Key employee concentration: qualified benefits to key employees cannot exceed 25% of those provided to all employees. Proposed regulations (72 FR 43938, 2007), which taxpayers may rely on pending final rules, would adopt section 410(b) classification tests for eligibility, require a uniform opportunity to elect benefits, test as of the last day of the plan year, and add a safe harbor for premium-only plans. The health flexible spending account usually sits inside this plan.

Simple cafeteria plans. Publication 15-B says an employer that averaged 100 or fewer employees in either of the 2 preceding years can set up a simple cafeteria plan, which is treated as meeting the cafeteria nondiscrimination rules. Employees with at least 1,000 hours in the preceding plan year must be eligible, and the employer must make a minimum contribution.

Dependent care assistance under section 129. A dependent care assistance program must not discriminate in favor of HCEs in eligibility, contributions or benefits. Section 129(d) adds two numeric tests: no more than 25% of the year's dependent care assistance may go to more-than-5% owners and their spouses or dependents, and the average benefits for non-HCEs must be at least 55% of the average for HCEs. For benefits through salary reduction, the 55% test may disregard employees paid less than $25,000, and employees under age 21 or with less than 1 year of service may be excluded.

Self-insured medical reimbursement plans under section 105(h). A plan is self-insured unless reimbursements come from an insurance policy issued by a licensed insurer or a regulated prepaid health plan (26 CFR 1.105-11). Section 105(h) requires the plan to benefit 70% or more of all employees (or 80% of eligible employees if 70% are eligible) or a nondiscriminatory classification, and to provide every benefit offered to highly compensated individuals to all other participants. Here "highly compensated individual" means the 5 highest-paid officers, more-than-10% shareholders and the highest-paid 25% of employees. Employees with under 3 years of service, under age 25, part-time or seasonal may be excluded.

What failing costs. Rank-and-file employees generally keep their tax benefits; the favored group loses them. A cafeteria plan that fails makes highly compensated participants or key employees include the taxable benefits they could have chosen in wages (Pub 15-B). A failed dependent care program still works for non-HCEs, but HCEs lose the exclusion. Under a discriminatory self-insured medical plan, excess reimbursements go in Form W-2 box 1 for the HCI but are generally not subject to income tax withholding or FICA (Pub 15-B); see imputed income. A qualified plan that fails section 410(b) is not qualified for that year, though a corrective amendment adopted by the 15th day of the 10th month after the plan year may count (26 CFR 1.401(a)(4)-11(g)).

Correction programs. Retirement plan failures can often be fixed through the IRS Employee Plans Compliance Resolution System (EPCRS), which includes self-correction, voluntary correction and audit closing agreements. On October 22, 2026 the IRS issued Revenue Procedure 2026-34, which replaces Revenue Procedure 2021-30, effective that day (IR-2026-126).

Step by step for an employer. (1) List every employee, including those who terminated during the year and employees of related companies. (2) Gather ownership records, including family members of owners. (3) Send compensation using the plan's own definition. (4) Classify HCEs, key employees and the section 105(h) group separately. (5) Run each test the plan needs and keep the results. (6) Calendar correction deadlines. The IRS says incorrect data may require rerunning the tests.

Example 1 (illustration): coverage ratio. An employer has 40 nonexcludable NHCEs and 5 HCEs. The plan covers 26 NHCEs (65%) and all 5 HCEs (100%), so its ratio percentage is 65% and it fails the 70% ratio percentage test. If it covered only 4 HCEs (80%), the ratio would be 65% divided by 80%, or 81.25%, a pass.

Example 2 (illustration): cafeteria concentration. Three key employees each elect $5,000 of nontaxable benefits ($15,000) and 10 other employees each elect $3,000 ($30,000). Key employees receive $15,000 of $45,000, or 33.3%, above 25%, so each key employee would include in income the taxable benefits they could have chosen.

Example 3 (illustration): dependent care 55% test. If HCEs average $6,000 of dependent care benefits and non-HCEs average $3,000, the ratio is 50%, below 55%. The non-HCE average would need to reach $3,300 (55% of $6,000) for this test.

Example 4 (illustration): top-heavy. On December 31, 2025, key employee accounts in a calendar-year 401(k) plan total $700,000 of $1,000,000 in plan accounts, or 70%. The plan is top-heavy for 2026. If the highest key employee contribution rate is at least 3%, a non-key employee paid $50,000 and employed on December 31, 2026 receives at least $1,500.

Where states differ. Non-discrimination testing is federal, but state tax treatment can follow it. For example, the Pennsylvania Department of Revenue says cafeteria plan payments for health, sickness, disability or death coverage are excluded from Pennsylvania compensation only if the program does not discriminate in favor of highly compensated individuals and only to the extent excluded federally, while employee contributions for dependent care and to a section 401 plan are not excludable.

Question: When is cafeteria plan testing done? The proposed regulations say testing is performed as of the last day of the plan year, counting nonexcludable employees and former employees employed on any day during the year.

Question: Who runs the tests? The IRS places responsibility on the plan sponsor, which often relies on a plan administrator or third-party administrator, but the employer supplies the employee, ownership and compensation data.

This entry summarizes federal rules and one state example; it does not decide whether a particular plan passes any test.

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