401(k) Nondiscrimination Testing: How to Stay Compliant and Avoid Refunds

401(k)s are designed to benefit all employees, and if you have employees, the plan is subject to government tests to help ensure they do. Nondiscrimination testing in 401(k) plans, known as Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) testing, is a critical requirement for employers offering traditional (non-safe harbor) retirement plans. These tests ensure that 401(k) benefits do not disproportionately favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs). If you have a Safe Harbor 401(k) plan design, it automatically satisfies these tests.

In this blog, we’ll break down what these tests mean, how they work, and what to do if your plan fails. You’ll learn:

• What is 401(k) nondiscrimination testing?

• How do the ADP and ACP tests work?

• What happens if your 401(k) fails testing?

• How can you avoid failure with safe harbor and other strategies?

What is 401(k) nondiscrimination testing?

401(k) nondiscrimination testing ensures HCEs do not benefit unfairly from a retirement plan.

The IRS mandates annual nondiscrimination testing for most 401(k) plans to prevent favoring owners or high earners. These tests compare deferral and contribution rates between HCEs and NHCEs, promoting fairness and regulatory compliance.

What are the ADP and ACP tests?

The ADP and ACP tests compare employee and employer contributions between HCEs and NHCEs to ensure plan fairness.

ADP (Actual Deferral Percentage) tests how much employees defer from salary (excluding catch ups).
ACP (Actual Contribution Percentage) evaluates employer match and voluntary after-tax contributions.

A plan fails if HCEs’ average rates exceed allowable thresholds, typically tied to NHCE averages (such as 125%, 200%, or plus 2%).

Who qualifies as a Highly Compensated Employee (HCE)?

An HCE is someone who owns over 5% of the company or earned more than $160,000 in the previous year.

IRS guidelines define HCEs in two ways:

1. Ownership: More than 5% of the business in the current or prior year.

2. Compensation: Earned over $160,000 in 2025. If more than 20% of employees earn above this threshold, you can elect to limit the HCE group to only the top 20% of employees by compensation using the IRS-approved Top Paid Group election. This helps reduce the number of employees considering HCEs for testing purposes.

What happens if your plan fails discrimination testing?

Failed testing requires corrective action, usually in the form of refunds to HCEs.

If your plan fails ADP or ACP testing:

• Refunds must be issued to HCEs by March 15 (if your plan ends on December 31st).

• A 10 percent excise tax applies to late refunds.

• Plans can avoid recurring issues by switching to a Safe Harbor 401(k) structure.

How can you prevent future testing failures?

Employers can avoid nondiscrimination failures through several strategic options.

Adopt a Safe Harbor 401(k): Automatically passes testing if contributions and notice rules are met.

Boost NHCE participation: Setting Auto-enrollment at 5% or more of salary deferrals, and financial education can improve your employee compensation ratios.

Explore advanced testing strategies, such as limiting the HCE group using the Top Paid Group election or separating newly eligible employees through Permissive Disaggregation, which can help improve your plan’s testing results.
Learn more about these IRS-approved testing options or consult your 401(k) provider for guidance.

What is a Safe Harbor 401(k) plan?

A Safe Harbor 401(k) automatically satisfies ADP and ACP testing rules by making mandatory employer contributions.

Types of Safe Harbor contributions include:

• Basic match: 100% match on the first 3% plus 50% on next 2 percent

• Enhanced match: Must be at least as generous as the basic match

• Nonelective contribution: A flat 3% of compensation is contributed to all eligible employees, including both NHCEs and HCEs, whether or not they contribute to the 401(k) plan.

Safe Harbor plans also often avoid top-heavy testing, offering administrative ease and plan reliability.

Are there other 401(k) compliance tests?

Yes. The Top-Heavy Test and Coverage Test also play key roles in compliance.

• Top-Heavy Test: Ensures key employees do not hold more than 60% of plan assets.
• Coverage Test: Confirms contributions benefit a broad enough group of NHCEs.

These tests ensure equitable participation and prevent the disqualification of your company’s plan.

What if I’m setting up a new 401(k)?

New plans using prior year testing can assume a 3% NHCE deferral rate unless they set auto enrollment at a higher percentage.

Assuming 3%, this gives HCEs a predictable threshold (typically 5%) in year one. Consider starting with a Safe Harbor plan to avoid uncertainty and increase plan success from the start.

How ShareBuilder 401k Helps You Stay Compliant

At ShareBuilder 401k, we offer full service 401(k) plans built with compliance in mind. Whether you're launching a new plan or switching providers, our platform helps:

• Design a plan that passes ADP and ACP testing
• Offer Safe Harbor solutions
• Educate your employees and encourage participation
• Proactively monitor contribution rates

Key Takeaways

1. What is 401(k) nondiscrimination testing?

• It ensures retirement plans do not favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs) by comparing contribution and deferral rates.

2. What are the ADP and ACP tests?

• These IRS tests check if employee deferrals and employer contributions unfairly favor HCEs.
• The Actual Deferral Percentage (ADP) test measures the average percentage of compensation that Highly Compensated Employees (HCEs) defer into the 401(k)-plan compared to Non-Highly Compensated Employees (NHCEs). It ensures that HCEs are not contributing significantly more than NHCEs.
• The Actual Contribution Percentage (ACP) test measures the average percentage of employer matching and after-tax contributions made for HCEs versus NHCEs. It ensures employer contributions are distributed fairly across employee groups.
• A plan fails if the average rate for HCEs exceeds the IRS limits based on NHCE contribution averages.

3. Who qualifies as a HCE?

• Anyone who owns more than 5% of the company or earned over $160,000 in the prior year.

4. What happens if your plan fails testing?

• Refunds must be issued to HCEs, and a 10% penalty applies to late corrections.

5. How can you avoid testing failures?

• Find a 401(k) provider that can help you educate employees or use testing strategies like Top Paid Group elections.