Understanding Non-Discrimination Testing

The Average Deferral Percentage (ADP) test determines whether the plan is discriminating in favor of Highly Compensated Employees (HCEs) with respect to employee deferrals, which include pre-tax contributions and Roth contributions, but exclude catch-up contributions. The Average Contribution Percentage (ACP) test is similar, but instead of employee contributions, it considers the employer contributions.

The first step in these tests is to separate eligible employees into HCE and Non-HCE (NHCE) groups. HCEs include those employees earning over $160,000 (for 2025 and 2026) and 5% owners of the employer, as well as direct relatives. All other eligible employees are considered to be NHCEs.

The plan passes the tests if the contributions (employee contributions for ADP test or employer contributions for ACP test) of the HCEs do not exceed the greater of:

The most common correction for failing these tests is to distribute the excess contributions to HCEs (in the case of an ADP test failure) or forfeit the excess employer contributions (in the case of an ACP test failure). In calculating the excess amounts to be distributed, certain contributions may be reclassified as catch-up contributions, in order to reduce the amount to be distributed. No penalties are incurred if the excess contributions are distributed within 2 ½ months after the close of a plan year (March 15th for a calendar year plan). If this distribution is made after the 2 ½ month deadline, a 10% excise tax may apply. Another correction option allows for an additional contribution, known as a Qualified Non-Elective Contribution (QNEC), to be made to NHCEs. Either correction option must be implemented by the end of the following plan year in order to maintain qualified plan status. If the corrective actions are not performed timely, the plan may use the IRS’s self-correction program to correct the error. Certain plan designs, such as safe harbor contribution plans, preclude the plan from requiring the ADP/ACP tests.

The 402(g) limit test determines if the individual deferrals made through pre-tax and Roth deferrals are within the annual limit set by the IRS. When determining the amount of the contribution made by the individual, it should include both pre-tax and Roth contributions. For those participants age 50 and over, there is a separate pre-tax catch-up contribution limitation. The 2025/2026 limits are as follows:

As part of the SECURE Act 2.0, for years beginning after December 31, 2024, participants turning 60, 61, 62, or 63 during the year may be eligible for additional catch-up contributions. The total annual catch-up contributions for these participants are limited to $11,250 for 2025 and 2026.

Contributions in excess of these limits must be returned to participants by April 15th following the plan year. If the excess deferral is not refunded by this date, then the participant will be taxed on the amount of the deferral in the year it was withheld and in the year it was refunded (double taxation).

The 415 annual additions test limits the overall annual contributions a participant may have contributed to a defined contribution plan. The contributions include all contributions made to the plan including pre-tax and Roth contributions, employer contributions, safe harbor contributions, and any allocation of forfeitures. Rollover contributions and catch-up contributions are not included. The 415 limit set by the IRS for 2025 and 2026 is the lesser of 100% of the participant’s gross compensation or $70,000 and $72,000, respectively.

If the contributions made are in excess of the limits, they will be corrected based on the provisions in the plan document, which most commonly are refunding of excess employee deferrals and forfeiting of excess employer contributions.

The coverage test is required to ensure that the plan covers a fair representation of employees. A plan must pass either the ratio percentage test or the average benefit test.

In order to pass the ratio percentage test, the plan must cover 70% of employees who have met the statutory minimum age and services requirements set by the IRS (age of 21 and one year of service).The calculation is as follows:

If the plan fails this test, then the average benefit test is performed. If the plan fails the average benefits test, the employer may make an amendment to the plan, up to 9 ½ months after the plan year end, in order to retroactively expand the plan coverage in order to pass the test.

If, as of the determination date, the account balances for the key employees exceed 60% of the total account values for all employees, then the plan is considered to be top-heavy. A key employee is defined as an employee with gross compensation over the limit set by the IRS (which for 2025 and 2026 is $230,000 and $235,000, respectively), a 5% owner of the business, or an employee owning more than 1% of the business with gross compensation greater than $150,000. Key employees are determined using the prior year information.

If the plan fails the top-heavy test, the employer may correct this by making a contribution of at least 3% of compensation to all NHCEs. Additionally, a top-heavy plan must have minimum vesting schedules of three-year cliff vesting or a six-year graduated vesting.

The tests described above are the most commonly required tests for defined contribution plans, but this list is not all-inclusive. Additional tests may be required, based on the design of the plan. It is important for employers to provide complete and accurate employee census data to the third-party administrator to ensure the testing is properly completed. It is the employer’s fiduciary responsibility to understand and monitor the required annual discrimination testing and results. Employers must ensure all corrections are properly made, by the specified deadlines, in order for the plan to continue to be a qualified plan under ERISA.

Author: Christine Flaker, CPA, Principal |[email protected]