Overview
Like all qualified plans, 401(k) plans may not discriminate in favor of highly compensated employees regarding the plan’s coverage, contributions, or benefits. To satisfy the nondiscrimination coverage rules, a 401(k) plan must meet either a percentage test or a ratio test.
A plan that appears nondiscriminatory on paper may prove discriminatory in operation — in many 401(k) plans, lower-paid employees elect to take compensation in cash rather than defer it. To ensure the plan is nondiscriminatory in operation, it must satisfy the Actual Deferral Percentage (ADP) test. Plans that include voluntary and matching contributions must also satisfy the Actual Contribution Percentage (ACP) test.
Highly Compensated Employees
The tax code defines an employee as highly compensated (HCE) if he or she:
- Owned more than 5% of the employer at any time during the current year or the preceding year, or
- Received compensation from the employer in excess of $160,000 during the preceding year (2026, inflation-adjusted). The employer may elect to designate as HCEs only those earning more than $160,000 who are also in the top 20% of employees by compensation.
Employers electing the top-paid group election include fewer employees in the HCE group. This increases the plan’s chances of passing the nondiscrimination tests by potentially categorizing relatively high-paid employees as non-HCEs.
Coverage Requirements
To qualify for tax-advantaged status, a 401(k) plan must satisfy either the percentage test or the ratio test — and then pass the 50/40 test. When applying these coverage tests, employers may exclude:
- Employees not meeting the plan’s age and service requirements (age 21 and one year of service)
- Nonresident aliens who earn no U.S.-source income
- Employees covered under collective bargaining agreements
All employees eligible to make elective contributions must be counted, regardless of whether they actually contribute.
At least 70% of all nonhighly compensated employees must be covered by the plan.
Able Manufacturing has 100 employees eligible to participate in its 401(k) plan, of which 10 are considered highly compensated.
Under the percentage test, at least 63 of the 90 non-HCEs (70% × 90) must be covered by Able’s plan to be nondiscriminatory.
The percentage of non-HCEs covered must be at least 70% of the percentage of HCEs covered.
Able Manufacturing has 100 eligible employees, 10 of whom are HCEs. Eight of the 10 HCEs are covered — an HCE coverage ratio of 80%.
Under the ratio test, at least 51 non-HCEs must be covered: 70% × 80% × 90 = 50.4 employees.
If only 6 of the 10 HCEs (60%) were covered, then only 38 non-HCEs would need to be covered: 70% × 60% × 90 = 37.8 employees.
Once a plan passes one of the above tests, it must also benefit the lesser of 50 employees or 40% of all eligible employees at all times. This test is applied to each plan separately — employers cannot aggregate plans to meet this requirement.
A company has 35 employees. Five failed to meet the age and service requirements, leaving 30 eligible employees.
To satisfy the 50/40 test, at least 12 employees (40% × 30) must be covered by the plan.
Non-Discrimination in Contributions — ADP Test
Even if a plan is open to all employees, lower-paid employees may not actually participate. The Actual Deferral Percentage (ADP) test measures whether the plan is nondiscriminatory in operation. It compares the average deferral percentage of HCEs to that of non-HCEs.
The ADP test primarily addresses elective contributions. To pass, the ADP of the HCE group must not exceed the ADP of the non-HCE group by more than:
- 1.25 times — if the non-HCE ADP is 8% or more
- 2 times — if the non-HCE ADP is under 2%
- 2 percentage points — if the non-HCE ADP is between 2% and 8%
| Non-HCE ADP | Rule | Max HCE ADP |
|---|---|---|
| 0.5% | × 2 | 1.0% |
| 1.0% | × 2 | 2.0% |
| 1.5% | × 2 | 3.0% |
| 2.0% | + 2 | 4.0% |
| 3.0% | + 2 | 5.0% |
| 4.0% | + 2 | 6.0% |
| 5.0% | + 2 | 7.0% |
| 6.0% | + 2 | 8.0% |
| 7.0% | + 2 | 9.0% |
| 8.0% | + 2 | 10.0% |
| 9.0% | × 1.25 | 11.25% |
| 10.0% | × 1.25 | 12.50% |
| 11.0% | × 1.25 | 13.75% |
To apply the test, calculate each eligible employee’s individual ADP (elective contribution ÷ compensation), then find the group average for HCEs and non-HCEs. Both employee and group ADPs are calculated to the nearest 0.01%. An eligible employee who makes no elective contribution has an ADP of zero.
| Employee | Compensation | Elective Contribution | ADP | Group ADP |
|---|---|---|---|---|
| Clauser (HCE) | $93,000 | $8,463 | 9.10% | 8.60% |
| Fike (HCE) | $92,000 | $7,820 | 8.50% | |
| Webster (HCE) | $70,000 | $5,740 | 8.20% | |
| Fields | $48,000 | $2,976 | 6.20% | 5.27% |
| Jovin | $34,000 | $1,530 | 4.50% | |
| Randum | $29,000 | $1,479 | 5.10% |
Clauser and Fike each own 40% of the company; Webster owns 20% — all are HCEs as 5%+ owners. HCE group ADP = 8.60%; non-HCE group ADP = 5.27%. Since the non-HCE ADP is between 2% and 8%, the maximum permissible differential is +2 percentage points, meaning the HCE ADP cannot exceed 7.27% (5.27% + 2%). The plan fails the ADP test — 8.60% exceeds 7.27%.
If Webster made no elective contributions, the HCE group ADP would be 5.87% [(9.10% + 8.50% + 0%) ÷ 3], which is below the 7.27% maximum. The plan would pass.
In some cases, qualified nonelective and matching contributions may be counted toward the ADP test, provided they:
- Are fully and immediately vested with the employee and subject to restrictions on premature distributions
- Do not favor highly compensated employees
If qualified matching contributions are used to meet the ADP test, they may not also be used to satisfy the ACP test.
Generally, all of an employer’s 401(k) plans are treated as a single plan for ADP and ACP testing purposes. If a highly compensated employee participates in more than one 401(k) plan of the same employer, all deferrals across all plans are combined to calculate that employee’s individual ADP.
Andy Harris has $100,000 in compensation and participates in two 401(k) plans of his employer. He defers 5% into Plan A ($5,000) and 4% into Plan B ($4,000). His combined ADP = ($5,000 + $4,000) ÷ $100,000 = 9%.
Actual Contribution Percentage (ACP) Test
If a 401(k) plan provides for employer matching contributions or employee voluntary after-tax contributions, it must also satisfy the ACP test. The ACP test applies the same differential rules as the ADP test, but measures voluntary contributions and employer matching contributions rather than elective deferrals.
Only matching contributions actually allocated to the employee’s account during the plan year — based on the amount of the employee’s elective contribution — are included. Nonelective contributions are not part of the ACP test.
An employee with $50,000 in compensation defers 4% ($2,000). The employer matches 50 cents on the dollar ($1,000). The employee also makes voluntary contributions of $5,000.
The employee’s ACP = ($5,000 + $1,000) ÷ $50,000 = 12%.
The same differential table applies to both the ADP and ACP tests. The ACP of the HCE group cannot exceed the ACP of the non-HCE group by more than 1.25 times, 2 times, or 2 percentage points, depending on the non-HCE ACP level. The $360,000 compensation cap also applies when determining ACPs.
If a plan passes the ADP test but fails the ACP test, the employer may — under certain circumstances — reclassify some employee elective contributions as matching contributions, providing a “cushion” to satisfy the ACP test.
Excess Contributions
A plan that contributes too much on behalf of HCEs will fail the nondiscrimination tests. If not corrected, the plan risks losing its tax-qualified status. Employers may correct excess contributions by:
- Reclassifying matching or voluntary contributions as “elective”
- Recharacterizing elective contributions as “voluntary”
- Distributing excess contributions to highly compensated employees
The IRS enforces excess contribution rules strictly. Penalties for noncompliance can be severe, including plan disqualification if not corrected within 12 months of the plan year. A 10% excise tax applies to the employer if not corrected within 2½ months of the plan year end.
Excess contributions distributed to employees are subject to ordinary income taxation but not the 10% premature withdrawal penalty.
Safe Harbor 401(k) Plans
Safe Harbor 401(k) plans use alternative methods to satisfy the ADP and ACP tests, simplifying plan administration and encouraging employer adoption. Employers are not required to use these alternatives but they may eliminate the need to apply the ADP and ACP tests entirely. Employers adopting a safe harbor must provide written notice to each eligible employee annually, in language understandable to the average employee.
As an alternative to the ADP test, the employer must make either a:
- Nonelective contribution of at least 3% of compensation for all eligible non-HCEs, or
- Matching contribution for non-HCEs of: a dollar-for-dollar match on elective contributions up to 3% of compensation, plus a 50¢-per-dollar match on contributions between 3% and 5% of compensation
The match rate for HCEs may not exceed the match rate for non-HCEs at any contribution level. Safe harbor contributions must be fully and immediately vested and subject to the same premature withdrawal restrictions as elective deferrals.
To satisfy the matching contributions portion of the ACP test, the employer must also:
- Meet the ADP safe harbor requirements described above
- Limit matching contributions to elective contributions that do not exceed 6% of the employee’s compensation
This ACP alternative does not eliminate the need to apply the ACP test to voluntary after-tax employee contributions — those must still be tested separately.
Qualified Automatic Enrollment Plans
The Pension Protection Act of 2006 made a significant change to 401(k) plan design. Prior to 2007, employees had to affirmatively “opt in” to participate. Beginning in 2007, employers may automatically enroll eligible employees, requiring them to “opt out” if they do not wish to participate. The premise is that more lower-paid employees will remain enrolled, improving nondiscrimination test results.
Under a Qualified Automatic Enrollment Program (QACA), all eligible employees automatically defer a stated percentage of compensation unless they elect otherwise. Plans with a qualified automatic enrollment feature:
- Automatically satisfy the ADP and ACP tests
- Are not subject to the top-heavy plan rules
To qualify, the plan must provide for an initial automatic deferral rate of between 3% and 10% of compensation, and the employer must provide either:
- A match of 100% on the first 1% of deferrals, plus 50% on the next 5% of deferrals, or
- A 3% nonelective contribution to all eligible employees
SECURE Act 2.0 (2022) expanded automatic enrollment requirements: new 401(k) plans established after December 29, 2022 must include automatic enrollment at a rate of at least 3%, escalating annually to at least 10%, with an opt-out available to employees.