Key Points
Highly Compensated Employees
Perhaps the most burdensome requirement for smaller, closely held employers is 401(k) nondiscrimination testing. As with all qualified plans, 401(k) plans may not discriminate in favor of highly compensated employees (HCEs) as to coverage, contributions, or benefits.
For 2026, a highly compensated employee is any employee who:
- owned more than 5% of the employer during the current or prior plan year, or
- received compensation of $160,000 or more from the employer during the prior year (2026, inflation-adjusted).
Employers may elect to limit the HCE definition to employees who are both above the compensation threshold and in the top 20% of all employees by compensation. This can reduce the number of employees classified as HCEs for plans with many well-paid workers.
All other eligible employees are classified as non-highly compensated employees (non-HCEs). If all employees are HCEs, the nondiscrimination tests are moot — there are no lower-paid employees to discriminate against.
Nondiscrimination in Coverage
A 401(k) plan must be established for the benefit of the general workforce, not just highly paid employees. The plan must satisfy one of two coverage tests:
The percentage of non-HCEs covered by the plan must be at least 70% of the percentage of HCEs covered by the plan.
The average benefit percentage for non-HCEs must be at least 70% of the average benefit percentage for HCEs. This test is used when a plan fails the ratio test.
Actual Deferral Percentage (ADP) Test
In many 401(k) plans, lower-paid employees elect to take cash compensation rather than defer it. The ADP test ensures the plan is nondiscriminatory in actual operation — not just on paper. The test compares the average elective deferral percentage of HCEs to that of non-HCEs.
The ADP of each employee equals their elective contributions divided by their compensation (capped at $360,000 for 2026). The ADP of each group is the average of individual employee ADPs. The ADP of an eligible employee who makes no elective contribution is zero.
To pass the ADP test, the HCE group’s ADP may not exceed the non-HCE group’s ADP by more than:
- 125% of the non-HCE ADP, if the non-HCE ADP is 8% or more;
- 200% of the non-HCE ADP, if the non-HCE ADP is 2% or less; or
- the non-HCE ADP plus 2 percentage points, if the non-HCE ADP is between 2% and 8%.
| Non-HCE ADP | Rule | Maximum 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 | 12.5% |
| 11.0% | × 1.25 | 13.75% |
A 401(k) plan covers six employees. Clauser, Fike, and Webster each own 20%+ of the company and are HCEs. Their ADPs are 9.10%, 8.50%, and 8.20% respectively — group average: 8.60%. Fields, Jovin, and Randum are non-HCEs with ADPs of 6.20%, 4.50%, and 5.10% — group average: 5.27%.
Since the non-HCE ADP (5.27%) falls between 2% and 8%, the maximum permissible HCE ADP is 5.27% + 2% = 7.27%. The HCE group’s ADP of 8.60% exceeds 7.27% — the plan fails the ADP test.
Same plan, but Webster makes no elective contributions (ADP = 0.00%). HCE group ADP: (9.10% + 8.50% + 0.00%) / 3 = 5.87%. Non-HCE group ADP remains 5.27%; maximum HCE ADP = 5.27% + 2% = 7.27%.
5.87% < 7.27% — the plan passes the ADP test, even though two individual HCEs have ADPs exceeding the maximum. The test is applied to group averages, not individuals.
Because ADP calculations use compensation capped at $360,000 (2026), very highly paid employees will have higher computed ADPs than their actual deferral percentage might suggest. This makes it harder for plans with extremely high earners to pass the ADP test.
Andrews earns $500,000 and defers $24,500 (the 2026 maximum). His ADP is computed on the $360,000 cap: $24,500 ÷ $360,000 = 6.81% — not 4.9% (which would result from dividing by actual compensation). Miles earns $100,000 and defers $6,000; ADP = 6.00%. HCE group average ADP: (6.81% + 6.00%) / 2 = 6.41%.
Non-HCEs Fields, Jovin, and Randum have ADPs of 3.00%, 2.00%, and 4.00%; group average: 3.00%. Maximum HCE ADP = 3.00% + 2% = 5.00%. Since 6.41% > 5.00%, the plan fails the ADP test — a result driven by the compensation cap inflating the HCEs’ ADPs.
Normally only elective contributions are used in the ADP test. However, employer nonelective and matching contributions may be reclassified as elective contributions for ADP purposes if they:
- are fully and immediately vested, and subject to the same premature distribution restrictions as elective contributions, and
- do not favor highly compensated employees.
If qualified matching contributions are used to satisfy the ADP test, they may not be used again to satisfy the ACP test.
Actual Contribution Percentage (ACP) Test
If a 401(k) plan provides for employer matching contributions or voluntary after-tax employee contributions, it must also satisfy the ACP test. The ACP test applies the same differential rules as the ADP test, but measures employer matching contributions and employee voluntary after-tax contributions — not elective deferrals.
Only matching contributions that are actually allocated to a participant’s account during the plan year and based on the employee’s elective contributions are included. Nonelective contributions are generally excluded from the ACP test.
The ACP of each participating employee equals their voluntary contributions plus employer matching contributions, divided by their compensation (capped at $360,000 for 2026). The same differential limits apply as the ADP test:
- 125% of the non-HCE ACP, if the non-HCE ACP is 8% or more;
- 200% of the non-HCE ACP, if the non-HCE ACP is 2% or less; or
- the non-HCE ACP plus 2 percentage points, if between 2% and 8%.
An employee earns $50,000 and defers 4% ($2,000) as an elective contribution. The employer matches 50¢ on the dollar ($1,000). The employee also makes a voluntary after-tax contribution of $5,000. ACP = ($5,000 + $1,000) ÷ $50,000 = 12%.
If a plan passes the ADP test but fails the ACP test, the employer may — under certain circumstances — reclassify some elective contributions as matching contributions to create a cushion for the ACP test, provided the plan otherwise meets the requirements for such reclassification.
Plan Aggregation
If two groups of employees are eligible for separate 401(k) arrangements under the same employer, those arrangements are generally treated as a single 401(k) plan for purposes of the ADP test, ACP test, and other nondiscrimination rules — even if the plans have significantly different features or deferral limits.
If a highly compensated employee is eligible to participate in more than one 401(k) plan of the same employer, the ADP is calculated by treating all such plans as one plan.
Andy Harris earns $100,000 and is eligible under two separate 401(k) plans of his employer. He defers 5% ($5,000) into Plan A and 4% ($4,000) into Plan B. His individual ADP is calculated across both plans: ($5,000 + $4,000) ÷ $100,000 = 9% — not 5% or 4% separately.
Safe Harbor Alternatives to ADP and ACP Tests
To reduce the administrative burden of annual nondiscrimination testing, the tax code provides safe harbor alternatives that automatically satisfy the ADP and ACP requirements. Employers are not required to use these alternatives and may discontinue them, but they must provide annual written notice to all eligible employees of their rights and obligations under the plan.
As an alternative to the ADP test, the employer must either:
- make a nonelective contribution of at least 3% of compensation for all eligible non-HCEs, regardless of whether they make elective contributions, or
- make a matching contribution for each non-HCE equal to:
- a dollar-for-dollar match on elective contributions up to 3% of compensation, plus
- a 50¢-per-dollar match on elective 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. All safe harbor contributions must be fully and immediately vested and subject to premature distribution restrictions.
To satisfy the ACP test for employer matching contributions (but not employee voluntary contributions), the employer must:
- meet the ADP safe harbor requirements above, and
- limit matching contributions to no more than 6% of any employee’s compensation.
This alternative does not eliminate ACP testing if the plan permits voluntary after-tax employee contributions. Such contributions must still be tested separately. Safe harbor contributions may not be counted again in the ACP calculation.