Non-discrimination testing is a group of tests used to check whether certain employer-sponsored benefit plans favor highly compensated employees or key employees over other eligible employees. Federal tax rules set different requirements for different types of plans, so no single test covers every workplace benefit. For a 401(k) plan, testing may compare employee deferral rates and certain contribution rates. Other tests examine whether enough non-highly compensated employees benefit from a plan or whether eligibility rules provide fair access. Cafeteria plans and some self-insured health plans face their own tests. The goal is not to give every employee the same benefit. Instead, the plan must satisfy the rules that apply to its design and operation. A failed test can change the tax treatment of benefits or require a correction. Employers therefore need to understand which tests apply and maintain the records needed to administer them.
Table of Contents
- Which Benefit Plans Are Tested?
- How Do Retirement Plan Tests Work?
- Who Counts as Highly Compensated or Key?
- What Happens If a Plan Fails?
- What Information Supports Accurate Testing?
Which Benefit Plans Are Tested?
Testing is most often associated with tax-qualified retirement plans such as 401(k) plans. A 401(k) plan may need to satisfy the actual deferral percentage test, known as the ADP test, and the actual contribution percentage test, known as the ACP test. Coverage testing checks whether the plan benefits enough non-highly compensated employees under the applicable rules. Other requirements may apply based on the plan’s features and the employer’s circumstances. The IRS describes several of these requirements in its guide to common qualified plan requirements.
Rules also apply to certain health and welfare arrangements. A cafeteria plan generally must meet tests addressing eligibility and the availability of benefits. A self-insured health plan may be subject to separate federal tax rules. Fully insured coverage does not necessarily face the same tests as self-insured coverage. Employers should identify the type of plan rather than assume one rule applies to all employee benefits.
Not every plan uses the same employee definitions or testing method. Plan terms and applicable tax rules determine who counts and which measurements apply. An employer may sponsor several plans with distinct testing requirements, so each plan needs to be reviewed under its own rules. Identifying the plan type is an important first step because a test or correction that applies to one arrangement may not apply to another.
How Do Retirement Plan Tests Work?
The ADP test compares the average percentage of pay that highly compensated employees defer to their 401(k) accounts with the average percentage deferred by non-highly compensated employees. The ACP test makes a similar comparison for certain employer matching contributions and employee after-tax contributions. These are not simple comparisons of total dollars. Each test uses specified calculations and rules for determining compensation and employee groups. The IRS explains that a plan must satisfy the ADP and ACP requirements in operation unless a permitted alternative applies. An applicable safe harbor design is one example of an alternative.
Coverage testing asks whether enough non-highly compensated employees benefit under the plan. Federal law sets out the available tests, including a percentage test and other permitted methods. Employee classifications and exclusions can affect the result. Changes in workforce composition or business structure may also affect coverage testing. Special rules may apply to certain employees who participate before meeting the maximum age and service conditions allowed by law. These details make accurate employee records and consistent application of plan terms important.
Top-heavy testing is a separate retirement-plan test. It examines whether key employees hold more than 60% of the plan’s value, subject to applicable calculation rules and exceptions. A plan that is top-heavy may need to provide a minimum benefit for non-key employees. The IRS provides an overview of when a 401(k) plan is top-heavy. Not every plan is subject to every test, and a result under one test does not determine the result under another.
Who Counts as Highly Compensated or Key?
The terms “highly compensated employee” and “key employee” have specific tax-law meanings. They are not interchangeable labels for managers or people with high salaries. The definition depends on the type of test and may take account of compensation, ownership or officer status. Thresholds and look-back periods can also matter. Employers should use the applicable plan documents and current legal definitions rather than assume that a job title or pay grade alone determines an employee’s status.
Testing also requires deciding which employees are included in each calculation. Eligibility provisions may exclude or treat certain groups differently when the law permits it. Plan sponsors need reliable records of eligible employees and participation. They also need to apply the plan’s definition of compensation consistently. The IRS identifies use of an incorrect compensation definition as one example of a retirement plan error that can affect nondiscrimination testing.
Whether a worker is an employee of the plan sponsor can matter when establishing the population for testing. A common-law employee is generally distinguished from an independent contractor by the working relationship and applicable legal standards. The label in a contract does not settle that question. Classification is separate from the plan’s testing formulas, but it can affect which workers are considered. When a business has related employers or multiple plans, aggregation rules may also affect the analysis.
What Happens If a Plan Fails?
A failed test does not automatically mean that a plan must close. The consequence depends on the plan and the test that failed. For a 401(k) plan that fails the ADP or ACP test, a correction may involve distributing excess contributions to affected highly compensated employees or using another permitted approach. A top-heavy plan may need to provide a minimum contribution to eligible non-key employees. A cafeteria plan failure can affect the tax treatment of benefits for highly compensated participants or key employees. Applicable rules and plan terms determine which correction is available.
Timing matters because retirement-plan correction periods vary with the type of failure and the correction method. The IRS describes correction approaches in its guidance on correcting retirement plan errors. Employers should promptly ask the plan administrator or a qualified benefits professional to identify the failed test and confirm the required steps. A correction should not be assumed to apply in the same way across retirement, cafeteria and health plans.
Testing results can also reveal design or administration issues. Participation may be concentrated among highly compensated employees because lower-paid employees are not enrolling. An employer may review whether plan communications, eligibility rules or contribution features should change. Any proposed change must be checked against plan documents and applicable law before implementation. A design adjustment can affect future results, but it does not replace any correction required for a test already failed.
What Information Supports Accurate Testing?
Testing depends on complete and consistent employee and plan data. Depending on the test, the administrator may need compensation under the plan’s definition, ownership details, employee status, eligibility dates, hours or service information, deferrals, employer contributions and benefit elections. Missing eligible employees or using a payroll figure that does not match the plan’s compensation definition can distort results. Employers should confirm which data the administrator needs and how it should be reported.
For organizations using contingent workers, accurate worker classification and coordination of records can be relevant to identifying the population for testing. A staffing arrangement does not by itself determine whether a worker is treated as an employee for a particular legal purpose or whether a plan rule applies. Employers and plan administrators need to consider the relevant facts and governing plan terms. Where a workforce program involves multiple employers, the parties should establish who maintains the records needed for testing and who coordinates questions with the plan administrator.
Payroll data may be one input, but payroll processing does not by itself determine whether a plan passes. In contingent workforce management, clear processes for worker records and payroll information can help the responsible plan sponsor and administrator obtain relevant data. The plan administrator or a qualified compliance professional should confirm the required employee population, definitions and testing method for each plan. Keeping records consistent with plan terms also makes it easier to investigate discrepancies and address them promptly.
