Non-discrimination testing: 401(k) compliance


By Vijay Mirpuri

At Human Interest, we work on non-discrimination testing for small businesses every day. We monitor all of our clients’ accounts to notify them when they’re at risk of failing, and help set up plans that keep them from failing in the first place — all included. It can be tricky, and since we haven’t found a good resource that explains all of the components of non-discrimination testing in a straightforward, simple way, we’ve decided to make our own guide!

We delve into more detail about how to perform non-discrimination testing and more onerous sub-topics in our post about Safe Harbor 401(k) Plans.

If you’re completely new to the world of NDT, we recommend starting off by reading the sections below to understand the basics. We hope you find it helpful! If you’re looking to set up a 401(k) you can feel confident about, reach out to our team and we’ll be happy to answer any other questions you have.


We’ll be using several acronyms as we provide a walkthrough of non-discrimination testing in this article! To ensure clarity, we’ve listed them out below. All of these are explained in further detail in later sections:

  • NDT = Non-discrimination testing

  • SMB = Small and medium-sized business, typically any company with fewer than 100 employees

  • HCE = Highly compensated employee

  • NHCE = Non-highly compensated employee

  • ADP Test = Actual deferral percentage test

  • ACP Test = Actual contribution percentage test

Note: many of the compensation dollar amounts in the more detailed definitions below tend to be increased every few years by small increments by the IRS to account for inflation. For example, the $125,000 cap used to be $115,000 back in 2014.

What is non-discrimination testing?

Non-discrimination testing requires that employees of a certain status (highly compensated employees and key employees) stay within a specific contribution rate, as determined by the contribution rate of NHCEs. (We’ll define these terms and outline the various tests and approaches in greater detail below.)

These tests measure the participation levels of HCEs and NHCEs in order to make sure all employees have equal access to and awareness of a company’s benefit plans. These tests follow federal regulations that have been established for every type of benefit plan under IRC Section 105, IRC Section 125, and IRC Section 129.

While the tests focus on participation levels across all employee types within an organization, multiple factors can play a role in that participation and whether a company passes or fails the nondiscrimination tests. One of these factors is the plan’s employer contributions. If employers partially or fully match employee contributions, that can incentivize employees to contribute when they otherwise might not have. Percentage-based matching schemes are particularly attractive to HCEs because the organization is obligated to match up to a certain percentage of the employee’s salary based on their total contributions. A dollar cap, on the other hand, can attract a greater proportion of general employees and won’t make the company liable for potentially too-large matching obligations.

Vesting schedules, which are part of the employer’s contribution matching plan, determine what percentage of an employer’s matching contributions an employee owns outright based on their length of employment. This can also drastically affect the total level of employee engagement and so impact the results of a non-discrimination test.

Why does non-discrimination testing exist for 401(k)s?

Because the U.S. government offers substantial tax benefits through 401(k) retirement savings plans, they want to make sure that 401(k) plans do not unfairly benefit company owners (key employees) and HCEs over NHCEs. To ensure that the 401(k) plan isn’t “discriminating” or favoring specific employees, the plan must pass a set of annual tests, and this responsibility falls on the company offering the 401(k) to its employees.

While most traditional, large companies have no issues passing, the tests were not designed with startups and SMBs in mind and can be confusing and difficult to navigate. Don’t be discouraged! You’re doing a great thing by making the effort to offer a 401(k) to your employees, and we’re here to make the compliance portion a little less intimidating. The IRS isn’t trying to scare you away from setting up a 401(k). In fact, the government encourages employers to offer retirement benefits through tax credits and deductions (see articles for employer 401(k) contribution tax and 401(k) cost for employers).

HCE (Highly Compensated Employees) and NHCE (Non-Highly Compensated Employees)

An HCE is technically defined as an employee who meets either of the following qualifications, as outlined by the Internal Revenue Service:

  • Ownership: The employee owned more than 5% of the interest in the business at any time during the year OR the preceding year, regardless of how much compensation (defined by the IRS as including wages and salaries, bonuses, tips, and fringe benefits) that person earned or received. OR, the employee is related to an owner. “Related” is defined via family attribution (spouse, children, parents, and grandparents but NOT in-laws, siblings, or grandchildren).

  • Compensation: The employee’s annual compensation was $130,000 or more (if the preceding year is 2020) and, if the employer so chooses, was in the top 20% of employees when ranked by compensation in the previous year.

HCEs and NHCEs are mutually exclusive categories, so all other eligible employees who do not meet the above tests are considered NHCEs.

*Side note relevant to very HCE-heavy companies: The optional top 20% distinction is called the “top paid election.” The “top-paid group” is the top 20% in compensation of the entire participant group. This characterization is normally only used when there is a relatively large number of HCEs — this is a very specific use case, so if you have questions about this, let us know!

The HCE (and consequently, the NCHE) definition and count can be tricky because of the “any time during the year” and the “top 20% of employees when ranked by compensation” components. These two factors create moving targets, so the categorization of who is and isn’t an HCE—and your NHCE to HCE ratio—may change as the year progresses, raises are given, or employees join/leave the company. For this reason, most HCE categorizations are determined by prior year compensation, as described in detail below.

New, mid-year hires: Keep in mind that if an HCE joined your company this year, or if they were not at the company for the full year before, they could technically be NHCEs for the purposes of NDT, since they were not fully compensated (by your company) over $130,000/year. So, you might have more NHCEs than you think!

Key Employees

On top of the HCE/NHCE distinction, someone is also considered a key employee if ANY of the qualifications below are met:

  • Compensation: Any officer whose annual compensation is $185,000 or more (for 2021 and for 2020).

  • Ownership OR relationship: Any employee who owns more than 5% of the company, or is directly related to someone who does.

  • Ownership AND compensation: Any employee who owns more than 1% of the company and earns more than $150,000. An HCE may also happen to be a key employee, and an NHCE could also potentially be a key employee (< $125,000 in compensation/bottom 80% of compensation but is directly related to someone who owns > 5% of the company).

The Standard Approaches: ADP Test and ACP Test

If just reading the title of this section is exhausting you, we recommend skipping to the next section, “The Easy Approach: Safe Harbor Match.”

Safe Harbor Match requires the company to match employee contributions (i.e., offer them automatic contributions) but exempts the company from the ADP and ACP tests, so it’s the recommended option if you have the capital to spare.

Actual Deferral Percentage (ADP) Test

This test compares the average percentage of their salary that participating HCEs defer to the average percentage that NHCEs defer. This percentage reveals how relatively engaged in the plan each employee type is at a glance. This test doesn’t reveal the total number or percentage of employees who are making deferrals; instead, it measures the level of engagement.

There are two percentages you need to calculate:

  1. Annual HCE Contribution Rate: Group the HCEs together and calculate their average annual employee contribution rate as a % of their total compensation.

  2. Annual NHCE Contribution Rate: Group the non-HCEs together and calculate their average annual employee contribution rate as a % of their total compensation.

Annual NHCE Contribution RateMaximum Annual HCE Contribution Rate
2% or lessNHCE% x 2
2-8%NHCE% + 2
more than 8%NHCE% x 1.25

This table represents a causal relationship: the annual NHCE contribution rate dictates the maximum allowed contribution for the HCEs. For example, if the NHCEs contributed 1%, the HCEs, as an average, can only contribute 2% (or lower).

A note on calculating HCE salaries by prior year vs. current year: “Prior year” means that the average contribution rate for HCEs will be compared to the average contribution rate for the NHCEs from the prior calendar year instead of the current year. This is generally advantageous since you’ll know in advance what the HCE limit is (see the table in the ADP Test section above), rather than trying to manage against a moving target that changes throughout the year.

If you’re setting up a new 401(k), you won’t have a “prior year” to compare against — so the IRS allows you to assume 3% as the non-highly-compensated employee average (the left-hand column in the ADP Test table). This means that for your first year of administering a 401(k), your highly-compensated employees will be able to contribute up to 5% of their compensation on average.

Actual Contribution Percentage (ACP) Test

This test applies only to companies offering 401(k) match. The calculations and breakdowns are the same as with ADP, but they include employer match and after-tax contributions when calculating the average contribution rate.

A Third “Test”: The Top-Heavy Determination

This is not technically a non-discrimination test, but a determination that may result in required contributions to your participants, so we’re explaining it here. Group key employees together and calculate their total account balance from the prior year. In the first year of the plan (no assets in the prior year), the top-heavy determination is done on the last day of the current year.

If the key employees’ total account balance exceeds 60% of the entire plan’s account balance, the plan is deemed to be top-heavy and the employer may be required to make a contribution to participants (based on plan document specifications).

Action steps for the ADP, ACP, and top-heavy tests

To ensure that your company’s 401(k) plan is neither non-discriminatory nor top-heavy, it’s legally required that your 401(k) administrator performs testing annually. However, being determined as top-heavy may result in required contributions from your employees (this can be a huge headache). We strongly advocate for more proactive, regular monitoring and tracking of contribution percentages by cohort (Human Interest can help your company with this). Staying vigilant through the year can help your company make employee withholding adjustments as needed without the risk of failing the tests or having to make major adjustments near the end of the plan year.

It’s important that throughout the year, employers encourage NHCEs to contribute to their 401(k) plans, so that the ratio isn’t skewed too heavily to the HCEs. This is both a helpful thing to do from an NDT perspective and a good thing to do for your employees in terms of financial literacy.

Here are three tips to increase their contribution rates that can be done proactively before annual testing:

  • Auto-enroll employees into your 401(k) plan, which is shown to increase overall participation rates.

  • Make the 401(k) experience easy: Human Interest’s dashboard is uncomplicated and easy for employees to use, making them more likely to sign up and adjust their contributions as needed.

  • Educate NHCEs about the importance of contributing to a 401(k), not just for helping the company pass NDT, but for their own financial futures.

On the flip side (but for the same ratio-preserving reasons), you should notify your key employees and HCEs that there is a limit to how much they may be able to contribute (read 401(k) contribution limits). If communicated properly, they would understand that such a cap is necessary so that the company does not fail IRS compliance tests, especially if the alternative is not having a retirement benefit at all. This is a much better scenario for all involved than having to notify your HCEs and key employees after they’ve already contributed too much that they may need to be refunded.

The Easy Way: Safe Harbor Match

Safe harbor is the most popular match for companies. This is primarily because it automatically exempts you from the ADP and ACP tests. As long as you’re not doing a profit-sharing plan, your 401(k) will also be automatically exempt from the top-heavy test. If you’re not sure whether your plan has a profit-sharing feature, then you probably don’t have one.

Requirements of a safe harbor match:

  • The company matches 100% of all employee 401(k) contributions, up to 4% of their compensation, OR

  • The company matches 100% of all employee 401(k) contributions up to 3% of their compensation, plus a 50% match of the next 2% of their compensation

Pros of a safe harbor match:

  • Automatically pass ADP and ACP testing, satisfy top-heavy testing requirements and allow all employees to contribute the maximum allowable amounts to their 401(k).

  • Provide a tremendous incentive for employees to save for their future.

  • A matching 401(k) gives you an enormous advantage for recruiting and retaining talented employees, and it is tax-deductible.

Cons of a safe harbor match:

  • Under the Safe Harbor match, you need to commit to 1 year, and this needs to be renewed on an annual basis.

  • There is a termination fee charged by some 401(k) record keepers if you ever change your mind.

  • There are specific deadlines. So if you decide to offer safe harbor matches, it may take a few months to go into effect. You can learn more details here: Non-Discrimination Testing Deadlines.

  • It can be relatively expensive, depending on the salaries of your employees.

What happens if I fail NDT? What can I do?

First off, we want to say that failing nondiscrimination testing is quite common, and you shouldn’t be embarrassed or stressed out! If you take corrective measures quickly, it’s quite easy to resolve and avoid any negative long-term consequences and penalties.

Human Interest and NDT

You may be wondering why and how we know so much about NDT, and it’s because it’s part of what we do! Human Interest is an online 401(k) provider, and because we work with many small businesses, we’ve been through the NDT battle with multiple clients.

Our NDT experience:

  • We’ve helped companies set up completely new 401(k) plans and actively prevent any NDT issues.

  • We’ve helped companies decide which plan design is the best for their budgets, needs, and plausible testing scenarios.

  • We’ve helped companies who come to us after a poor experience with another 401(k) provider that caused them to fail NDT.

  • We’ve helped stressed out founders, CEOs, COOs, directors of HR, and business owners with questions and worries about NDT so that they can focus on their core business functions.

The ways in which we help clients with non-discrimination testing, with a combination of technology and friendly service:

  • Provide employers an easy-to-use dashboard in which they can look at high-level statistics on contribution rates for employees.

  • Communicate to employees the rules of IRS testing, both during training and also through notifications on our website.

  • Encourage contributions from all employees, especially non-highly compensated employees, through ease of use and financial literacy education.

  • Give employers the option to auto-enroll employees so that they opt-out rather than opt-in, which also improves participation rates.

  • Remit money quickly if the test is failed, so that there will be no tax penalties involved.

We hope you found this guide helpful. Let us know at [email protected] if there are any other NDT-related topics you’d like us to write about!

If you’re looking for a great 401(k) for your employees, click here to request more information about Human Interest.

Many thanks to Connie D. Husley, QKA, ERPA, and Compliance Specialist, for her help in reviewing the content of this article.

Vijay Mirpuri, QPA (Qualified Pensions Administrator), is a former 401(k) Compliance Manager at Human Interest.

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