401(k) Plans: Compliance Testing Basics

401(k) compliance testing confirms you’re meeting the Internal Revenue Service (IRS) standards for retirement
plans so that you and your employees can take advantage of the tax and other benefits available through your
plan.

Company-sponsored retirement plans support employees in planning for their financial futures and are a great tool
you can use to attract and retain top talent. However, in order for the plan to remain compliant, it must pass
certain tests each year to confirm that all eligible employees have the opportunity to experience the retirement
plan’s advantages—not just highly paid employees, officers, and owners.

In this article, we’ll review the different types of nondiscrimination tests that employers should be familiar
with.

The Basics: Understanding Highly Compensated and Key Employees

Before jumping into the different types of nondiscrimination tests, you should understand two important
terms—highly compensated and key employees.
These concepts serve as the foundation for the IRS’s nondiscrimination tests.

What Is a Highly Compensated Employee (HCE)?

An HCE is an individual who meets one or multiple of these criteria:

• Owned more than 5% of the business at any time during the current year or the preceding year,
  regardless of how much compensation that person earned or received.
• Received compensation from the employer in excess of a specified threshold, defined by the IRS,
  in the preceding year. For 2025, the threshold is $160,000.
• Family Member Attribution: Certain family members of owners, as defined above, are also
  considered owners. This includes spouses, children, grandchildren, or parents of owners. For example, a child
  might be considered an HCE and/or key employee because of shares owned by their parent.

Non-Highly Compensated Employees (NHCEs) are those who are not considered an HCE.

What Is a Key Employee?

Similar to an HCE, a key employee is an individual identified as an officer, owner, or someone with ownership
attribution during the plan year:

• Officer: An officer who earned more than a specified threshold in the previous year. For 2025,
  this threshold is $230,000 (up from $220,000 for 2024).
• Owner: An owner is a person who owns more than 5% of the business, regardless of their
  compensation, or an individual who owns more than 1% of the business
  and earns more than $160,000 in compensation.

Types of 401(k) Nondiscrimination Tests

The following common nondiscrimination tests may apply to your 401(k) plan.

Actual Deferral Percentage (ADP) Test

The ADP test compares the percentage of both
pre-tax and Roth employee deferral contributions
deducted from payroll for HCEs against those for NHCEs. Catch-up contributions available to participants over age 50
are not included in the ADP test.

To pass the ADP test, the HCE average contribution rate cannot exceed the greater of:

• 125% of the NHCE average rate

OR

• The lesser of:
  • 200% of the NHCE average rate, or
  • The NHCE average rate plus 2%

The ADP percentages for NHCEs may be based on current or prior-year contributions. The plan document contains the
election for either current or prior year contributions.

Actual Contribution Percentage (ACP) Test

The ACP test uses the same calculations as the ADP test, except it compares the average employer matching
contribution percentage of HCEs against the average for NHCEs. It also includes after-tax employee contributions, if
allowed by the plan.

Top-Heavy Test

A retirement plan is
top-heavy
if the company owners and key employees hold more than 60% of the plan assets’ value. The top-heavy test is
conducted annually based on the account balances of the prior plan year’s last day.

If your top-heavy ratio exceeds 60%, then your business typically pays a minimum contribution (such as 3%) to
non-key employees.

Minimum Coverage Test

The minimum coverage test confirms that a retirement plan benefits enough NHCEs. This test uses the Ratio Percentage
Test (RPT) to examine the ratios of employees who are “eligible” to participate (i.e., those meeting minimum age and
service requirements) and those who are “benefiting” from the plan (i.e., those who actually receive a
contribution). If at least 70% of NHCEs benefit from the plan, it passes the RPT minimum coverage test.

However, beyond the RPT test, there is another method called the Average Benefits Test (ABT), which is slightly more
complex. To determine minimum coverage, you can use either the RRT or the ABT, or a combination of both, depending
on the specific needs and structure of your plan.

Compensation Ratio Test

Not every plan will have to complete the Compensation Ratio Test. It is only required for plans that exclude certain
types of compensation. This test confirms that the retirement plan’s compensation definition does not
disproportionately benefit HCEs. To determine this:

1. Calculate the compensation ratio for each participating employee.
2. Divide the participating employees into an HCE and NHCE group.
3. Average the compensation ratios for each group.

To pass the test, your average ratio for the HCE group may not exceed the average ratio for the NHCE group by more
than a certain amount, typically within three percentage points of the NHCE’s average.

What Happens if My Plan Fails a Nondiscrimination Test?

If your 401(k) plan fails any applicable nondiscrimination tests, you must take corrective action within specific
timelines specified by the IRS. The action needed will depend on which test was failed and certain other
plan-specific factors, but in general, failing one or more annual tests could require you to make an additional
contribution to your plan or make refunds to your HCEs for a portion of their contributions. The IRS and DOL may
also impose other penalties or taxes; in some cases, they may disqualify the plan.

Partner With a Trusted Recordkeeper to Make Compliance Testing a Breeze

By bundling all retirement plan services with Vestwell, such as investment management, recordkeeping, and compliance
support, you can more easily administer your retirement plan while avoiding nondiscrimination testing hiccups along
the way. Vestwell offers several services designed to help businesses streamline the compliance testing process:

• Customized Plan Design: Our Plan Design team collaborates with employers from the start,
  tailoring their plan and making recommendations to meet the custom needs of each individual business.
• Annual Compliance Reminders and Census Collection: Throughout the testing season, our Client
  Services team keeps employers updated on the need-to-knows of staying compliant. This involves sending multiple
  reminders to submit employee census data on time to meet IRS deadlines.
• Detailed Compliance Testing and Follow-Up: Once employers provide the census data, Vestwell
  completes all necessary testing. If any issues arise, our team is available to meet with employers and advisors to
  review results, propose solutions, and consult on ways to prevent future issues.

Conclusion

Compliance testing can be complicated. However, Vestwell’s experienced professionals can help you navigate a
retirement plan’s legal requirements, protecting you and your employees’ financial futures.