December 12, 2025
Sponsoring a 401(k) plan provides meaningful value to employees, but it also requires employers to demonstrate each year that the plan is working as intended. Nondiscrimination testing is the primary way the IRS evaluates that performance, checking whether contributions and participation patterns are balanced between highly compensated employees (HCEs) and everyone else. For plan sponsors, a clear understanding of these tests can support compliance and plan design decisions. To help clients, prospects, and others, Wilson Lewis has summarized the key details below.
Nondiscrimination testing compares participation and contribution rates between HCEs and all other eligible employees. The IRS defines an HCE as someone who owns more than 5% of the company or earned more than $160,000 in 2025, an increase from $155,000 in 2024. Compensation includes wages, bonuses, commissions, overtime, and salary deferrals. Employers may also apply the top-20% election, which limits HCE status to the highest-paid group of employees.
Accurately identifying HCEs matters because the distinction drives the annual compliance results. If HCEs defer at much higher rates than non-HCEs, the plan can fail testing. That could mean administrative work, refunds, and other corrective steps, which are outcomes most plan sponsors want to avoid. Knowing who falls into the HCE group early in the plan year helps sponsors monitor activity before issues develop. The IRS requires several tests at the end of the year to ensure compliance.
Average Deferral Percentage (ADP) Test — The ADP test evaluates whether employee salary deferrals are distributed equitably between HCEs and non-highly compensated employees (NHCEs). After separating eligible employees into the two groups, the plan calculates each person’s deferral rate as a percentage of pay and determines the average for each group. The test is designed to ensure that owners and higher-earning employees are not contributing at levels far above the rest of the workforce.
The IRS sets strict limits on how far ahead HCEs may be. A plan passes the ADP test if the average HCE deferral rate does not exceed 125% of the NHCE average, or, alternatively, does not exceed the lesser of 200% of the NHCE average or the NHCE average plus two percentage points.
Average Contribution Percentage (ACP) Test — The ACP test measures employer contributions; this includes matching contributions and any employee after-tax contributions, if applicable. After calculating the contribution rates for each participant and group (HCEs and NHCEs), it assesses whether employer contributions for HCEs fall within the IRS limits relative to NHCEs.
This test uses the same comparison thresholds as the ADP test: the HCE average cannot exceed 125% of the NHCE average, or the lesser of 200% of the NHCE average or the NHCE average plus two percentage points. Because matching formulas directly influence contribution rates, many plan sponsors look at ACP implications when reviewing plan design. Safe harbor plans, which provide required employer contributions, are generally exempt from both ADP and ACP testing.
Top-Heavy Test — The top-heavy test evaluates whether a disproportionate share of total plan assets is held by key employees. This is defined as someone who owns more than 5% of the company, owns more than 1% and earns more than $150,000 per year, or serves as an officer earning above the IRS compensation threshold for the year. Annually, the plan reviews account balances as of the last day of the prior plan year to determine whether key employees own more than 60% of total plan assets. The purpose is to see that the plan’s benefits are not concentrated among owners or company leaders. If a plan is determined to be top-heavy, it may be required to provide minimum contributions to non-key employees for that year.
Coverage Test — The coverage test ensures a 401(k) plan benefits a representative group of employees rather than favoring highly compensated employees (HCEs). A plan must pass either the ratio percentage test or the average benefit test. The ratio percentage test is the most common, and it requires that eligible NHCEs are covered at a rate that is at least 70% of the coverage level for eligible HCEs. Eligible NHCEs must be age 21 or over with at least one year of service. The ratio is calculated as:
(Eligible NHCEs in the plan / Eligible NHCEs employed) / (Eligible HCEs in the plan / Eligible HCEs employed).
Annual Limits — In addition to nondiscrimination testing, 401(k) plans must meet IRS limits that cap how much an individual can contribute or receive during the plan year. The first of these is the 402(g) limit, which applies to an employee’s combined pre-tax and Roth deferrals. For 2025, employees may defer up to $23,500, increasing to $24,500 in 2026. Participants age 50 and older can make additional catch-up contributions of $7,500 in 2025 and $8,000 in 2026. SECURE 2.0 also provides a higher catch-up limit for participants who turn 60, 61, 62, or 63 during the year; this special catch-up is $11,250 for both 2025 and 2026 and replaces the standard catch-up amount. Any deferrals above the 402(g) limit must be returned by April 15 of the following year to avoid double taxation.
Another key limit is the 415 annual additions limit. This applies to all contributions that end up in a participant’s account during the year, regardless of the source. For 2025 and 2026, this limit is the lesser of 100% of the participant’s compensation or $70,000 and $72,000, respectively.
Next Steps for Plan Sponsors
Although nondiscrimination testing occurs after year-end, the factors that determine the results develop throughout the year. Plan sponsors may want to first focus on the two areas with the biggest impact on testing outcomes: 1) tracking compensation trends to anticipate who will qualify as an HCE, and 2) reviewing participation and deferral rates among non-HCEs, since these directly influence ADP and ACP results. Being familiar with the rules and checking in on these areas can help ensure the plan operates as intended and reduces the likelihood of corrections.
Nondiscrimination testing is a major part of 401(k) administration, and plan sponsors have a key role in its success. Being proactive can help ensure the plan is compliant and positioned to meet the needs of employees across the organization. If you have questions about the information outlined above or need assistance with your next benefit plan audit, Wilson Lewis can help. For additional information call 770-476-1004 or click here to contact us. We look forward to speaking with you soon.