Avoid Penalties and Promote Equity with Non-Discrimination Testing

Non-discrimination testing (NDT) refers to a series of annual tests required by the Internal Revenue Service (IRS) to ensure benefit plans—such as 401(k) plans, cafeteria plans, HSAs and HRAs—do not disproportionately favor highly compensated employees (HCEs) or key employees. These tests evaluate plan design, eligibility, contributions and participation levels to confirm that benefits are offered equitably across the workforce.

NDT typically includes the ADP test (actual deferral percentage), ACP test (actual contribution percentage) and the average benefits test, among others. If a plan fails, corrective action—such as refunding excess contributions or making qualified nonelective contributions (QNECs)—must be taken before the end of the plan year to maintain tax benefits and ERISA compliance.

Non-discrimination testing must be conducted annually for most benefit plans, including retirement plans like 401(k)s and cafeteria plans with health savings accounts (HSAs), health reimbursement arrangements (HRAs) and flexible spending accounts (FSAs). Testing generally occurs near the end of the plan year using either current year or prior year data, depending on the plan design.

Annual testing evaluates eligibility, contributions and benefits across all plan participants to meet nondiscrimination requirements set by the IRC. Plan sponsors are responsible for confirming that eligible employees, including non-key employees, are treated equitably in terms of enrollment, contribution limits, employer matching contributions and after-tax or additional contributions. If the plan fails, corrective action must be taken by the last day of the plan year to protect tax benefits and avoid penalties.

Most tax-advantaged benefit plans must complete nondiscrimination testing each year. These include 401(k) and other retirement plans, cafeteria plans, flexible spending accounts (FSAs), dependent care assistance programs, health reimbursement arrangements (HRAs) and group term life insurance plans. Plans that permit after-tax contributions, offer safe harbor 401(k) options, or include employer matching must be tested to confirm compliance with IRS rules.

Testing reviews items such as the eligibility test, contribution rate across plan participants and whether the plan document aligns with operational activity. Plans must prove that highly compensated employees are not receiving benefits that exceed those available to non-highly compensated or non-key employees. Safe harbor contributions may exempt plans from the ADP, ACP, and top-heavy test requirements, but these plans still need to meet specific annual conditions. If a plan passes, it maintains tax-favored status for both employees and the employer.

If a plan fails nondiscrimination testing, the benefits provided to highly compensated employees (HCEs) may become taxable. For 401(k) plans, failing the ADP or ACP test requires either refunding excess deferrals or making qualified nonelective contributions (QNECs) to non-HCEs. These adjustments must be completed within a set correction window or the plan risks disqualification.

Beyond taxes, a failed test can impact employer deductions, raise compliance concerns and affect plan assets. Plan sponsors may also need to review contribution rates, revise the plan document, or limit after-tax contributions in future plan years. Retesting is often needed to confirm the plan passes before the last day of the plan year and safe harbor contributions may be considered to avoid future failures.