Non-Discrimination Testing: Who Fails and Who Pays
Non-discrimination testing decides whether your 401(k) and cafeteria plan keep their tax treatment. The tests, the deadlines, and who pays when one fails.
The first time an administrator told me a plan had failed testing, I assumed we had done something wrong. We had not. The documents were right, the deposits on time, the payroll file clean. What had happened was arithmetic.
Three people at the top were saving hard and nobody else was saving at all. Non-discrimination testing is not an audit hunting for mistakes. It is a set of ratios, and when one comes out wrong the tax treatment is taken from the top of the org chart, not the bottom.
Here is the whole map: the two percentage tests, the top-heavy determination, the three cafeteria plan tests, the dependent care rules and the self-insured health pair. I build the people tooling for businesses without an HR department at FirstHR, an onboarding and HR platform rather than a plan administrator. This is general information, not tax advice.
What the Testing Actually Is
Non-discrimination testing is the annual arithmetic that decides whether a benefit plan keeps its tax treatment. Every test compares a favored group against everybody else, and a plan that fails usually loses the tax break for that group rather than its status.
Nobody designs a plan to exclude their own staff. It gets designed generously, the people earning $19 an hour decline to defer 6 percent of it, and the ratios do the rest.
| Test | Which plan | Pass condition | Who pays on failure |
|---|---|---|---|
| Actual deferral percentage test | 401(k) deferrals | Within 1.25 times the other average, or within 2 points and no more than double | Highly compensated employees, through taxable refunds |
| Actual contribution percentage test | 401(k) match and after-tax | The same math on match percentages | Same people. Unvested amounts are forfeited |
| Top-heavy determination | The plan as a whole | Key employee balances at 60 percent or less | The employer, through a minimum non-key contribution |
| Coverage test | The plan as a whole | A wide enough cross section of other staff benefits | The employer, who must widen coverage |
| Cafeteria eligibility test | Section 125 plan | Eligibility does not favor the highly compensated | Highly compensated participants lose the exclusion |
| Contributions and benefits test | Section 125 plan | Neither favors that same group | Highly compensated participants |
| Key employee concentration test | Section 125 plan | Key employees get 25 percent or less of the total | Key employees only, usually the owners |
| Eligibility and benefits tests | Dependent care program | Neither favors the highly compensated | Highly compensated employees, on the election |
| 55 percent average benefits test | Dependent care program | Other average is at least 55 percent of theirs | Highly compensated employees |
| Owner concentration rule | Dependent care program | 25 percent or less goes to more than 5 percent owners and their spouses or dependents | Highly compensated employees, owners included |
| Eligibility test | Self-insured health plan | 70 percent of all employees benefit, or 80 percent of eligibles when 70 percent are eligible | Highly compensated individuals, on excess reimbursement |
| Benefits test | Self-insured health plan | Favored benefits are open to all on the same terms | Highly compensated individuals |
The table above maps every test to its plan, its pass condition and the person who pays. It omits one thing: a fully insured group health plan skips the self-insured plan rules in section 105(h) entirely, and the parallel rule for insured plans has been unenforced since IRS Notice 2011-1.
Who Counts as Favored
There is no single definition of the favored group. The 401(k) percentage tests and the dependent care tests use highly compensated employee. Top-heavy and the cafeteria concentration test use key employee. The cafeteria eligibility and benefits tests and the self-insured health rules each use a further definition that matches neither.
The lookback mechanic trips people up more than the thresholds do. For most retirement testing, status this year turns on pay the year before, so a person promoted in January is generally not in the group until the following year. Ownership counts the current year too, and the indexed figures reset annually (IRS cost of living adjustments).
The fix is one census and four separate columns off it. Fill the first sheet once from payroll, mark the four groups on the second, and record last year's results on the third so you start the design conversation from evidence rather than memory.
| A | B | C | D | E | F | G | H | I | J | |
|---|---|---|---|---|---|---|---|---|---|---|
| 1 | Employee | Hire date | Termination date | Hours worked | Compensation, this year | Compensation, prior year | Ownership percent | Officer | Family relationship to an owner | Eligible for the plan |
| 2 | Example: owner | _______ | _______ | _______ | _______ | _______ | Yes | None | Yes | |
| 3 | Example: spouse of owner | _______ | _______ | _______ | _______ | _______ | No | Spouse | Yes | |
| 4 | ||||||||||
| 5 | ||||||||||
| 6 | ||||||||||
| 7 | ||||||||||
| 8 | ||||||||||
| 9 | ||||||||||
| 10 | Note | Every test reads from this sheet, so an error here is an error on every test at once | ||||||||
| 11 | Note | Include everyone employed on any day of the plan year, not only people employed at year end |
The Actual Deferral Percentage Test
The actual deferral percentage test compares the average deferral rate of highly compensated employees against the average for everybody else. It passes if the favored average is no more than 1.25 times the other average, or no more than two percentage points higher and no more than double it (26 CFR 1.401(k)-2).
How the averages get built is what decides small business outcomes. You take each eligible person's deferral rate, then a plain average of those rates. Anyone eligible who defers nothing enters as a zero, and one zero counts as much as one enthusiastic saver.
| Non-highly compensated average | 1.25 times limit | 2 points or 2 times, whichever is less | Ceiling for the favored group |
|---|---|---|---|
| 1.0 percent | 1.25 percent | 2.0 percent (2 times) | 2.00 percent |
| 2.0 percent | 2.50 percent | 4.0 percent (2 times) | 4.00 percent |
| 3.0 percent | 3.75 percent | 5.0 percent (2 points) | 5.00 percent |
| 4.0 percent | 5.00 percent | 6.0 percent (2 points) | 6.00 percent |
| 5.0 percent | 6.25 percent | 7.0 percent (2 points) | 7.00 percent |
| 6.0 percent | 7.50 percent | 8.0 percent (2 points) | 8.00 percent |
Read the last column as your real limit. If the rest of your workforce averages 2 percent, your owners are capped at 4 percent, which on $200,000 of pay is $8,000 against a 2026 deferral limit of $24,500. The $24,500 limit never comes into play. The test sets the ceiling.
You also pick a method. Prior year testing compares this year's favored group average with last year's average for everyone else, so the target is known twelve months ahead. Current year testing compares both groups within the same year.
The Actual Contribution Percentage Test
The actual contribution percentage test runs identical arithmetic on employer matching contributions and any after-tax employee contributions. Same two groups, same two-part limit, different numerator. A plan can pass one and fail the other.
When the match is a straight formula tied to deferrals, the tests move together and a deferral failure drags the matching test with it. They separate when the match is discretionary, when a year-end true-up applies, or when after-tax contributions exist.
Correction has one wrinkle: only the vested portion of an excess aggregate contribution can be distributed, and anything unvested is forfeited (26 CFR 1.401(m)-2). A plan with no match and no after-tax money skips this test entirely, which is worth knowing before you add a match to a plan already near the line.
The Top-Heavy Test
A plan is top-heavy when key employee account balances exceed 60 percent of total balances on the determination date, the last day of the preceding plan year. Failing it taxes nobody. It obliges the employer to fund up to 3 percent of pay for every non-key participant, under Internal Revenue Code section 416.
Notice what is measured. The test counts accumulated balances rather than current year contributions, so a plan can pass both percentage tests and still be top-heavy because the founder has been saving for eight years.
The minimum has a useful ceiling: it is capped at the highest percentage any key employee received, so if owners take nothing, nothing is owed.
Top-heavy status is set annually, so a plan can cross the line after long-tenured non-key employees cash out. It does not happen at once, because distributions in the year ending on the determination date are added back into the totals.
The Safe Harbor Escape
A safe harbor 401(k) is not subject to the two percentage tests, and in a plan year where the only contributions are deferrals and safe harbor contributions, it is also exempt from the top-heavy rules. The price is an employer contribution that is mandatory and fully vested when made (IRS 401(k) plan overview).
You are buying certainty with a fixed cost. That is worth doing when refunds already go back to your owners every March, and much less so when the plan passes.
A plan without a safe harbor match can also adopt a nonelective safe harbor after the year starts. For a 3 percent contribution, the amendment must be adopted before the 30th day before the plan year closes. A 4 percent contribution can be adopted any time before the last day of the following plan year (26 U.S.C. 401(k)(12)(F)).
The relief people lose without noticing is the top-heavy one, because it depends on the year rather than the plan. Allocate discretionary profit sharing or forfeitures on top of the safe harbor money, and the top-heavy rules return for that year (Rev. Rul. 2004-13). That tends to happen in a good year, exactly when an owner wants to.
The Three Cafeteria Plan Tests
A Section 125 cafeteria plan runs three tests: eligibility, contributions and benefits, and key employee concentration. The plan does not collapse when one fails. The favored group loses the exclusion and their elections become taxable wages, while everybody else is unaffected (26 U.S.C. 125).
The first two tests are the plain ones. The eligibility test asks whether the rules for joining the plan favor the highly compensated, and the contributions and benefits test asks whether what the plan then provides favors them.
The concentration test is the one small businesses fail. It asks whether key employees receive more than 25 percent of aggregate qualified benefits. In a company of nine where two owners hold family coverage and four staff waive onto a spouse plan, that 25 percent line is easy to cross.
Under the IRS proposed cafeteria plan regulations, the tests run as of the last day of the plan year and count everyone employed on any day during it. Two structural fixes are available before that date.
The first is to run premiums through a plan of their own. A premium-only plan that clears the eligibility safe harbor percentage in those proposed regulations is deemed to pass the other cafeteria tests, so splitting premiums off from the flexible spending accounts becomes a testing decision.
The second is a simple cafeteria plan under section 125(j), open to an employer that averaged 100 or fewer employees in either of the two preceding years. The employer contributes at least 2 percent of pay for every qualified employee, or a matching alternative, and the plan is treated as meeting the cafeteria, dependent care and self-insured health tests.
Dwight SchruteSales3 people
Darryl PhilbinWarehouse1 person
Kelly KapoorCustomer Service1 personThe Dependent Care Tests
A dependent care assistance program carries four requirements: an eligibility test, a contributions and benefits test, a 55 percent average benefits test, and a rule that no more than 25 percent of the money may go to more than 5 percent owners and their spouses or dependents (26 U.S.C. 129).
The last two fail for the same structural reason. The people who elect a dependent care account have young children and can set aside thousands a year, which at a small company means the owners. The pool of participants is small, and the owners are most of it.
The 55 percent test averages across employees rather than participants, so anyone who elects nothing counts as zero, although a salary reduction plan may leave out employees earning under $25,000.
A failed dependent care test turns the excluded amount into taxable wages for the highly compensated employees, while the money stays locked in an account that only reimburses care. The 2026 cap is $7,500, per IRS Publication 15-B.
The Self-Insured Health Plan Test
Internal Revenue Code section 105(h) applies to any self-insured medical reimbursement plan, which sweeps in level-funded arrangements, most health reimbursement arrangements, and any employer paying claims from its own funds. It runs eligibility and benefits tests against a favored group defined nowhere else.
Eligibility is satisfied three ways: the plan benefits 70 percent or more of all employees; or 70 percent are eligible and at least 80 percent of those benefit; or it covers a classification the IRS finds nondiscriminatory. You may leave out staff with under three years of service, staff under age 25, and part-time or seasonal staff.
The benefits test asks whether the benefits themselves are the same. A plan that waives the deductible for executives fails here even when everybody is eligible. Failure produces excess reimbursement, included in the taxable income of that person alone, which is why the problem can sit unnoticed for years.
When to Run Each Test
Every test is formally run after the plan year ends, and almost every useful fix happens before it starts. Two dates carry the weight: the close of open enrollment, when the cheap fixes expire, and the two and a half month mark, when the section 4979 excise tax starts.
The retirement side and the cafeteria side behave very differently. Retirement failures have a correction mechanism with statutory deadlines, so a bad March result is unpleasant but solvable. Cafeteria plan and dependent care failures have no equivalent, because the elections locked at open enrollment.
The Fixes, and Which Ones Expire
There are two categories of fix and the difference is money. Design fixes are cheap and only work before elections lock. Corrective fixes work afterwards and cost either taxable income to your owners or real contributions to everybody else.
| Fix | Which tests it helps | Deadline | What it costs |
|---|---|---|---|
| Cap what owners and highly compensated people elect | Every test here | Before open enrollment closes | Nothing in cash. They get less pre-tax room |
| Raise participation through communication | Every test here | Before the plan year starts | Time, plus the higher take-up you asked for |
| Add automatic enrollment to the 401(k) | Both percentage tests | Amendment before the year, or a year ahead under prior year testing | Higher match spend as participation climbs |
| Switch to a safe harbor design | Percentage tests, top-heavy in a clean year | A match design before the year starts. A 3 percent nonelective design before the 30th day before year end, or a 4 percent one before the last day of the next plan year | A mandatory, immediately vested contribution |
| Qualified nonelective contribution | Both percentage tests | 12 months after year end, under current year testing | Employer money, vested, to people who did not ask |
| Corrective refunds to the favored group | Both percentage tests | 2.5 months after year end to avoid the excise tax, 6 with an eligible automatic contribution arrangement, 12 at the latest | Taxable income for the people you meant to help |
| Top-heavy minimum contribution | Top-heavy determination | By the due date of the employer tax return with extensions, to deduct it for that year | Up to 3 percent of pay for non-key participants |
| Restructure eligibility or split the plan | Coverage and eligibility tests | Before the plan year starts | Amendments, and a harder conversation about who gets what |
The first row is the one nobody wants and almost always the cheapest. Telling two owners to elect $4,000 into a dependent care account instead of $7,500 costs the business nothing. Discovering in February that the whole election is taxable costs the owners more, and costs you the conversation anyway.
Put together, the year runs in seven steps, from the first census to the filed workpapers.
Frequently Asked Questions
What is non-discrimination testing?
Non-discrimination testing is the annual set of calculations that decides whether a benefit plan keeps its favorable tax treatment. Each test compares what a favored group receives against what everyone else receives, and the favored group is defined differently depending on the test. Congress attached these conditions to the tax breaks: employers get pre-tax treatment for retirement deferrals, health premiums and dependent care provided the arrangement does not exist mainly for the people who wrote it. In practice the rank and file seldom pay anything when a plan fails. The cost lands on owners, officers and highly compensated employees, who lose the tax break, or on the employer, who must fund a contribution for everybody else.
Which benefit plans have to be tested?
A 401(k) runs two percentage tests on deferrals and matching contributions, a coverage test, and an annual top-heavy determination. A Section 125 cafeteria plan runs an eligibility test, a contributions and benefits test, and a key employee concentration test. A dependent care assistance program adds an eligibility test, a contributions and benefits test, a 55 percent average benefits test and an owner concentration rule. A self-insured medical reimbursement plan, a category that takes in level-funded arrangements and most health reimbursement arrangements, runs eligibility and benefits tests under Internal Revenue Code section 105(h). Group term life insurance and educational assistance carry their own rules. A fully insured group health plan is the main arrangement that escapes testing, although paying its premiums pre-tax through a cafeteria plan brings the Section 125 tests back in.
What happens if a 401(k) fails the deferral test?
The excess has to come back out. The standard correction refunds the excess contributions, plus the earnings on them, to the highly compensated employees, starting with whoever deferred the most dollars, and the refunds are taxable to them in the year they are received. Timing matters for the employer: a refund made more than two and a half months after the plan year ends triggers a 10 percent excise tax on the excess under Internal Revenue Code section 4979, with a six month window for a plan that has an eligible automatic contribution arrangement. The alternative is for the employer to fund a qualified nonelective contribution for the non-highly compensated group. That is real money, it vests immediately, and it can be made up to twelve months after year end.
Who is a highly compensated employee for 401(k) testing?
An employee is highly compensated for 401(k) testing through either ownership or pay. Ownership comes first: holding more than 5 percent of the business at any time during the current or preceding plan year makes someone highly compensated at any salary, and family attribution rules can extend that to a spouse, child or parent. Pay is the second route: earning more than $160,000 in the lookback year, the 2026 figure set by IRS Notice 2025-67, which is indexed annually. A business can also elect the top-paid group, which confines the pay route to the highest paid 20 percent of employees. That helps a company with several well-paid people and no owners among them.
What makes a 401(k) plan top-heavy?
What tips a 401(k) plan into top-heavy status is key employees holding more than 60 percent of the plan total, measured on the last day of the preceding plan year. Because the ratio counts accumulated savings and not current year contributions, young plans at small companies cross it easily: the owner has been saving the longest and the total pool is small. One exclusion helps, since a rollover the owner brings in from a plan at an unrelated employer stays out of the ratio. Nobody owes tax for a top-heavy result. Instead the employer must contribute a minimum for each non-key participant, up to 3 percent of pay, and never more than the highest percentage any key employee received.
Do small businesses have to run cafeteria plan testing?
Yes. A small business with a Section 125 cafeteria plan faces the same three tests as any larger employer, and the key employee concentration test is the one that most often catches it. The plan fails when owners and other key employees take more than 25 percent of all the qualified benefits, which happens easily where two owners carry family coverage and half the staff waives. Only the key employees pay for a failure, because their elections turn into taxable wages while everyone else keeps the exclusion. Two design choices reduce the exposure. A premium-only plan that clears the eligibility safe harbor percentage in the IRS proposed regulations is treated as passing the other two tests, and an employer averaging 100 or fewer employees can adopt a simple cafeteria plan, which is treated as passing all of them.
When should non-discrimination testing be run?
Run the tests twice: a rough model in late summer, and the official test once the year has closed. The official run uses final payroll and final deferrals, so for a calendar year plan it happens in the first quarter, and the retirement corrections then face hard deadlines at two and a half months and at twelve months after year end. The late summer model is the one that saves money. Capping owner elections, adding automatic enrollment and pushing participation must all happen before open enrollment closes, because after that point cafeteria plan elections cannot be changed except for a qualifying event.
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