An overview of nondiscrimination testing for retirement plans

What is nondiscrimination testing for a DB or DC plan?

Employers who sponsor qualified defined benefit (DB) and defined contribution (DC) plans are responsible for making sure that their plans remain in compliance with IRS requirements, and failure to do so can result in excessive costs, penalties, or even plan disqualification. These requirements include the nondiscrimination rules, which are complex and can cause problems for plan sponsors that are unfamiliar with the details.

DB and DC plans may be deemed qualified by the IRS and therefore eligible for favorable tax treatment as long as they do not provide excessive benefits to highly compensated employees (HCEs) at the expense of lower-paid employees. The nondiscrimination rules were established to give plan sponsors a framework for demonstrating that their plans do not provide benefits that significantly favor HCEs.

HCEs are generally those employees with total compensation in excess of a specified limit. An employee who earns more than $160,000 in 2025 is generally considered to be an HCE in 2026, unless the plan sponsor makes use of the alternative top 20% definition, which can potentially reduce the number of HCEs. Employees who own more than 5% of the organization are also considered HCEs. The remainder of employees are non-highly compensated employees (NHCEs).

Plan sponsors need to keep their plans in compliance with the nondiscrimination rules to remain qualified, and this is normally accomplished by performing annual testing that demonstrates compliance. In certain cases where a plan passes the testing by a significant margin, plan sponsors are permitted to perform the testing on a three-year cycle if there have been no significant changes to the plan or the workforce.

Which retirement plans must go through nondiscrimination testing?

Some plans are exempt from nondiscrimination testing, such as:

• Plans that have discontinued contributions or benefit accruals
• Plans that benefit only NHCEs
• Plans that benefit only collectively bargained employees

One exception to the above is that DB plans that no longer provide benefit accruals (frozen plans) are still subject to a prior benefit structure test, which is covered in more detail in the Participation section below.

During testing, a plan can sometimes be combined with one or more plans in the controlled group to facilitate passing. This aggregated plan is tested as if it were one plan. For example, one plan that benefits executives could be aggregated with a second plan that benefits the rank-and-file employees if the plans meet certain requirements. However, plans may sometimes be disaggregated into separate plans for testing purposes. In addition, some plans contain features, such as Internal Revenue Code (IRC) §401(k) deferrals and IRC §401(m) matching contributions, which are required to be tested separately.

How is the employer defined for nondiscrimination testing?

Prior to performing nondiscrimination testing, plan sponsors must first determine if their organization is part of a controlled group. In general, two organizations are considered part of a controlled group if one organization owns at least 80% of the other or if the organizations are connected through a common parent that owns 80% of each organization. (Other types of controlled groups are also possible.) For testing purposes, the employer is defined as the entire controlled group of companies.

There is an exception for an employer that can demonstrate it operates qualified separate lines of business (QSLOBs). If the QSLOB requirements are met, each separate line of business can be tested individually, which will often help plan sponsors to pass the nondiscrimination tests.

In addition, when companies enter or leave the controlled group due to acquisition or disposition, plan sponsors may be granted transition relief. This relief provides plan sponsors with the opportunity to modify their benefit plans to meet the nondiscrimination requirements and is generally available until the end of the plan year following the acquisition or disposition.

Who is considered an employee for nondiscrimination testing?

All of the controlled group’s employees are considered employees, but some employees can be (or are required to be) excluded for testing purposes, such as:

• Collectively bargained employees
• Non-U.S. residents with no U.S. source income
• Employees who do not meet certain criteria, such as:
• Individuals who have not attained age 21 with at least one year of service
• Individuals who are terminated with fewer than 500 hours of service

Before performing any testing, plan sponsors must identify the benefiting employees under the plan being tested. Employees are considered to benefit under a plan if they receive an allocation of contributions or forfeitures under a DC plan or an increase in their accrued benefit under a DB plan. Employees who are eligible to receive a benefit under an IRC §401(k) deferral plan or an IRC §401(m) matching contribution program are deemed to be benefiting employees, even if they receive no benefit under the plan. Employees who reach the service limit or some other limitation under a DB plan and receive no increase in their accrued benefit are also deemed to be benefiting employees.

Once the plans and the employees have been established, the nondiscrimination testing can be performed. The three main nondiscrimination tests are:

• Participation
• Coverage
• Benefits

There are other nondiscrimination tests that may apply to a specific plan, depending on the circumstances.

Nondiscrimination testing requirements: Participation

What is participation testing for retirement plans?

Participation testing is designed to ensure that a DB plan is not excessively small for the size of the organization. DB plans that are currently providing accruals must generally provide them to the lesser of 50 employees or 40% of all employees at a minimum. DC plans are exempt from participation testing.

Certain DB plans are deemed to meet the minimum participation requirements:

• Plans that have frozen benefit accruals for all participants
• Plans that do not benefit any HCEs
• Plans that solely benefit collectively bargained employees

Legislation introduced in 2019 (the SECURE Act) modified these requirements to provide additional testing relief to DB plans that continue to provide benefits to a closed class of participants. Such a plan is deemed to meet the minimum participation requirements if it met the participation requirements as of the date of the closure and (for closures on or after April 5, 2017) if it had no significant increase in the coverage or the value of the benefits provided for the five-year period leading up to the closure date.

All DB plans, including closed plans and plans with frozen benefits, are subject to a prior benefit structure test. This test requires that the lesser of 50 employees or 40% of employees have meaningful benefits. Alternatively, a plan can satisfy this test if the lesser of 50 employees and former employees or 40% of employees and former employees have meaningful benefits.

Nondiscrimination testing requirements: Coverage

What is coverage testing for retirement plans?

Coverage testing ensures that plans do not provide benefits to a disproportionate number of HCEs. Plans that have discontinued contributions and plans that have frozen benefits for all participants are exempt from the coverage testing requirements.

To pass coverage testing, plan sponsors will perform the ratio percentage test, also known as the 70% test.

The ratio percentage test is satisfied if the percentage of NHCEs who benefit under a plan is at least 70% of the percentage of HCEs who benefit under that plan. As an example, assume that an employer has 200 employees, 40 of whom are HCEs, and that it sponsors a DB plan that benefits 80 of these employees (60 NHCEs and 20 HCEs). The ratio percentage test is performed as follows:

The percentage of NHCEs benefiting under the plan is 60 divided by 160, or 37.50%.

The percentage of HCEs benefiting under the plan is 20 divided by 40, or 50.00%.

The ratio percentage test result for the DB plan is 37.50% divided by 50.00%, or 75.00%. Because this exceeds the passing threshold of 70%, the test is passed.

If a plan does not pass the ratio percentage test, it may still be able to pass the coverage testing through an alternative testing method known as the average benefits test. The average benefit test consists of two separate tests:

• Nondiscriminatory classification test
• Average benefit percentage test

The nondiscriminatory classification test permits plans to pass coverage testing using a ratio percentage threshold that is lower than 70% (20% to 50%, depending on the percentage of NHCEs) as long as the classification of employees who benefit under the plan is reasonable and based on objective business criteria.

In order to pass the average benefits percentage test, the plan sponsor must demonstrate that the average benefit percentage (annual benefits as a percentage of salary) for the NHCEs is at least 70% of the average benefit percentage of the HCEs. This usually requires plan sponsors to obtain data for all of the nonexcludable employees in all of the benefit plans sponsored by the controlled group, which can complicate the testing procedure.

Nondiscrimination testing requirements: Benefits

What is benefits testing for retirement plans?

Benefits testing demonstrates that the level of benefits provided by a plan does not discriminate in favor of HCEs.

The testing process may be somewhat involved but can be broken down as follows:

• Step 1: As noted above, plans that have features such as IRC §401(k) deferrals and IRC §401(m) matching contributions are required to be disaggregated into separate plans and tested separately.
  When this occurs, the §401(k) deferrals are subject to the actual deferral percentage (ADP) test, and §401(m) matching contributions are subject to the actual contribution percentage (ACP) test. Plan sponsors can avoid these tests if they provide a safe harbor matching or contribution formula (such as a 100% match on the first 4% of compensation deferred or a contribution of 3% of compensation for all eligible employees).
• Step 2: With respect to the remaining portion of the plan, after any §401(k) and §401(m) disaggregation, plans that have discontinued contributions and plans that have frozen benefits for all participants are exempt from the benefits testing requirements.
• Step 3: Catch-up deferrals are exempt from testing requirements and can be excluded from the testing.
• Step 4: The remaining benefit structures should be reviewed to determine if they make use of a safe harbor design, such as a DB plan that provides 1% of final average pay for each year of service or a DC plan with an employer contribution of 4% of compensation. If so, these structures are also exempt from benefit testing.
• Step 5: In certain instances, the benefits provided by a plan can be disaggregated into two or more plans to facilitate testing. For example, a DC plan might provide benefits of 5% of compensation to employees in location A and 4% of compensation to employees in location B. While this arrangement would not be considered to be a safe harbor design, it may be possible to disaggregate the plan into two separate plans that meet the safe harbor design exemption as long as each separate plan passes the coverage requirements separately.

If the plan does not meet any of the safe harbor or other exemptions described above, then detailed testing is required. The benefits (such as DB plan accruals or DC profit-sharing allocations) will be subject to a numerical test known as the general nondiscrimination test (GNT). The GNT was designed to determine whether or not the benefits provided by a plan significantly favor HCEs.

The GNT is essentially a series of coverage tests. When performing the GNT, a rate group is established for each HCE under the plan. Each rate group consists of that specific HCE plus any other HCEs and NHCEs with equal or greater benefit accrual (or contribution) rates. Each rate group is then tested for coverage as if it were a separate plan. If all of the rate groups meet the coverage test, then the plan will pass the GNT.

Generally speaking, it is easier for plans to pass the GNT by comparing benefit accrual rates rather than comparing contribution rates. DC plans and hybrid DB/DC plans can be tested on a benefit accrual basis if they meet certain additional requirements. These requirements are known as the cross-testing rules. The SECURE Act identified additional situations in which plans that provide benefits to a closed class of participants could be tested on a benefit accrual basis.

Nondiscrimination testing requirements: Other testing

Plans that provide benefits using a safe harbor formula are still subject to the GNT if the compensation used to calculate benefits is determined to be discriminatory. To avoid the GNT, the compensation must either meet a safe harbor definition, such as W-2 compensation or total compensation plus certain deferrals, or pass a nondiscrimination test under §414(s). For the §414(s) test, an inclusion percentage is calculated for each employee by dividing the employee’s plan compensation by the employee’s total compensation. If the average inclusion percentage for the NHCEs is equal to or greater than the average inclusion percentage for the HCEs, the test is passed. As an example, consider a plan that uses base pay plus bonus as the compensation definition and excludes overtime from consideration. If overtime is a significant portion of total compensation for the NHCEs, it is likely that this definition of pay would be considered discriminatory.

The §414(s) test can still be passed if the average inclusion percentage for the NHCEs is less than the average inclusion percentage for the HCEs and if the difference is small.

Another type of testing is known as the benefits, rights, and features (BRF) test. Plans are permitted to provide certain plan design elements as long as they are made available to employees in a nondiscriminatory manner. For example, these may include ancillary benefits, such as death or disability benefits, optional forms of payment (including lump sums), and eligibility for early retirement benefits. To pass this test, the group of employees currently eligible for any BRF must satisfy the standard coverage requirements as if the employees in the group were covered by a separate plan. This is known as the current availability portion of the BRF test. Testing must also demonstrate compliance with the effective availability requirement: The group that is effectively available for a BRF must not substantially favor HCEs under a facts and circumstances determination.

Many benefit plans need to be closely monitored to ensure that they remain in compliance with the nondiscrimination requirements. This is especially important when contemplating plan changes because the changes could have an adverse impact on current or future nondiscrimination testing. For further information, please contact your Milliman consultant.