Specialized Returns and Taxpayers · Retirement plans
Non-discrimination rules
tax year · reviewed 2026-08-21 · Draft for I. Ohu review
Three separate tests stand between a plan and disqualification, and they are not variations on a theme. Coverage asks who is in the plan. Contribution testing asks what the people in it actually received. Top-heavy testing asks where the money has ended up. A plan can be generous, cover everyone, and still be top-heavy; it can pass coverage comfortably and fail the deferral test because nobody at the lower end chose to participate.
The rule
Coverage (IRC § 410(b)(1)). a trust is not qualified unless the plan meets one of three coverage tests: it benefits at least 70 percent of employees who are not highly compensated (the ratio percentage test in its simplest form); the percentage of non-highly compensated employees benefiting is at least 70 percent of the percentage of highly compensated employees benefiting; or it satisfies the average benefit percentage test (IRC § 410(b)(1))TY2026 the average benefit percentage test is met where the plan benefits a classification the Secretary finds not discriminatory in favour of highly compensated employees, and the average benefit percentage for non-highly compensated employees is at least 70 percent of that for highly compensated employees, the average being taken over every employee in the group whether or not a participant in any plan (IRC § 410(b)(2))TY2026 The first two tests count heads. The third measures benefits, and is the escape route for a plan whose classification is defensible but whose headcount is not.
Who counts as highly compensated. a highly compensated employee is one who was a 5-percent owner at any time during the year or the preceding year, or who for the preceding year had compensation above the indexed threshold and, if the employer elects, was in the top-paid group — the top 20 percent of employees ranked by compensation. The statutory compensation figure is $80,000, indexed from the quarter ending 30 September 1996 (IRC § 414(q))TY2026 the threshold in the definition of highly compensated employee under IRC § 414(q)(1)(B) remains $160,000 for 2026, and the IRC § 416(i)(1)(A)(i) threshold for a key employee for top-heavy purposes is $235,000, up from $230,000TY2026 Ownership is measured in the current or preceding year; compensation is measured in the preceding year only. The top-paid group election is what a plan uses when a large share of its workforce is above the dollar threshold.
Contribution testing: deferrals. a cash or deferred arrangement is qualified only if the eligible employees satisfy IRC § 410(b)(1) and the actual deferral percentage for eligible highly compensated employees meets one of two tests against that for all other eligible employees for the preceding plan year: it is not more than 1.25 times that percentage, or it exceeds it by no more than 2 percentage points and is not more than twice it (IRC § 401(k)(3)(A))TY2026 the actual deferral percentage for a group is the average of the ratios, computed separately for each employee in the group, of employer contributions actually paid over to the trust on that employee’s behalf for the plan year to that employee’s compensation for the year — an average of individual ratios, not a ratio of aggregates (IRC § 401(k)(3)(B))TY2026 The averaging method is the point most often got wrong. Each employee’s own ratio is computed first and the ratios are then averaged, so one employee deferring heavily on a small salary moves the group average far more than the dollars would suggest.
Contribution testing: matches. matching and employee contributions are tested separately: the contribution percentage for eligible highly compensated employees may not exceed the greater of 125 percent of that percentage for all other eligible employees for the preceding plan year, or the lesser of 200 percent of it or that percentage plus 2 percentage points (IRC § 401(m)(2)(A))TY2026 The two tests run in parallel on different contributions, and a plan can pass one and fail the other.
Buying an exemption. the safe harbour match requires the employer to contribute, for each employee who is not highly compensated, 100 percent of elective contributions up to 3 percent of compensation and 50 percent of elective contributions between 3 and 5 percent of compensation, with no higher rate of match at any deferral rate for a highly compensated employee (IRC § 401(k)(12)(B))TY2026 the alternative safe harbour requires an employer contribution of at least 3 percent of compensation for each non-highly compensated employee eligible to participate, whether or not that employee defers anything (IRC § 401(k)(12)(C))TY2026 the matching safe harbour also requires that each eligible employee be given written notice, within a reasonable period before the year, of rights and obligations under the arrangement, sufficiently accurate and comprehensive and written to be understood by the average eligible employee (IRC § 401(k)(12)(D))TY2026 A safe harbour plan is deemed to satisfy the deferral test, which is why almost every small 401(k) is designed as one. a plan may be amended after the plan year begins to adopt the nonelective safe harbour, if adopted before the 30th day before the close of the plan year, or as late as the last day for distributing excess contributions for the year — but only where the required contribution is at least 4 rather than 3 percent of compensation, and not where the plan provided at any time during the year that the matching safe harbour applied (IRC § 401(k)(12)(F))TY2026
Top-heavy testing. a defined benefit plan is top-heavy for a plan year if, at the determination date, the present value of cumulative accrued benefits for key employees exceeds 60 percent of that for all employees; a defined contribution plan is top-heavy if the aggregate of key employees’ accounts exceeds 60 percent of all accounts (IRC § 416(g)(1)(A))TY2026 a key employee is one who at any time during the plan year is an officer with annual compensation above the indexed threshold — with no more than 50 employees, or if fewer the greater of 3 or 10 percent of employees, treated as officers — or a 5-percent owner, or a 1-percent owner with annual compensation from the employer of more than $150,000 (IRC § 416(i)(1)(A))TY2026 Note that key employee and highly compensated employee are different definitions doing different jobs. An officer earning above the key employee threshold is a key employee; a rank-and-file worker who owns five percent is both.
And what a top-heavy plan owes. a top-heavy defined contribution plan must contribute for each non-key employee at least 3 percent of that participant’s IRC § 415 compensation, counting employer matching contributions; a top-heavy defined benefit plan must provide each non-key employee an accrued benefit of at least the lesser of 2 percent of average testing-period compensation per year of service or 20 percent (IRC § 416(c))TY2026
Vesting. a defined contribution plan must vest employer contributions under one of two schedules: 100 percent after 3 years of service, or graded vesting of 20 percent after 2 years rising by 20 points a year to 100 percent after 6 (IRC § 411(a)(2)(B))TY2026 a defined benefit plan must vest employer-derived accrued benefits under one of two schedules: 100 percent after 5 years of service, or graded vesting of 20 percent after 3 years rising by 20 points a year to 100 percent after 7 (IRC § 411(a)(2)(A))TY2026
Current figures
| Item | 2026 |
|---|---|
| Coverage tests | a trust is not qualified unless the plan meets one of three coverage tests: it benefits at least 70 percent of employees who are not highly compensated (the ratio percentage test in its simplest form); the percentage of non-highly compensated employees benefiting is at least 70 percent of the percentage of highly compensated employees benefiting; or it satisfies the average benefit percentage test (IRC § 410(b)(1))TY2026 |
| Highly compensated and key employee thresholds | the threshold in the definition of highly compensated employee under IRC § 414(q)(1)(B) remains $160,000 for 2026, and the IRC § 416(i)(1)(A)(i) threshold for a key employee for top-heavy purposes is $235,000, up from $230,000TY2026 |
| Actual deferral percentage test | a cash or deferred arrangement is qualified only if the eligible employees satisfy IRC § 410(b)(1) and the actual deferral percentage for eligible highly compensated employees meets one of two tests against that for all other eligible employees for the preceding plan year: it is not more than 1.25 times that percentage, or it exceeds it by no more than 2 percentage points and is not more than twice it (IRC § 401(k)(3)(A))TY2026 |
| Actual contribution percentage test | matching and employee contributions are tested separately: the contribution percentage for eligible highly compensated employees may not exceed the greater of 125 percent of that percentage for all other eligible employees for the preceding plan year, or the lesser of 200 percent of it or that percentage plus 2 percentage points (IRC § 401(m)(2)(A))TY2026 |
| Safe harbour match | the safe harbour match requires the employer to contribute, for each employee who is not highly compensated, 100 percent of elective contributions up to 3 percent of compensation and 50 percent of elective contributions between 3 and 5 percent of compensation, with no higher rate of match at any deferral rate for a highly compensated employee (IRC § 401(k)(12)(B))TY2026 |
| Safe harbour nonelective | the alternative safe harbour requires an employer contribution of at least 3 percent of compensation for each non-highly compensated employee eligible to participate, whether or not that employee defers anything (IRC § 401(k)(12)(C))TY2026 |
| Top-heavy definition | a defined benefit plan is top-heavy for a plan year if, at the determination date, the present value of cumulative accrued benefits for key employees exceeds 60 percent of that for all employees; a defined contribution plan is top-heavy if the aggregate of key employees’ accounts exceeds 60 percent of all accounts (IRC § 416(g)(1)(A))TY2026 |
| Top-heavy minimum | a top-heavy defined contribution plan must contribute for each non-key employee at least 3 percent of that participant’s IRC § 415 compensation, counting employer matching contributions; a top-heavy defined benefit plan must provide each non-key employee an accrued benefit of at least the lesser of 2 percent of average testing-period compensation per year of service or 20 percent (IRC § 416(c))TY2026 |
| Defined contribution vesting | a defined contribution plan must vest employer contributions under one of two schedules: 100 percent after 3 years of service, or graded vesting of 20 percent after 2 years rising by 20 points a year to 100 percent after 6 (IRC § 411(a)(2)(B))TY2026 |
| Defined benefit vesting | a defined benefit plan must vest employer-derived accrued benefits under one of two schedules: 100 percent after 5 years of service, or graded vesting of 20 percent after 3 years rising by 20 points a year to 100 percent after 7 (IRC § 411(a)(2)(A))TY2026 |
How it works in practice
Classify every employee before running any test, because both definitions turn on facts the payroll system does not record. Highly compensated status looks at ownership in the current or preceding year and at compensation in the preceding year only, so a new hire on a large salary is not highly compensated in their first year unless they are a five percent owner. Key employee status looks at the current plan year and reaches officers, five percent owners and one percent owners above a much lower compensation figure.
For the deferral test, compute the individual ratios first. The statute defines the actual deferral percentage as the average of the ratios calculated separately for each employee, not the ratio of total deferrals to total compensation. An employer who computes it the aggregate way will usually get a flattering answer, because the highly compensated employees’ large salaries dominate the denominator.
Decide on the safe harbour before the plan year begins, not after. The matching safe harbour requires the advance notice, so it cannot be adopted retrospectively at all. The nonelective safe harbour can be adopted late — up to thirty days before the year ends at three percent, or as late as the deadline for distributing excess contributions if the employer is willing to pay four percent — and that flexibility is the practical answer for a plan that discovers a failure after the year has run.
Check top-heavy status separately every year, because it moves. A plan that has been comfortably under sixty percent for a decade can cross the line when a long-serving owner’s balance grows or a group of employees takes their money on leaving. Crossing it triggers the minimum contribution for every non-key employee, including those who deferred nothing, and that cost is not budgeted for in the year it first appears.
The ratio that flattered
A design firm’s 401(k) has four highly compensated employees earning $250,000 each and deferring $25,000 each, and sixteen other employees earning $50,000 each. Of the sixteen, four defer $2,500 each and twelve defer nothing. The plan administrator computes the deferral percentages as total deferrals over total compensation for each group: $100,000 over $1,000,000 for the highly compensated group, and $10,000 over $800,000 for the rest.
That gives 10 percent against 1.25 percent, which fails either way, but the method is wrong and the correct method gives a different answer. Under IRC § 401(k)(3)(B) each employee’s own ratio is computed and the ratios are averaged. For the highly compensated group every ratio is 10 percent, so the average is 10 percent — the same answer, because the group is uniform. For the other group four employees have a ratio of 5 percent and twelve have a ratio of zero, so the average is 1.25 percent. Here the two methods coincide, but only because compensation happens to be uniform within each group. Change one of the sixteen to a $20,000 part-timer deferring $2,500 and the individual-ratio method jumps while the aggregate method barely moves. The plan fails on either computation: 1.25 times 1.25 percent is 1.5625 percent, and 1.25 plus two points is 3.25 percent, both far below 10 percent.
The late safe harbour
A veterinary practice’s 401(k) has never used a safe harbour. In October the administrator’s interim testing shows the plan will fail the deferral test for the calendar year by a wide margin. The owner asks whether the practice can adopt a safe harbour now to avoid refunding her deferrals.
Only one of the two safe harbours is available, and it costs more. The matching safe harbour under IRC § 401(k)(12)(B) requires the notice under subparagraph (D) within a reasonable period before the year, so it cannot be adopted in October. The nonelective safe harbour can be: under IRC § 401(k)(12)(F)(i)(I) the plan may be amended at any time before the 30th day before the close of the plan year, which is 1 December for a calendar-year plan, and the required contribution is 3 percent of compensation for every eligible non-highly compensated employee. Had the practice waited past that date, subparagraph (F)(i)(II) would still allow the amendment up to the deadline for distributing excess contributions — but only at 4 percent under subparagraph (F)(iii).
The plan that turned top-heavy
A family printing business sponsors a profit-sharing plan. The owner, aged 63, has an account of $1,400,000 after thirty years. Her operations manager, an officer earning $260,000, has $310,000. The remaining eleven employees have accounts totalling $980,000. Three long-serving employees left last year and rolled their balances out.
Key employee accounts are the owner’s $1,400,000, as a five percent owner, plus the operations manager’s $310,000, as an officer above the key employee compensation threshold — $1,710,000 against a plan total of $2,690,000, or 63.6 percent. That exceeds 60 percent, so the plan is top-heavy for the year. The consequence is that every non-key employee who is a participant must receive an employer contribution of at least 3 percent of IRC § 415 compensation, whether or not they deferred and whether or not the profit-sharing formula would have given them anything. Note what tipped it: the departures. Rollovers out by non-key employees shrank the denominator without touching the numerator.
Highly compensated and key employee are different definitions. IRC § 414(q) uses a 5-percent ownership test and a prior-year compensation threshold; IRC § 416(i) uses officer status above a lower threshold, 5-percent ownership, and 1-percent ownership above a fixed unindexed figure. The two thresholds also move independently — for 2026 the highly compensated figure did not change while the key employee figure did.
The deferral percentage is an average of ratios. IRC § 401(k)(3)(B) is explicit. Computing total deferrals over total compensation is a different calculation that gives a different answer whenever compensation varies within a group, which it always does.
Top-heavy status is about balances, not contributions. A plan can contribute identically for everyone every year and still become top-heavy through investment returns, length of service, or non-key employees taking distributions. It has to be retested annually against the determination date.
A safe harbour exempts the deferral test, not everything. IRC § 401(k)(12) addresses IRC § 401(k)(3)(A)(ii). Coverage under IRC § 410(b) still has to be satisfied, and a safe harbour plan is still subject to top-heavy testing — though a plan whose only contributions are safe harbour contributions and deferrals is deemed to satisfy the top-heavy requirements.
How this has changed
The current structure dates from the Tax Reform Act of 1986, which introduced the actual deferral percentage test in its present form, and from the Small Business Job Protection Act of 1996, which added the IRC § 401(k)(12) safe harbours and simplified the highly compensated employee definition down to the two-limb test now in IRC § 414(q). Before 1996 that definition ran to five categories.
The Pension Protection Act of 2006 shortened defined contribution vesting to the present three-year cliff or two-to-six graded schedules for all employer contributions; before it, only matching contributions were on the shorter schedules and other employer contributions could use five-year cliff or three-to-seven graded vesting. Material describing a five-year cliff for a profit-sharing plan is pre-2007.
SECURE 2.0 changed who must be covered. For plan years beginning after 31 December 2024, a long-term part-time employee who completes at least 500 hours in two consecutive years must be permitted to make elective deferrals, down from three years under the original SECURE Act. Such employees may be excluded from coverage, non-discrimination and top-heavy testing, which is what makes the rule workable — but they are in the plan.
The safe harbour amendment timing at IRC § 401(k)(12)(F) is also a SECURE 2.0-era relaxation, and it is the reason a mid-year rescue is possible at all. The three percent and four percent figures in it are statutory and are not indexed.
Exam focus
Know the three coverage tests and that only one of them has to be met. Know that the ratio percentage test compares the percentage of non-highly compensated employees benefiting to the percentage of highly compensated employees benefiting, and that seventy percent is the ratio, not a headcount.
Know both contribution tests and their two alternative limits — 1.25 times, or two points plus a doubling cap. Know that they run on different contributions and that a safe harbour exempts only the deferral test.
Know the two definitions of a favoured employee and which test uses which. Know the sixty percent top-heavy threshold, the three percent minimum for non-key employees in a defined contribution plan, and the two vesting schedules for each plan type.
Check yourself
1. A plan benefits 40 of an employer’s 50 non-highly compensated employees and 9 of its 10 highly compensated employees. Does it pass coverage?
Answer: Yes, on the ratio percentage test. The plan benefits 80 percent of non-highly compensated employees and 90 percent of highly compensated employees; 80 divided by 90 is 88.9 percent, which is at least 70 percent. Note it fails the first test in IRC § 410(b)(1)(A) only if fewer than 70 percent of non-highly compensated employees benefit — here 80 percent do, so that test is also met.
2. The actual deferral percentage for non-highly compensated employees is 4 percent. What is the maximum for highly compensated employees?
Answer: 6 percent. The two alternatives in IRC § 401(k)(3)(A)(ii) give 1.25 times 4 percent, which is 5 percent, or the lesser of 4 plus 2 points and twice 4 percent — 6 percent against 8 percent, so 6 percent. The plan takes the more favourable of the two, so 6 percent.
3. An employee is hired on 1 February 2026 at $400,000 a year and owns no part of the employer. Is she a highly compensated employee for 2026?
Answer: No. IRC § 414(q)(1)(B) looks at compensation for the preceding year, and she had none from this employer in 2025. She is not a 5-percent owner, so subparagraph (A) does not reach her either. She will be highly compensated for 2027.
4. A defined contribution plan uses a five-year cliff vesting schedule for its profit-sharing contributions. Is that permissible?
Answer: No. IRC § 411(a)(2)(B) allows only 100 percent vesting after three years of service, or graded vesting reaching 100 percent after six. Five-year cliff vesting is a defined benefit schedule and has not been available for defined contribution employer contributions since the Pension Protection Act of 2006.
5. A top-heavy profit-sharing plan makes no contribution for the year because there were no profits. Does anything need to be contributed?
Answer: Yes, unless no key employee received anything either. IRC § 416(c)(2) requires a contribution for each non-key employee participant of at least 3 percent of IRC § 415 compensation where the plan is top-heavy. The minimum is capped at the percentage contributed for the key employee with the highest percentage, so if no key employee received a contribution the required minimum is zero — but a discretionary contribution to the owner alone would trigger the full obligation.
Change log
- Initial draft. Separates the three tests a qualified plan must pass — IRC § 410(b) coverage, IRC § 401(k)(3) and § 401(m)(2) contribution testing, and IRC § 416 top-heavy testing — and sets out the IRC § 401(k)(12) safe harbours that buy an exemption from the second, the IRC § 414(q) highly compensated employee definition against the IRC § 416(i) key employee definition, and the IRC § 411(a)(2) vesting schedules.