401(k) Plan Compliance Testing: What Your Company Needs to Know

Providing your employees with the opportunity to save through a 401(k) retirement plan is a valuable benefit that helps them build financial security for retirement. Any company that provides a 401(k) needs to be aware of mandatory government compliance tests that ensure a company's plan does not discriminate in favor of highly compensated or key employees. Compliance testing ensures that companies administer their 401(k) plans fairly and equally, in accordance with the rules established by the Employment Retirement Income Security Act (ERISA) of 1974. 

Why Does 401(k) Compliance Testing Exist?

Compliance testing is crucial for maintaining the tax-qualified status of 401(k) plans. These tests, mandated by the IRS, ensure that plans do not disproportionately benefit highly compensated employees (HCEs) or key employees (such as company owners) and meet coverage requirements. Failing to comply with these tests can result in plan disqualification, penalties, and adverse consequences for both employers and employees.

Companies must test their plans each year and address any compliance errors exposed by the tests. Typically a third-party plan administrator (TPA) or the plan recordkeeper helps plan sponsors carry out the tests.

The Three Key 401(k) Compliance Tests

Companies apply three different compliance tests to the plan each year. These tests look at how much income employees defer into the plan, how much the employer 401(k) match adds up to, and what percentage of assets in the plan belong to key employees and highly compensated employees versus what belongs to non-highly compensated employees.

1. ADP Test (Actual Deferral Percentage)

The ADP tests pre-tax and Roth elective deferrals - not including catch-ups - for nondiscrimination. To pass the ADP test, the average contribution rate of HCEs for the year cannot exceed the greater of:

2. ACP Test (Actual Contribution Percentage).

This test reveals how much the employer contributes to each participant’s plan as a percentage, based on their W-2 income. Companies pass the Actual Contribution Percentage test if the ACP for the eligible highly compensated employees doesn’t exceed the greater of:

• 125% of the non-HCE average rate,
• or the lesser of: 
  • 200% of the non-HCE average rate, or
  • the non-HCE average rate plus 2%.

Companies may run both the ADP and ACP tests using prior year or current-year contributions.

3. Top-Heavy Test

The Top-Heavy test targets key employees within an organization who contribute to qualified retirement plans. The IRS defines a key employee as any current, former or deceased employee who at any time during the plan year was:

• An officer making over $220,000 for 2024
• A 5% owner of the business, or
• An employee owning more than 1% of the business and making over $150,000 for the plan year

Top-Heavy Timing: Under IRS rules, a plan is top heavy if on the last day of the prior plan year the total value of plan accounts for key employees is more than 60% of the total value of plan assets. If the plan is top heavy, the employer must contribute up to 3% of compensation for all non-key employees still employed on the last day of the plan year. This is designed to bring plan assets back into a fair balance.

Safe Harbor Plans: Lessen the Administrative Burden of 401(k) Compliance testing

A safe harbor 401(k) plan exempts an employer from annual nondiscrimination testing that is required with a traditional 401(k) plan. A safe harbor plan requires employers to provide, among other things, contributions to employees' accounts that are fully vested when made.

According to the Internal Revenue Service (IRS), the safe harbor contribution can be either employer-matching contributions (limited to employees who defer) or contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. Those contributions can benefit the employees, the company, and the business owner in the following ways: 

• Most testing requirements are automatically satisfied, thus eliminating the need for annual nondiscrimination testing.
• Business owners and HCEs have greater ability to maximize salary deferrals.
• Employer contributions encourage employee participation in the plan. This can ultimately lead to greater financial

401k Plan Compliance Testing FAQ's

What Happens if a Compliance Test Fails?

When compliance tests reveal failures, employers must take prompt corrective action to remedy the situation. Options include returning excess contributions to HCEs, making qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs) to NHCEs, or amending plan provisions to meet compliance requirements.

How Test Failures Can Impact Plan Participants 

401(k) compliance test failures can have significant implications for plan participants. HCEs may face limitations on their contributions or unexpected tax liabilities, while NHCEs may experience reduced benefits or delayed retirement savings growth. Employers must strive to minimize the adverse effects on all participants through transparent communication and equitable corrective actions.

401(k) Compliance Testing Best Practices

To navigate the complexities of 401(k) compliance testing effectively, companies should implement best practices such as:

• Regularly reviewing plan documents and administrative procedures.
• Conducting annual compliance audits and consulting with qualified retirement plan professionals.
• Providing comprehensive employee education on plan features, the advantages of saving through the plan, contribution options, and compliance requirements.
• Considering automatic enrollment and escalation plan design features.
• Leveraging technology solutions to streamline plan administration and data management.

When is 401(k) Compliance Testing Due?

Please refer to our compliance calendar for due dates for compliance testing and various other relevant deadlines.

Final Thoughts

401(k) compliance testing is a critical aspect of plan administration that requires careful attention and proactive management. By understanding the key compliance tests, leveraging safe harbor provisions if appropriate, and implementing best practices, companies can maintain the tax-qualified status of their plan and support the retirement security of their employees.