What Is Nondiscrimination Testing, And Why Does It Matter?
If you’re sponsoring a retirement plan, especially a 401(k), profit-sharing, or defined benefit plan, nondiscrimination testing isn’t optional. It’s a compliance requirement with real financial consequences for plan sponsors and owners who don’t pay attention.
Let’s explore what nondiscrimination testing is, why it exists, who it protects, and how smart plan design can help you pass, while still maximizing owner contributions.
What Is Nondiscrimination Testing?
Nondiscrimination testing (NDT) is a set of IRS-mandated compliance tests designed to ensure that retirement plans do not unfairly benefit highly compensated employees (HCEs) at the expense of rank-and-file employees.
It applies to:
- 401(k) and Safe Harbor plans
- Profit-sharing plans
- Defined benefit and cash balance plans
- Combination plans (e.g., DB/DC)
In short, if you’re offering retirement benefits, the IRS wants to ensure you’re not only enriching owners and top executives while leaving everyone else behind.
Why Was It Created?
Nondiscrimination testing exists to protect employees.
“It’s to make sure you’re not giving way too much money to your CEO and executives when compared to your staff,” says Alison Quesada, Partner at Mirador.
It ensures fairness and plan qualification. A plan that discriminates in favor of HCEs risks disqualification by the IRS, which can result in:
- Refunds of employee deferrals
- Required employer contributions
- Loss of tax-favored plan status
- Costly corrections or audits
Who Needs to Pay Attention to Nondiscrimination Testing?
NDT isn’t just the responsibility of your TPA, it affects:
- Business Owners: Because the structure of your contributions depends on passing these tests
- HR and Finance Leaders: Who handle compliance documentation and employee communication
- Advisors and CPAs: Who integrate retirement plan strategy into overall tax and compensation planning
If your plan includes both HCEs and rank-and-file employees (and most do), you’re subject to nondiscrimination testing.
Common Testing Areas
Here are the key tests most plans must pass annually:
ADP (Actual Deferral Percentage) Test
Compares how much HCEs and non-HCEs defer from their own pay into the 401(k).
ACP (Actual Contribution Percentage) Test
Compares employer matching and after-tax contributions between HCEs and non-HCEs.
Top-Heavy Testing
Determines whether key employees (e.g., owners, officers) hold more than 60% of total plan assets.
What Happens if You Fail?
Failing nondiscrimination testing can trigger:
- Refunds to HCEs, forcing owners and execs to pull money out of their accounts
- Additional employer contributions, to “rebalance” benefits to rank-and-file employees
- Penalties and potential loss of plan qualification if not corrected in time
The good news? These failures are often avoidable, with the right plan structure.
Smart Design: Combining Plans to Satisfy Compliance and Maximize Value
As Rachel Rosner explains in the video, one of the most powerful ways to pass NDT and support both owners and employees is by combining plan types:
“We call them DB/DC or CB/DC combination plans. So it’s a defined benefit plan paired with a 401(k) profit-sharing plan.”
How It Works:
- The defined benefit (DB) plan delivers large contributions for owners, designed around age, compensation, and years to retirement
- The 401(k) profit-sharing plan offers visible contributions for employees on familiar investment platforms like John Hancock or American Funds
This structure not only passes nondiscrimination testing, it also serves as:
- A tax strategy for owners
- A retention tool for employees
- A balanced benefit plan that satisfies IRS fairness rules
“While we say we set these plans up for the owners, it still is for the owners,” says Rosner. “But the employees get real value too.”
