Why 401k Nondiscrimination Testing Could Be Your Hidden Risk
If you sponsor a retirement plan, there’s a test you might not even realize you’re responsible for until it’s too late. It’s called 401k nondiscrimination testing, and it’s one of the most overlooked compliance requirements for small businesses offering a 401k plan.
In plain terms, 401k nondiscrimination testing is the IRS’s way of making sure your company’s retirement plan doesn’t favor higher-paid employees over everyone else. It’s designed to keep things fair between owners, executives, and rank-and-file workers. But here’s the catch: many business owners don’t think about it until they fail. And failing can mean penalties, refunding contributions, and scrambling to correct issues after the fact.
If you have a Solo 401k, you might assume you’re completely off the hook. And for now, you might be. But understanding how 401k nondiscrimination testing works is still critical, because as soon as you hire an employee, the rules change. Scaling your business without preparing for compliance is one of the biggest missteps Solo 401k owners make.
Let’s break down what this testing measures, how it affects you, and why knowing the rules early can save you headaches down the road.
What 401k Nondiscrimination Testing Really Measures
At its core, 401k nondiscrimination testing is about fairness. The IRS wants to make sure your company’s retirement plan doesn’t become a tool that primarily benefits highly compensated employees (HCEs) while leaving non-highly compensated employees (NHCEs) behind.
Who falls into these groups? Generally:
- HCEs: earn more than $150,000 (2025 limit) or own more than 5% of the company
- NHCEs: everyone else
Each year, the IRS requires employers to compare how much these two groups contribute and benefit from the 401k. That’s where the three primary 401k nondiscrimination testing categories come into play:
- Actual Deferral Percentage (ADP) Test: Looks at how much of their salary HCEs contribute vs. NHCEs.
- Actual Contribution Percentage (ACP) Test: Reviews employer contributions like matching funds or profit-sharing across the groups.
- Top-Heavy Test: Checks whether key employees (usually owners and execs) hold too much of the plan’s total assets.
Passing these tests is more than just a box to check. Failing impacts your business financially (potential refunds, forced contributions) and can erode trust with employees who expect fair benefits.
The Solo 401k Exception
One of the reasons many self-employed professionals love the Solo 401k is that it skips some of the headaches of traditional plans, like 401k nondiscrimination testing.
As long as you’re the only participant (or only you and your spouse), you don’t need to run these annual tests. The IRS doesn’t require nondiscrimination testing for Solo 401k plans without employees because there’s no risk of favoring HCEs over NHCEs when you’re the only employee.
But what happens when your business grows?
The moment you hire a W-2 employee who meets eligibility requirements to join the plan, your Solo 401k effectively converts into a standard small business 401k plan. From that point forward, you’re no longer exempt from 401k nondiscrimination testing.
This transition is where many business owners stumble. Adding a staff member without adjusting your plan design can inadvertently expose you to testing failures. If you’re planning to scale, it’s worth proactively working with your 401k provider or administrator to prepare for compliance from day one.
401k Nondiscrimination Testing Explained Without the Jargon
Let’s get into what these tests really do, in simple terms.
ADP Test: Keeping Contributions Fair
The Actual Deferral Percentage (ADP) Test compares how much of their pay HCEs contribute vs. NHCEs. The IRS doesn’t want your execs maxing out their contributions if regular employees aren’t participating much.
Example:
- NHCEs average 4% salary deferral
- HCEs average 10% salary deferral
This gap could cause the plan to fail the test because HCEs are contributing too disproportionately.
ACP Test: Preventing Match Favoritism
The Actual Contribution Percentage (ACP) Test looks at employer contributions like matching funds. It ensures HCEs aren’t receiving a much bigger match percentage than NHCEs.
Example:
- NHCEs get 3% average match
- HCEs get 7% average match
Too large a gap = potential failure.
Top-Heavy Test: Keeping Balance of Assets
The Top-Heavy Test checks whether key employees control more than 60% of the plan’s total assets. If they do, the company has to make mandatory contributions to NHCEs to level the playing field.
Example:
- Total plan assets = $1 million
- Key employees’ accounts = $700,000 (70%)
Fail.
Each of these tests protects lower-paid employees from being disadvantaged. But for business owners, failing them leads to corrective contributions, refunding exec contributions, or even penalties from the IRS.
Surprising Ways to Accidentally Fail 401k Nondiscrimination Testing
Failing 401k nondiscrimination testing doesn’t always come from blatant unfairness. In fact, many failures happen by accident, often because small businesses don’t realize how easy it is to tip the scales.
Here are a few common culprits:
🚩 Owner raises or big bonuses: If an owner or HCE gets a sudden compensation bump, their contribution percentages may spike, throwing off the ADP or ACP balance.
🚩 Mid-year changes to matching formulas: Adjusting employer match formulas mid-year can cause uneven contributions across groups.
🚩 Low participation from NHCEs: Even if HCEs don’t max out their contributions, having too few NHCEs participating at all can create a failure.
🚩 Hiring family members as key employees: Adding relatives into ownership or management positions can inadvertently trigger top-heavy failures.
So how can you sidestep these landmines?
One solution is adopting a safe harbor 401k plan. A safe harbor plan uses mandatory employer contributions (either matching or non-elective) and automatically exempts your plan from the ADP and ACP tests. It’s a way to “buy” compliance by building fairness into the plan design from the start.
But even safe harbor plans must pass the Top-Heavy Test. So understanding these rules is key no matter what.
Failing any one of these tests doesn’t just trigger a quick fix. The corrective actions can affect your company’s cash flow, increase taxable income for your HCEs (from refunded contributions), and damage employee trust in the plan’s fairness.
Action Plan: Passing 401k Nondiscrimination Testing with Confidence
The best way to handle 401k nondiscrimination testing is to avoid surprises. Many companies wait until the end of the year to check compliance. This last-minute approach leads to stress, rushed decisions, and costly fixes.
A smarter strategy is year-round monitoring. By testing mid-year or quarterly, you can spot issues early. This gives you time to adjust contribution rates or boost NHCE participation before formal testing.
Another key move is hiring a third-party administrator (TPA). A TPA specializes in plan compliance. They run the tests, interpret results, and suggest corrections before problems grow. Many TPAs also use software tools to track participation and contributions automatically.
You can also take proactive steps internally:
- Encourage all employees to participate in the 401k.
- Offer education sessions about retirement saving.
- Adjust matching formulas to incentivize NHCE contributions.
Small changes throughout the year can help balance contributions between HCEs and NHCEs. Staying ahead of the testing process protects your business from penalties and keeps your plan running smoothly.
Case Studies: Real Scenarios, Real Solutions
Let’s look at how businesses handled 401k nondiscrimination testing challenges in real life.
Case Study 1: Small Business Failed ADP Test
A company with 20 employees failed the ADP test. Their HCEs contributed aggressively, but most NHCEs skipped contributions. The solution was auto-enrollment. By automatically enrolling all new hires at 4% contributions (with an opt-out option), the company boosted NHCE participation. They passed the test the next year without refunds or penalties.
Case Study 2: Founder Hired Spouse and Failed Top-Heavy Test
A business owner added their spouse to payroll as a key management role. Together, they held more than 60% of the plan’s total assets. This triggered a top-heavy test failure. To fix it, the company made a mandatory 3% contribution to all NHCE accounts for the year. This restored compliance and avoided IRS penalties.
Case Study 3: Startup Adopted Safe Harbor from Day One
A new startup wanted to avoid the headache of 401k nondiscrimination testing altogether. Their advisor recommended a safe harbor 401k plan. The plan included a 3% non-elective employer contribution. By adopting safe harbor upfront, they automatically passed ADP and ACP tests every year. Their compliance was built into the plan from the start.
These examples show how different situations require tailored solutions. Planning ahead makes all the difference.
The Role of 401k Nondiscrimination Testing in Your Tax Strategy
401k nondiscrimination testing isn’t just about compliance. It’s also part of your business’s overall tax strategy.
When you fail a test, you may need to refund contributions to HCEs. Those refunded amounts become taxable income for the HCEs. This increases their tax bill unexpectedly. It also means your business loses part of its deduction for those contributions.
Passing the tests keeps those employer contributions deductible. It protects your tax savings. It also helps avoid penalties or corrective contributions that could strain your cash flow. Compliance also boosts employee morale. Workers are more likely to trust and value a plan they see as fair and equitable.
Conclusion
401k nondiscrimination testing is often ignored by small businesses until it becomes a problem. Don’t wait until you fail. Learning the rules now puts you in control.
Even if you’re a Solo 401k owner today, knowing when testing will apply prepares you for growth. If you already employ workers, proactive planning can help you avoid penalties, protect tax deductions, and build trust.
Think of testing as more than a legal checkbox. It’s a smart part of growing your business the right way.
Work with a 401k specialist or plan advisor. They can design a plan that aligns compliance with your business goals. With the right strategy, you can meet IRS requirements while keeping your retirement plan strong for everyone.
