Providing a qualified retirement plan to employees is a generous benefit for any employer to offer. Still, the IRS wants to make sure these generous benefits are provided in a non-discriminatory manner. To enforce this, qualified retirement plans must pass a series of compliance tests each year to show that the benefits were provided fairly. We refer to this process as year-end testing.
Terminology
What do we mean when we refer to a benefit as being discriminatory or non-discriminatory? The IRS has identified categories of employees that, through either high salary, company ownership, or officer status, tend to receive a greater benefit from retirement plans than those who do not fall into those categories. Retirement plans that benefit a fair cross-section of employees across all salary, ownership, or officer statuses are determined to be non-discriminatory.
Before diving into the test descriptions, you should understand the categories of employees that we are referring to. Please note that the classification of employees into the following categories is based on the payroll information provided to us throughout the year and the year-end information submitted to us at the end of each plan year.
Highly Compensated Employees (“HCEs”): These are employees who either:
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Own (directly or indirectly) more than 5% of the stock, capital, or profits of the company during the current plan year or during 12 months preceding the plan year.
- If an individual meets the above criteria and has a family member who is an employee of the company, the family member(s) could also be considered an HCE.
- Employees earning more than $160,000 in the prior year (for 2025, adjusted annually by the IRS.)
Non-Highly Compensated Employees (“NHCEs”): These are employees that do not meet the conditions to be considered an HCE.
Key Employees: These are employees who satisfy any of the following conditions:
- Compensation: Any officer whose annual compensation is $230,000 or more (for 2025, adjusted by the IRS.)
- Ownership (in the current or prior year) OR relationship: Any employee who owns more than 5% of the company or is directly related to someone who does.
- Ownership (in the current or prior year) AND compensation: Any employee who owns more than 1% of the company and earns more than $160,000. An HCE may also happen to be a key employee, and an NHCE could also potentially be a key employee (< $135,000 in compensation/bottom 80% of compensation but is directly related to someone who owns > 5% of the company.)
Non-Key Employees: These are employees that do not meet the conditions to be considered a key employee.
Eligible Employees: These are employees who are eligible to participate in the retirement plan and, regardless of whether they choose to participate in the plan, will be included in the compliance tests.
Types of Tests
Once all employees have been classified into the correct categories, the tests are run. Below is a list of the required tests and a brief explanation of each one.
Coverage Test
- Plans must offer benefits to a significant percentage of lower-paid employees.
- A plan will pass the coverage test if the percentage of NHCEs benefiting under the plan is equal to at least 70% of HCEs benefiting under the plan.
Top Heavy Test
- Plans must show that the account balances of their rank & file employees comprise a significant portion of the total plan assets.
- A plan satisfies this test if the combined account balances of the key employees do not exceed 60% of the plan’s total account balance, after considering distributions made within the last four years and excluding unrelated rollovers.
Average Deferral Percentage Test (“ADP”)
- Plans that allow employee deferrals must make sure that the NHCEs are deferring at a relatively comparable rate to the HCEs.
- A plan passes this test if the total Average Deferral Percentage (“ADP”) of the HCEs is within the allowable limit based on the ADP of the NHCEs, see below:
- If the ADP of the NHCE group is equal to or less than 2%, the HCE limit is double the NHCE ADP.
- If the ADP of the NHCE group is between 2%-8%, the HCE limit is the NHCE limit plus 2%
- If the ADP of the NHCE group is greater than 8 percent, the HCE limit is the NHCE ADP multiplied by 1.25%
Actual Contribution Percentage Test ("ACP")
- This only applies to plans with an employer match. The calculations and breakdowns are the same as with ADP, but they include employer match and after-tax contributions when calculating the average contribution rate.
General Non-Discrimination Test
- If a plan makes profit-sharing contributions, the allocation of those contributions must pass the general non-discrimination test to confirm they are not weighted in favor of highly compensated employees.
- The plan passes this test if all eligible employees receive a pro-rata allocation of the contribution or more complex testing is performed that is not detailed here.
Safe Harbor Plans
Plans that have a safe harbor feature are deemed to pass the compliance tests (not including top-heavy or general non-discrimination if an additional employer contribution is made in addition to the safe harbor), but a compliance package should still be produced each year to show that all employees receive the safe harbor contribution they were due.
IRS COLA Limits
The IRS publishes an annually updated limits table that correlates directly with some of the above determinations and contribution limits that affect retirement plans. The latest article can be found here for the current and past two calendar years. Please also note, however, for a plan year that is less than 12 months (either due to initially establishing the plan after the first of the year or terminating a plan before the end of the year), these limits must be prorated based on the number of months in the short plan year.
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Retirement Cost-of-Living Adjustments Maximum Dollar Limitations | |||
| Employee Deferral Limits | 2026 | 2025 | 2024 |
| 401(k) Contribution | $24,500 | $23,500 | $23,000 |
| 403(b) Contribution | $24,500 | $23,500 | $23,000 |
| 457 Contribution | $24,500 | $23,500 | $23,000 |
| SIMPLE 401(k)/IRA | $17,000 | $16,500 | $16,000 |
| Employee Catch-Up Limits | |||
| 401(k), 403(b), 457 | $8,000 | $7,500 | $7,500 |
| SIMPLE 401(k)/IRA | $4,00 | $3,500 | $3,500 |
| Other Plan Limitations | |||
| Compensation Cap | $360,000 | $350,000 | $345,000 |
| Defined Benefit Plan Maximum Benefit | $290,000 | $280,000 | $275,000 |
| Defined Contribution Plan Maximum Contribution | $72,000 | $70,000 | $69,000 |
| Highly Compensated Employee's Compensation Exceeding | $160,000 | $160,000 | $155,000 |
| Key Employee Office Compensation | $235,000 | $230,000 | $220,000 |
| Key Employee 1% Owner | $150,000 | $150,000 | $150,000 |
| SEP Participation Coverage Compensation Level | $800 | $750 | $750 |
| ESOP Threshold for 5-Year Distribution Period | $1,455,000 | $1,415,000 | $1,380,000 |
| ESOP Increment Threshold for Extending 5-Year Distribution Period (max 5 additional years) | $290,000 | $280,000 | $275,000 |
| Social Security Taxable Wage Bases | |||
| Social Security | $184,500 | $176,100 | $168,600 |
| Medicare | No Limit | No Limit | No Limit |
| Social Security Tax Rates | |||
| Social Security – Employer | 6.20% | 6.20% | 6.20% |
| Social Security – Employee | 6.20% | 6.20% | 6.20% |
| Medicare – Employer and Employee | 1.45% | 1.45% | 1.45% |
| Per Employer/Per Employee Combined Rate | 7.65% | 7.65% | 7.65% |
| Combined Rate | 15.30% | 15.30% | 15.30% |
| Additional Medicare Tax on Wages above $200,000 – Employee Only | 0.90% | 0.90% | 0.90% |
| * The Affordable Care Act imposes an additional .9% Medicare tax on wages above $200,000 ($250,000 for marries couples filing jointly, $125,000 for married couples filing separately, and $200,000 for other filers.) Employers are required to withhold additional .9% Medicare tax (a total of 2.35%) on wages above $200,000 regardless of the employee's tax filing status. Employers do not match the additional tax. | |||