What Is Nondiscrimination Testing?

Small to medium-sized business owners and human resources professionals must familiarize themselves with several compliance requirements, especially those regarding employee benefits and taxation. While all are important, one key requirement you may not be aware of is nondiscrimination testing (NDT).

While the concept may sound complex, NDT is simply an Internal Revenue Service (IRS) rule designed to ensure you offer certain employee benefits fairly across your workforce. Not only is understanding how nondiscrimination rules apply critical for staying compliant, but it also helps you avoid costly tax penalties and maintain employee trust.

This article will explain the aspects of NDT, why it matters, and what steps to take if your plan doesn’t pass the tests.

In this blog post, you’ll learn:

• What nondiscrimination testing is and why the IRS requires it for certain employee benefits.
  
  
• When and how to complete nondiscrimination benefits testing to keep your plans compliant.
  
  
• What happens if your benefit plan fails testing, and how to take corrective action.

What is nondiscrimination testing?

NDT is a series of tests established by the IRS to evaluate the fairness of an organization’s fringe benefits. NDT aims to ensure your company’s benefits plans are accessible to all eligible current employees, not just highly-compensated employees (HCEs)¹.

The federal government initially created these additional tests for 401(k) plans. However, now they apply to certain Section 125 cafeteria plans and Section 105 medical reimbursement plans².

Pre-tax benefits that require NDT include:

• Retirement plans
• Flexible spending accounts (FSAs)
• Health savings accounts (HSAs), where employer contributions are made through a Section 125 cafeteria plan
  • HSA contributions outside a cafeteria plan must satisfy HSA comparability rules instead
• Health reimbursement arrangements (HRAs) like the individual coverage HRA (ICHRA)

There are a few different tests for determining if your current plan is discriminatory toward non-highly-compensated employees (NHCEs) in favor of key employees. But first, let’s look at the difference between HCEs and NHCEs.

Who does the federal government consider a highly-compensated employee?

NDT relies on comparing HCEs and NHCEs. The IRS has clear guidelines on which you should consider employees HCEs.

Employees eligible as an HCE must meet the following criteria:

1. They own more than 5% of the interest in the organization at any time during the current or preceding year.
2. They receive more than the annual compensation threshold from the organization in the current or preceding year (lookback year).
   1. For 2025, the prior year threshold is $155,000.
   2. For 2026, the prior year threshold is $160,000.

The IRS allows you to consider any eligible employees in the top 20% of workers by compensation as HCEs. However, this is optional. You should classify all other staff members as NHCEs.

When should you do nondiscrimination testing?

NDTs are annual tests that employers must complete and satisfy by the final day of the benefit plan year. It’s a good idea to conduct your tests before this date so you have time to make corrections to comply with IRS guidelines. Otherwise, you won’t have time to correct any errors that you find. You must keep these results in case of an IRS audit.

Why must you perform annual nondiscrimination testing?

NDT ensures that your qualified retirement and Section 125 plans are fair to all employees. Since these are tax-advantaged plans, the IRS enforces NDT so that your benefits don’t unfairly compensate employers and certain key employees.

What are the different types of nondiscrimination tests?

Depending on the kind of benefits you offer, you may need to complete different annual testing methods. Retirement and Section 105 health plans that provide tax-free benefits are subject to NDT³. This includes HRAs, dental and vision insurance, and health FSAs.

We’ll look at each type of test in the following sections.

Eligibility test

The eligibility test determines whether enough NHCEs benefit from the plan compared to HCEs. You must include all employees in the current year testing group. The only exceptions are those who have been with your company for fewer than three years, those younger than 25, and part-time and seasonal employees.

Your plan must satisfy one of the following three tests to pass:

1. 70% test: Your plan benefits 70% or more non-excludable employees.
2. 70% / 80% eligibility test: Your plan benefits 80% or more of your non-excludable workers who are eligible for the plan if at least 70% of your non-excludable workers are eligible.
3. Non-discriminatory classification test: Your plan benefits a class of employees that doesn’t discriminate in favor of HCEs. You must use bona fide employee classes, and your plan must have an acceptable ratio of benefiting NHCEs to HCEs.

The ICHRA has special rules. For example, you can offer varying ICHRA allowances and eligibility rules to 11 different classes of employees as long as those classes aren’t discriminatory. You can also vary allowances by age (not more than a 3:1 ratio) and by family status.

Benefits test

Under the benefits test, Section 105 plans must provide the same additional benefits offered to HCEs to all other participants. This only reflects the actual benefits you can reimburse employees for, not the amount.

If your health plan includes HCEs, it must satisfy the following to pass:

• Employee contributions: Employee contributions, such as FSA allowances, must be the same for HCEs and NHCEs.
• Benefit limits: Contribution limits must be uniform for all participants and free from modification based on age or years of employment.
  • For example, if you offer your employees a $6,000 annual ICHRA allowance but a $10,000 allowance to your executives only, your benefit would fail the NDT.
• Waiting periods: Requiring a longer waiting period for NHCEs than HCEs can cause you to fail the test.

Section 105 allows for an exception for NDT for medical diagnostic procedures, such as blood tests, physical exams, and X-rays.

Actual deferral percentage (ADP) test

Actual deferral percentage (ADP) looks at elective deferrals and divides that amount by the plan participant’s compensation. You use this NDT for retirement plans like 401(k)s.

First, you’ll need to find the annual contribution rate for both HCEs and NHCEs. Then, divide the average elective deferrals for each type of employee by their average compensation. Now, you’ll compare the two values.

To pass, the ADP for HCEs can’t exceed the greater of:

• 125% of the ADP for the NHCEs.
• 200% of the ADP for the NHCEs.
• The ADP of the NHCEs plus an additional 2%.

Actual contribution percentage (ACP) test

This test is similar to ADP but includes employer-matched contributions, including any employer contributions through a non-elective contribution model. Like with ADP, you’ll divide each participant’s matching contributions and after-tax contributions by compensation.

To pass the ACP test, you must adhere to the following:

• HCEs can’t exceed 125% of the ACP for the NHCEs.
• HCEs can’t have less than 200% of the ACP for the NHCEs.

Top-heavy test

You’ll use the top-heavy test to determine whether your current retirement benefits provide more value to key employees⁵.

The IRS defines key employees as:

• An employee making more than $200,000 per year.
• Anyone with a 5% or more ownership stake in the company.
• Any employee who owns more than 1% of the organization and makes more than $150,000 in annual compensation.

Suppose the value of the plan assets in key employees’ retirement accounts is greater than 60% of all assets from the overall employer-sponsored plan, including non-key employees. In that case, the benefit plan will fail the test.

Key employee concentration test

With the key employee concentration utilization test, you must provide no more than 25% of the combined tax-free benefits to key employees. This includes all pre-tax contributions for HSAs, FSAs, HRAs, and life or disability insurance premiums combined.

Dependent care tests

There are two unique utilization tests for dependent care benefits: the 55% of average benefits test and the 5% owners test.

Here’s what you must do to pass each test:

1. 55% average benefits test: Dependent care plans must provide at least 55% of the average company contributions to eligible NHCEs.
2. 5% owners test: You may give no more than 25% of the additional contributions for dependent care assistance to a 5% shareholder or a business owner.

What happens if you fail nondiscrimination testing?

If your plans fail NDT, your tax-free benefits will become taxable income for HCEs on all excess reimbursements. You must include these excess contributions on employees’ W-2s as gross income. However, they aren’t subject to income tax withholding.

Here’s how to determine excess reimbursements:

1. First, divide the total reimbursements to HCEs by the total reimbursed to all employees for the plan year.
2. Then, multiply the number by the total reimbursed to a single HCE.

Failing NDT doesn’t affect the tax-free status of your benefit for NHCEs.

Conclusion

By completing nondiscrimination testing during each plan year, you can keep your employee benefits fair, compliant, and tax-advantaged. You’ll also ensure that your staff gets maximum value from your compensation package, regardless of their overall income or position.

If any of the IRS tests fail, review your benefits to confirm you’ve classified your employees properly and how you can enhance your benefits for your NHCEs. That way, you can correct your plan design before sending the results to the IRS.

If you want to expand your compensation package, PeopleKeep by Remodel Health can help. Our HRA administration software makes setting up and managing personalized health benefits easy. Book a call with an HRA specialist today to see how health benefits can bolster your compensation package for NHCEs.

PeopleKeep by Remodel Health doesn’t conduct nondiscrimination testing. However, we do assist employers in designing and administering HRA plans that align with IRS requirements.

This article was originally published on January 24, 2024. It was last updated on September 12, 2025.

References

1. Issue snapshot - Identifying highly compensated employees in an initial or short plan year

2. 401(k) plan Fix-it Guide — The plan failed the 401(k) ADP and ACP tests

3. 26 U.S. Code § 105 - Amounts received under accident and health plans

4. Safe harbor 401(k) plans

5. Is my 401(k) top-heavy?