Key Takeaways
- Highly Compensated Employee (HCE) for 2025: >5% owner OR compensation >$160,000 in prior year (with top 20% election)
- Key Employee for 2025: >5% owner, >1% owner with >$150,000 comp, OR officer with comp >$230,000
- Coverage tests: Safe Harbor (70% of NHCEs covered), Ratio Percentage (NHC%/HC% >= 70%), or Average Benefits Test
- Defined benefit plans must also pass the 50/40 test (cover lesser of 50 employees or 40% of employees)
- Top-heavy plans (>60% to key employees) require 3% DC minimum contribution or 2% DB minimum benefit per year of service
- Safe harbor 401(k) plans avoid ADP/ACP testing by providing 3% non-elective OR 100%/50% matching formula
Coverage and Discrimination Testing
Qualified retirement plans must satisfy coverage and nondiscrimination requirements to prevent plans from disproportionately benefiting highly compensated and key employees. Understanding these testing requirements is essential for plan design and ongoing compliance.
Highly Compensated Employee (HCE) Definition
The Highly Compensated Employee (HCE) definition is critical for coverage and discrimination testing. An employee is an HCE if they meet EITHER of the following tests:
2025 HCE Thresholds
| Test | Requirement | Notes |
|---|---|---|
| Ownership Test | >5% owner at any time during current or prior year | Any 5%+ owner is automatically HCE |
| Compensation Test | Compensation >$160,000 in the prior year | 2025 testing uses 2024 compensation |
| Top 20% Election | If elected, only top 20% of employees by pay are HCE | Reduces number of HCEs |
Important Timing Rule: HCE status is determined using the prior year's compensation (look-back rule). For 2025 plan year testing, you look at 2024 compensation to determine who is an HCE.
HCE Examples
| Employee | 2024 Salary | Current Year Ownership | Prior Year Ownership | HCE Status |
|---|---|---|---|---|
| Jeanette | $50,000 | 5% | 95% | HCE (>5% owner last year) |
| Cheryl | $50,000 | 95% | 5% | HCE (>5% owner this year) |
| Delano | $165,000 | 0% | 0% | HCE (comp >$160,000) |
| Marcus | $155,000 | 0% | 0% | Not HCE (comp <$160,000) |
Top 20% Election
Employers can elect to limit HCE status to only those highly-paid employees who are also in the top 20% by compensation. This election can reduce the number of HCEs, making it easier to pass coverage tests.
Without Top 20% Election: All employees earning >$160,000 are HCE With Top 20% Election: Only those in top 20% who also earn >$160,000 are HCE
Key Employee Definition
Key employees are used to determine if a plan is top-heavy. The key employee definition differs from the HCE definition:
2025 Key Employee Thresholds
| Category | Threshold | Indexed? |
|---|---|---|
| >5% Owner | Any ownership >5% | N/A |
| >1% Owner | With compensation >$150,000 | NOT indexed |
| Officer | With compensation >$230,000 (2025) | Yes, indexed |
Officer Determination: The IRS limits the number of officers who can be key employees based on company size. The determination is based on "all facts and circumstances."
HCE vs. Key Employee Comparison
| Feature | Highly Compensated Employee | Key Employee |
|---|---|---|
| >5% Owner | Yes | Yes |
| Compensation Test | >$160,000 (2025) | >$150,000 (1% owner only) |
| Officer Test | No | Yes, >$230,000 (2025) |
| Top 20% Election | Available | Not applicable |
| Primary Use | Coverage testing, ADP/ACP testing | Top-heavy determination |
| Indexed | Yes (compensation threshold) | Partially (officer only) |
Coverage Tests
All qualified plans must pass at least ONE of three coverage tests to ensure the plan benefits a broad group of employees.
Excludable Employees
Before applying coverage tests, certain employees may be excluded:
- Employees not meeting 21-and-1 eligibility requirements
- Employees covered under a collective bargaining agreement (union members)
- Nonresident aliens with no U.S.-source income
- Part-time employees not meeting SECURE Act eligibility
Safe Harbor Percentage Test
The simplest test to satisfy:
Requirement: Plan must benefit at least 70% of non-highly compensated employees (NHCEs)
Formula: (NHCEs covered / Total NHCEs) >= 70%
Example: Company has 75 NHCEs, 55 are covered
- 55/75 = 73.3% - PASS
Ratio Percentage Test
Compares the coverage ratio of NHCEs to HCEs:
Requirement: NHCE coverage ratio / HCE coverage ratio >= 70%
Formula: (% of NHCEs covered) / (% of HCEs covered) >= 70%
Example:
- 75 NHCEs, 55 covered = 73.3%
- 25 HCEs, 21 covered = 84%
- Ratio: 73.3% / 84% = 87.3% - PASS
Average Benefits Test
The most complex test, used when other tests fail:
Two-Part Requirement:
- Average Benefit Percentage Test: Average benefit % for NHCEs / Average benefit % for HCEs >= 70%
- Nondiscrimination Test: Plan must also satisfy nondiscrimination in contributions or benefits
Example:
- NHCE average benefit: 6% of compensation
- HCE average benefit: 10% of compensation
- Ratio: 6% / 10% = 60% - FAIL
Coverage Test Summary
| Test | Requirement | Simplicity |
|---|---|---|
| Safe Harbor | 70% of NHCEs covered | Easiest |
| Ratio Percentage | (NHC% / HC%) >= 70% | Moderate |
| Average Benefits | (NHC avg / HC avg) >= 70% + nondiscrimination | Most complex |
50/40 Test for Defined Benefit Plans
Defined benefit plans have an ADDITIONAL coverage requirement called the 50/40 test:
Requirement: Plan must cover the LESSER of:
- 50 employees, OR
- 40% of all employees
Memory Tip: "Employees come first" - the numbers are 50 and 40.
Example: Company with 100 eligible employees
- 50 employees OR 40% of 100 = 40 employees
- Lesser of 50 or 40 = 40 employees minimum must be covered
Top-Heavy Plans
A plan is top-heavy when more than 60% of plan assets or accrued benefits belong to key employees.
Top-Heavy Determination
| Plan Type | Top-Heavy If |
|---|---|
| Defined Contribution | >60% of account balances attributable to key employees |
| Defined Benefit | >60% of accrued benefits attributable to key employees |
Top-Heavy Minimum Contributions
When a plan is top-heavy, the employer must provide minimum contributions to non-key employees:
| Plan Type | Minimum Contribution | Notes |
|---|---|---|
| Defined Contribution | 3% of compensation | Unless key EE contribution is less than 3% |
| Defined Benefit | 2% x years of service x avg comp | Maximum 20 years (40% total) |
Top-Heavy Vesting Requirements
Top-heavy plans must use accelerated vesting:
- 2-6 year graded vesting, OR
- 3-year cliff vesting
This is the same as the standard DC vesting, but DB plans must also use this accelerated schedule when top-heavy.
Top-Heavy DC Example
Facts:
- James earns $65,000
- Not a key employee
- Plan is top-heavy
- Key employees receive 3%+ contributions
Minimum contribution for James: $65,000 x 3% = $1,950
Top-Heavy DB Example
Facts:
- James has 10 years of service
- Average compensation: $100,000
- Non-top-heavy formula: 1.5% x years x avg comp
| Formula | Calculation | Annual Benefit |
|---|---|---|
| Regular formula | 1.5% x 10 years x $100,000 | $15,000 |
| Top-heavy minimum | 2% x 10 years x $100,000 | $20,000 |
| Required benefit | Greater of above | $20,000 |
ADP/ACP Testing for 401(k) Plans
401(k) plans must pass additional discrimination tests to ensure highly compensated employees don't defer disproportionately more than non-highly compensated employees.
Actual Deferral Percentage (ADP) Test
Tests whether HCE elective deferrals are proportionate to NHCE deferrals:
| If NHCE ADP is: | Maximum HCE ADP is: |
|---|---|
| 0% - 2% | 2x NHCE ADP |
| 2% - 8% | NHCE ADP + 2% |
| 8% or higher | 1.25x NHCE ADP |
Examples:
| NHCE ADP | Max HCE ADP | Calculation |
|---|---|---|
| 1% | 2% | 1% x 2 |
| 3% | 5% | 3% + 2% |
| 5% | 7% | 5% + 2% |
| 8% | 10% | 8% + 2% OR 8% x 1.25 = 10% |
| 10% | 12.5% | 10% x 1.25 |
Actual Contribution Percentage (ACP) Test
Tests employer matching contributions and employee after-tax contributions using the same formula as ADP.
Correcting ADP/ACP Failures
| Method | Effect | Notes |
|---|---|---|
| Corrective Distributions | Decreases HCE ADP/ACP | Return excess to HCEs |
| Recharacterization | Changes pre-tax to after-tax | Decreases HCE ADP |
| Qualified Non-Elective Contributions (QNEC) | Increases NHCE ADP | 100% vested to all eligible |
| Qualified Matching Contributions (QMC) | Increases NHCE ADP/ACP | 100% vested to those deferring |
Safe Harbor 401(k) Plans
Safe harbor 401(k) plans are exempt from ADP and ACP testing by providing guaranteed employer contributions:
Safe Harbor Contribution Options
| Option | Formula | Vesting |
|---|---|---|
| Non-Elective Contribution | 3% of compensation to ALL eligible employees | 100% immediate |
| Basic Matching | 100% on first 3% + 50% on next 2% of deferrals | 100% immediate |
| Enhanced Matching | At least as generous as basic match | 100% immediate |
Safe Harbor Example
Employee earns $100,000 and defers 6%:
| Match Type | Employee Deferral | Employer Match Calculation | Match Amount |
|---|---|---|---|
| Basic | 6% = $6,000 | 100% x 3% + 50% x 2% = 4% | $4,000 |
| Non-Elective | Any amount | 3% flat | $3,000 |
QACA (Qualified Automatic Contribution Arrangement)
A QACA combines automatic enrollment with safe harbor contributions:
- Automatically enrolls employees at a minimum deferral rate
- Provides safe harbor matching (can use reduced formula)
- May use 2-year cliff vesting (exception to immediate vesting rule)
Summary: Key Thresholds for 2025
| Threshold | 2025 Amount | Purpose |
|---|---|---|
| HCE Compensation | $160,000 (2024 comp) | Coverage/ADP testing |
| Key Employee - 1% Owner | $150,000 | Top-heavy determination |
| Key Employee - Officer | $230,000 | Top-heavy determination |
| Top-Heavy Threshold | >60% to key employees | Minimum contribution trigger |
| Safe Harbor Coverage | 70% of NHCEs | Coverage test |
| Ratio Percentage | 70% | Coverage test |
For the 2025 plan year, which of the following employees would be classified as a Highly Compensated Employee (HCE)?
A defined contribution plan is top-heavy. What is the minimum employer contribution required for a non-key employee earning $80,000?
A safe harbor 401(k) plan uses the basic matching formula. An employee earning $120,000 defers 5% of compensation. What is the employer matching contribution?