ERISA-Extra

The federal tax code confers tax-favored status on numerous types of employer-provided retirement plans. In order to retain that tax-favored status, plans must be able to demonstrate that they do not discriminate in favor of Highly Compensated Employees (HCEs). Over the years, Congress has developed several types of nondiscrimination tests intended to prevent qualified retirement plans from favoring HCEs by more than de minimis amounts.

The Actual Deferral Percentage (ADP) test compares the average deferral percentage of HCEs to non-highly compensated employees (NHCEs). The ADP test counts elective deferrals (both pretax and Roth deferrals but not catch-up contributions) of the HCEs and the NHCEs. It is designed to ensure that HCEs do not receive a disproportionate benefit compared to NHCEs.¹

The other test that plan sponsors must perform is the Annual Contribution Percentage (ACP) test. This test measures employer contributions, such as employer matches or after-tax employee contributions, and compares the average contribution percentage of HCEs to that of NHCEs. It is also intended to ensure that HCEs do not unfairly benefit.

Both tests must be performed annually. The tests use various formulas to compare the eligibility and the contribution rates of HCEs and NHCEs to determine if the plan discriminates in favor of HCEs.

Defining a highly compensated employee

Generally, an HCE is an employee who is either:

• A more-than-5% owner of the business in the year of testing or the prior year or
• An employee who earned more than USD 160,000 in compensation (in 2025) in the prior year, as adjusted annually or as the cost-of-living increases. Compensation includes regular salary, overtime, bonuses, commissions, and deferred compensation.² It is possible to additionally limit the number of HCEs to those in the top 20% of earners.  

When a plan fails ADP or ACP testing

A plan that fails the ADP/ACP test could potentially lose its tax-advantaged status. However, two methods exist to remedy a failure.

The first corrective method available to plans is the distribution option. Under this method, the plan can distribute the excess contributions and any plan income attributable to those contributions to the appropriate HCEs.³ In general, the distribution method requires four steps: calculating the dollar amount of excess contributions, apportioning the total excess contributions among HCEs, determining the income that’s allocable to the excess contributions, and distributing the apportioned excess contributions and allocable income.⁴

The plan can distribute excess contributions at any time within 12 months after the close of the plan year period.⁵ However, if the distributions are returned more than 2½ months following the close of the plan year, the employer will face a 10% excise tax.⁶

Plans that are considered “eligible automatic contributions arrangements” can make corrective distributions up to six months following the end of the plan year without incurring the excise tax.⁷ However, these distributions are taxable to the employees.⁸

The other available corrective option for plans is to make contributions to NHCEs,⁹ where the employer can make additional contributions to the 401(k) accounts of NHCEs. These contributions are known as Qualified Nonelective Contributions (QNECS). A QNEC essentially increases the deferral percentage or matching rate of NHCEs to move the plan into compliance with ADP/ACP limits.

How plans can avoid this mistake

Employers can take several steps to prevent their plans from failing the ADP/ACP tests. These include:

• Adopt a safe harbor—Employers can avoid issues with the ADP/ACP tests by establishing a safe harbor 401(k) plan or by changing an existing plan from a traditional 401(k) plan to a safe harbor 401(k) plan. Under a safe harbor plan, the employer is not required to perform the ADP and ACP tests, if it meets certain requirements.
• Increase NHCE participation rates—Employers may want to revisit and reevaluate what education materials they use to encourage their employees to join and contribute to their retirement plans. The goal is to encourage the broadest participation levels in the retirement plan by nonmanagement, nonsupervisory employees. Employers could consider offering personalized financial education and support to help nonparticipating employees understand the numerous benefits that come from joining and contributing to their 401(k) plan. Retooling the plan’s design by introducing automatic enrollment with appropriate default deferral rates and automatic escalation are effective in boosting employee participation rates among lower-paid employees.
• Offer a 401(k) match—If not already a plan feature, employers can offer a 401(k) matching contribution to incentivize employee deferrals.
• Limit HCE contributions—Consider placing a cap on HCE contributions if the NHCE participation rates are low. 

If you have questions or concerns about nondiscrimination testing or correcting excess deferrals, please contact your ERISA legal counsel.

Retirement security is the confidence that one’s financial resources will be sufficient to support their needs and lifestyle throughout retirement. Attaining retirement security requires employees to set aside adequate resources to maintain a desired standard of living and a sense of financial independence after leaving the workforce.

Numerous employers over the years have introduced retirement plans into their workplace because they are committed to helping their employees on the path to retirement security after a lifetime of work. Unfortunately, not all employees avail themselves of this opportunity.

Many employees tend to focus on their current spending needs rather than setting money aside for their retirement years. Others, either through inertia or a lack of financial education, do not participate in their employer-provided retirement plan. If they do participate, they may end up contributing less than what is needed for a secure retirement.

High stakes

In response to low participation rates, a growing number of companies are taking a proactive approach by automatically enrolling employees in their 401(k) plans. Automatic enrollment is now required for new plans, but not for plans established before December 30, 2022.

When employers automatically enroll employees in a 401(k) plan, the employees are enrolled at a default contribution rate (unless the employee makes an affirmative election to contribute at a different rate or to opt out altogether). The most common default deferral percentage is 3%, although the employer can select another rate appropriate for its workforce.

Some plans take automatic enrollment to the next level by automatically increasing the deferral rate every year until it reaches a certain percentage of the employee’s compensation. This process is known as automatic escalation.

Some plans also offer automatic portability. Automatic portability is the process of automatically rolling over a former workplace retirement plan account into a new workplace retirement account when an employee changes jobs.

Research confirms the advantages of auto enrollment

Automatic enrollment, especially in combination with automatic escalation and automatic portability, helps encourage employees to make saving for retirement a priority.

A new study¹⁰ from the Employee Benefit Research Institute (2025) found that auto enrollment, auto escalation, and auto portability can substantially reduce the likelihood that today’s workers will run short of money in retirement. It found that this is particularly true for younger employees, who potentially could spend a significant number of years participating in a retirement plan before they retire. Some key findings of the research include the following:

• When automatic enrollment with a 6% default contribution is adopted by all defined contribution plans, the retirement savings shortfall among those individuals who have access to a defined contribution plan in the future decreases by 7%. This shortfall decreases by over 10% for those ages 35 to 39.
• When automatic escalation of 1% of annual salary until the contribution percentage reaches 12% is added to plans that have a 6% default contribution rate, the retirement savings shortfall decreases by 9%.
• When automatic portability is used by all plans, the reduction in the retirement savings shortfall reaches over 11% for those ages 35 to 39.
• When automatic enrollment, with a default contribution rate of 6%, automatic escalation, and automatic portability are adopted by all plans, the retirement savings shortfall decreases by 16%. Under the same scenario, the likelihood of not running short of money in retirement for those employees with access to a defined contribution plan, such as a 401(k) plan, increases by nearly 5%. For employees in the 35-to-39-year-old age group, the likelihood of not running short of money increases by almost 9%, and retirement savings shortfall is reduced by 26%.
  
• Automatic features are more likely to have a positive impact on younger employees who will spend years participating in a retirement plan. The researchers determined that the retirement savings shortfall decreases by 60% for those employees with 27 to 30 years of future eligibility in a defined contribution plan.

The research reinforces that a key determinant for retirement security is access to employment-based plans. Access and regular, uninterrupted contributions to an employer-provided retirement plan combined with Social Security payments can play a huge role in ensuring that employees will have sufficient funds to live well during their retirement. The bottom line is that plan design can have a huge impact on the future retirement security of their employees.