The basics of the 401(k) and Roth coverage test

What’s the 401(k) and Roth coverage test, and how does a plan pass it?

This is a compliance test required by the IRS under Section 410(b) to make sure a retirement plan benefits a broad group of employees, not just higher-paid ones. The test compares employees eligible to participate in the plan with those who aren't.

If the plan meets either the ratio percentage test or the average benefit test, it passes the coverage requirements. Many plan sponsors start with the ratio test because it’s easier to perform. The average benefit test is typically used only when a plan fails the ratio test.

What’s the ratio percentage test?

The ratio percentage test is a straight numerical test comparing the ratio of NHCEs benefiting from the plan with the ratio of HCEs benefiting from the same plan. To pass this test, the coverage ratio must be 70% or higher.

Example

What’s the average benefit test?

The average benefit test is a more complex, two-part test.

Part 1: nondiscriminatory classification test

The first part of the average benefit test has two steps, and a plan must pass both to move on to part two.

Employee classifications

Plan sponsors must ensure the plan uses reasonable, objective classifications, such as job categories or geographic location, to identify which employees will benefit under the plan. Unreasonable classifications are open to interpretation, such as a valued contributor.

Numerical nondiscrimination test

There are two ways a plan can pass this test. Option one is to have a coverage ratio that’s greater than or equal to the safe harbor percentage, which the IRS determines based on the NHCE concentration percentage. The NHCE concentration percentage is determined by dividing the number of nonexcludable NHCEs by the number of all nonexcludable employees.

Under the second option, the plan must have a coverage ratio that’s greater than or equal to the unsafe harbor percentage, also set by the IRS, and pass a facts and circumstances test, which is a series of questions designed to make sure NHCEs are being treated fairly.

The higher the NHCE concentration, the lower the safe and unsafe harbor percentages will be. In essence, the more NHCEs the plan covers, the easier it is to pass this test.

Part 2: average benefit percentage test

To pass the average benefit percentage test, the average benefit percentage for NHCEs must be at least 70% of the HCE average benefit percentage. You can use different methods to adjust how benefits are tested for each employee. Using these methods, individual benefit percentages can be adjusted for testing purposes. For example:

• Cross-testing—Converts contributions into equivalent benefits at retirement age to compare employees fairly
• Permitted disparity/Social Security integration—Allows plans to provide higher benefits on pay above the Social Security wage base

The average benefit test is quite complex. Plan sponsors should work closely with their TPA or ERISA consultant to make sure this test is performed correctly.

How often must coverage testing be performed?

Coverage testing is usually performed annually as of the last day of the plan year (December 31 for calendar year plans). It considers all employees who worked at any point during the plan year. Alternative timeframes are available but rarely used, and specific criteria must be met.       

Who’s considered an employee?

For purposes of the 401(k) and Roth coverage test, a plan sponsor’s total workforce includes:

• Common-law employees
• Leased employees employed for a year or more
• Self-employed individuals
• Employees of certain related businesses (controlled group members)

If your business is related to or affiliated with another entity or has employees other than common-law employees, you should work closely with your third-party administrator (TPA) or ERISA consultant to make sure the right individuals are included in your coverage test.

Once you identify who’s an employee, you next need to determine which employees are benefiting from the 401(k) or Roth plan. Employees who are eligible to defer into the plan are deemed to be benefiting even if they’ve chosen not to make deferrals.

Can any employees be excluded from the 401(k) or Roth coverage test?

While all employees must be taken into account, you can generally exclude the following individuals from coverage testing:

• Employees who don’t meet the plan’s minimum age and service requirements, such as age 21 and 1 year of service
• Nonresident aliens with no U.S. income from the employer
• Employees subject to a good-faith collective bargaining agreement

Before excluding any employees, you should consider how this will affect your actual deferral percentage (ADP) and actual contribution percentage (ACP) nondiscrimination tests. Any employees excluded from coverage testing must also be excluded from these tests. You may not want to exclude employees who haven’t met the minimum age and service requirement if including them improves your ADP and ACP test results.

Do any plans automatically pass coverage testing?

In the following situations, a 401(k) or Roth plan is deemed to pass coverage testing so that neither the ratio percentage nor the average benefit test needs to be performed:

• The plan doesn’t have any includable NHCEs
• No HCEs benefited from the plan during the year
• The plan benefits only union employees
• The employer recently went through a merger or acquisition and takes advantage of the IRS transition rule

What’s involved with correcting a failed coverage test?

If left uncorrected, a failed coverage test can result in plan disqualification, which means the participants’ vested account balances would become immediately taxable—an outcome no one wants. The corrective action varies, such as retroactively adding NHCEs who were excluded from coverage for the year into the plan.  

The plan’s document must be amended retroactively to expand the coverage group or permit an additional allocation. Any additional allocation funding would address minimum coverage failures related to employer contributions, rather than elective deferrals. This amendment must be completed within 9½ months after the end of the plan year and requires corrective contributions to address the elective deferral benefit exclusion.

If an employer has more than one retirement plan, they may combine them for the coverage test. This is called permissive aggregation. If they do this, the plans must also be combined in the same way for nondiscrimination testing for that same plan year. If neither of these options is available, the plan sponsor needs to use the IRS Voluntary Correction Program to correct the test failure.

401(k) or Roth coverage test─positioning your plan for success     

Understanding the fundamentals of coverage testing is essential for fulfilling your fiduciary duty. Equally important is making sure you have accurate data, documented procedures, and a knowledgeable and trusted TPA or ERISA consultant. Having all three in place can help you feel more confident about the results and any steps you may need to take to keep your plan on track.

Review our plan testing guide.

FAQs

How does the 401(k) or Roth ratio percentage test work? 

This test compares the percentage of non-highly compensated employees benefiting to the percentage of highly compensated employees benefiting. The coverage ratio (NHCE ratio/HCE ratio) must be at least 70% to pass.

What is the average benefit test in a 401(k) or Roth plan? 

It’s a two-part test. First, the plan must use reasonable employee classifications and meet numerical nondiscrimination thresholds (safe or unsafe harbor tied to NHCE concentration). Second, NHCEs’ average benefit percentage must be at least 70% of HCEs’ average benefit percentage.

Who’s included in 401(k) or Roth coverage testing? 

All nonexcludable employees: common-law employees, leased employees (≥1 year), self-employed individuals, and employees of controlled group members. Employees eligible to defer are considered benefiting, even if they choose not to contribute.

Can employees be excluded from coverage testing? 

Yes, generally, employees who don’t meet the minimum age/service requirements (e.g., 21 and 1 year), nonresident aliens with no U.S. income, collectively bargained employees, and certain terminated employees who fail hours/last-day rules can be excluded. Consider ADP/ACP impacts before excluding.

What happens if a 401(k) or Roth plan fails coverage testing? 

If uncorrected, the plan risks disqualification and immediate taxation of vested balances. Corrections include expanding coverage to more NHCEs or providing additional employer contributions, plus a retroactive plan amendment within 9½ months, or using the IRS Voluntary Correction Program.