F.48.1 Coverage and Discrimination Testing

Certified Financial Planner CFP

Track your progress as you read

Finished sections get a check mark.

1 A. Professional Conduct and Regulation

A.1 Code of Ethics and Standards of Conduct A.1.1 The Six Ethical Principles A.2 Procedural Rules and Discipline A.2.1 Fitness Standards for Candidates A.3 Financial Institutions Overview A.3.1 Broker-Dealers vs. RIAs A.4 SEC and Securities Regulation A.4.1 FINRA and Broker-Dealer Regulation A.4.2 State Securities Regulation A.5 Consumer Protection Laws A.5.1 Privacy and Confidentiality Requirements A.6 Fiduciary Duty and Application

2 B. General Principles of Financial Planning

B.7 The Financial Planning Process B.7.1 Establishing the Client Relationship B.7.2 Gathering Client Data and Goals B.8 Personal Financial Statements B.8.1 Key Financial Ratios B.9 Cash Flow Management B.9.1 Emergency Fund Planning B.10 Debt Management Strategies B.10.1 Mortgage and Home Financing B.11 Economic Concepts B.11.1 Planning for Inflation B.12 Time Value of Money Concepts B.12.1 TVM Calculations and Applications B.12.2 Loan Amortization B.13 Education Needs Analysis B.14 Education Savings Vehicles B.14.1 529 Plans In-Depth B.15 Education Funding Strategies B.16 Gift/Income Tax Strategies

3 C. Risk Management and Insurance Planning

C.17 Principles of Risk and Insurance C.17.1 Risk Management Process C.18 Analysis of Risk Exposures C.19 Health Insurance Fundamentals C.19.1 Types of Health Insurance Plans C.20 Disability Income Insurance C.20.1 Disability Policy Features C.21 Long-Term Care Insurance C.22 Annuities Overview C.22.1 Fixed vs. Variable Annuities C.23 Life Insurance Fundamentals C.23.1 Types of Life Insurance C.24 Business Owner Insurance Solutions C.25 Insurance Needs Analysis C.26 Insurance Policy and Company Selection

4 D. Investment Planning

D.27 Equity Securities D.27.1 Fixed Income Securities D.27.2 Mutual Funds and ETFs D.27.3 Taxation of Investment Vehicles D.28 Systematic Risk D.28.1 Unsystematic Risk D.29 Economic and Market Cycles D.30 Measures of Risk and Return D.30.1 Investment Performance Measures D.31 Asset Allocation Strategies D.31.1 Portfolio Diversification D.32 Bond and Stock Valuation D.32.1 Stock Valuation Models D.33 Investment Policy Statement D.33.1 Modern Portfolio Theory D.34 Active vs. Passive Investing D.34.1 Common Investment Strategies D.35 Alternative Investments D.35.1 Options and Derivatives

5 E. Tax Planning

E.36 Income Tax Fundamentals E.36.1 Filing Status and Tax Brackets E.37 Types of Income E.37.1 Deductions and Credits E.37.2 Capital Gains and Losses E.38 Business Entity Taxation E.38.1 Self-Employment Tax E.39 Taxation of Trusts and Estates E.40 Tax Reduction Strategies E.40.1 Retirement Account Tax Strategies E.41 Property Transactions E.41.1 Basis Rules for Acquired Property E.42 AMT and NIIT E.42.1 Special Tax Situations E.43 Charitable Giving Strategies

6 F. Retirement Savings and Income Planning

F.44 Retirement Needs Analysis F.44.1 Sources of Retirement Income F.45 Social Security Benefits F.45.1 Social Security Claiming Strategies F.45.2 Medicare Planning F.46 Eldercare and Special Needs Planning F.47 Qualified Plan Overview F.47.1 Defined Benefit Pension Plans F.47.2 Defined Contribution Plans F.48 Eligibility and Vesting F.48.1 Coverage and Discrimination Testing F.48.2 Contribution and Benefit Limits F.48.3 401(k) Plan Features F.49 Non-Qualified Deferred Compensation F.49.1 Executive Compensation Plans F.50 Retirement Plan Selection for Businesses F.50.1 Individual Retirement Accounts F.51 Distribution Rules F.51.1 Required Minimum Distributions F.52 Retirement Income Strategies F.52.1 Tax-Efficient Withdrawal Strategies F.53 Business Succession Planning

7 G. Estate Planning

G.54 Property Titling and Beneficiary Designations G.54.1 Beneficiary Designations G.55 Strategies to Transfer Property G.55.1 Lifetime Gifting Strategies G.56 Wills and Estate Documents G.56.1 Powers of Attorney G.56.2 Advance Directives and Healthcare Documents G.57 Federal Gift Tax G.57.1 Federal Estate Tax G.57.2 Generation-Skipping Transfer Tax G.58 Sources for Estate Liquidity G.58.1 Life Insurance for Estate Liquidity G.59 Trust Fundamentals G.59.1 Revocable Living Trusts G.59.2 Irrevocable Trusts G.59.3 Trust Income Taxation G.60 Marital Deduction Planning G.60.1 QTIP Trusts G.60.2 Portability of Estate Tax Exemption G.61 Intra-family and Business Transfer Techniques G.61.1 Family Limited Partnerships G.61.2 GRATs and IDGTs G.62 Postmortem Estate Planning Techniques G.62.1 Disclaimer Planning G.62.2 Estate Tax Elections G.63 Planning for Divorce and Unmarried Couples G.63.1 Estate Planning for Unmarried Couples G.63.2 Planning for Blended Families G.64 Planning for Special Needs and Circumstances G.64.1 Special Needs Trusts G.64.2 ABLE Accounts

8 H. Psychology of Financial Planning

H.65 Client and Planner Attitudes, Values, Biases H.65.1 Money Scripts and Money Attitudes H.65.2 Planner Self-Awareness H.66 Behavioral Finance H.66.1 Cognitive Biases H.66.2 Emotional Biases H.66.3 Heuristics and Mental Accounting H.67 Sources of Money Conflict H.67.1 Couples and Money Conflict H.67.2 Family and Intergenerational Money Conflict H.68 Principles of Counseling H.68.1 Therapeutic Techniques in Financial Planning H.68.2 Professional Boundaries and Referrals H.69 General Principles of Effective Communication H.69.1 Listening and Questioning Skills H.69.2 Managing Difficult Conversations H.69.3 Non-Verbal Communication H.70 Crisis Events with Severe Consequences H.70.1 Death and Divorce H.70.2 Job Loss and Health Crisis H.70.3 Sudden Wealth and Sudden Loss H.70.4 Natural Disasters and Traumatic Events

F.48.1 Coverage and Discrimination Testing

Key Takeaways Explain This Topic AI

Highly Compensated Employee (HCE) for 2026: >5% owner OR compensation >$160,000 in the prior year, 2025 (with top 20% election)

Key Employee for 2026: >5% owner, >1% owner with >$150,000 comp, OR officer with comp >$235,000

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
Last updated: October 2026

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:

2026 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 2026 testing uses 2025 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 2026 plan year testing, you look at 2025 compensation to determine who is an HCE (for 2025 testing, the 2024 look-back threshold was $155,000).

HCE Examples

Employee 2025 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:

2026 Key Employee Thresholds

Category Threshold Indexed?

>5% Owner Any ownership >5% N/A
>1% Owner With compensation >$150,000 NOT indexed
Officer With compensation >$235,000 (2026) 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 (2026, using 2025 pay) >$150,000 (1% owner only)
Officer Test No Yes, >$235,000 (2026)
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 2026

Threshold 2026 Amount Purpose
HCE Compensation $160,000 (2025 comp) Coverage/ADP testing
Key Employee - 1% Owner $150,000 Top-heavy determination
Key Employee - Officer $235,000 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