If some of your employees are receiving refunds from your company’s 401(k) plan each year, it may be due to a failed compliance test. In this article, we’ll explain what these tests are and how you can prevent these from being a recurring problem.
Although 401(k) plans have emerged as one of the most popular types of retirement plans in the United States, they still come with a complex set of rules that can result in surprising limitations for some companies. And often times, these limitations are caused by nondiscrimination rules. These rules require the plan to pass a series of tests each year to make sure the plan doesn’t favor higher-paid employees and business owners over the rest of a company’s employees.
Nondiscrimination tests look at both employee contributions (salary deferrals) and employer contributions, like matching and profit sharing contributions. However, this post will focus just on the test for employee contributions, which is known as the Actual Deferral Percentage (ADP) Test.
What causes an ADP Test failure?
Many plans fail this test when “highly compensated employees” (HCEs) are contributing a significant amount more to their retirement plan account in comparison to the rest of the company’s employees or “non highly-compensated employees” (NHCEs). However, failing this test doesn’t mean that your plan instantly loses its tax-qualified status because there prescribed methods for correcting a failed test. And as long as those corrections are made in a timely manner, the plan can continue on as a tax-qualified plan.
The most common form of ADP test correction is refunding the HCEs’ contributions to bring the average deferral rate down to a passing level. However, refunding contributions isn’t the only correction method available. Employers also have the option of correcting the ADP test by making contributions to the NHCEs that will bring their contribution rates up, or a combination of these two correction methods.
So, ADP test refunds may be why some HCEs in your plan are receiving refunds from their 401(k) plan accounts every year around March. These corrective refunds are also known as corrective distributions.
Why is March significant?
For most plans, ADP tests have to be corrected no later than 2½ months after the close of the plan year to avoid excise taxes. So for calendar-year plans, this ends up being March 15. If your plan has an eligible automatic contribution arrangement feature, this deadline is extended to 6 months after the plan year.
Employees Included in Testing
In performing the ADP test, all active and terminated employees eligible to defer at any time during the plan year are included, whether or not they actually made a deferral.
Who is a Highly-Compensated Employee for the ADP Test?
Before a plan can be tested for discrimination, the Highly-Compensated Employees (HCEs) and Non-Highly-Compensated Employees (NHCEs) have to be identified using certain tests. HCEs are identified using the following tests:
- An owner of more than 5% of the company in the testing plan year or the prior testing plan year (family stock attribution rules apply which treat an individual as owning stock owned by his spouse, children, grandchildren or parents), or
- An employee who received compensation in excess of a specified limit from the employer in the previous year (e.g., employees who earned more than $130,000 in 2020 will be considered HCEs in 2021). The employer may elect that this group be limited to the top 20% of employees based on compensation.
After the HCEs and NHCEs have been identified, the plan will undergo the ADP test.
How to Calculate the ADP Test
First, each participant’s deferral percentage is determined by dividing the applicable deferrals by their compensation, which is defined in your plan document. Next, averages are calculated for the HCE and NHCE groups by dividing the sum of the deferral or contribution percentages by the number of employees in the group. Below is an example of the ADP determination:
|HCE Average (11.00% ÷ 2):||5.50%|
|NHCE Average (17.00% ÷ 4):||4.25%|
The HCEs’ average may only exceed the NHCEs’ average by specific limits summarized as follows:
|2% or less||NHCE % x 2|
|2% – 8%||NHCE % + 2|
|more than 8%||NHCE % x 1.25|
In the above example, the maximum ADP of the HCE group is 6.25% (the NHCE average of 4.25% plus 2%). The test passes since the ADP of the HCE group is 5.50% which is less than the 6.25% maximum.
Catch-up contributions (available to participants who are age 50 or older if permitted by the plan) that exceed a statutory limit or plan-imposed limit are not included in performing the ADP test. Also, compensation for plan purposes is subject to an annual limit ($255,000 for 2013 and $255,000 for 2014).
For example, assume Harry earned $300,000 in 2013 and deferred $23,000 (the maximum deferral of $17,500 for 2013 plus the maximum catch-up contribution of $5,500). His deferral percentage is calculated by dividing $17,500 (his deferral without the catch-up contribution) by $255,000 (the compensation limit for 2013).
Two testing methods are permitted. The first method is current year testing where current year deferral and contribution percentages are used to compare the percentages of both HCEs and NHCEs.
The other method is prior year testing where the deferral and contribution percentages for NHCEs in the prior year are compared with HCE deferral and contribution percentages in the current year. The prior year testing method gives employers the ADP and ACP limits for the HCEs in advance, which reduces the chance of a failed test at year-end and the need for taxable refunds or other corrective measures.
Whichever testing method is chosen, regulations require it to be specified in the plan document. The testing method may only be changed by amendment, subject to certain restrictions on changing from current year to prior year testing.
Correcting Test Failures
Plans that do not pass the ADP test must take some action, such as making corrective distributions to bring the HCEs contributions down or making additional employer contributions to NHCEs to bring their contribution levels up.
Refunding Deferrals (Corrective Distributions)
The most common method used to correct a failed ADP test is to make corrective distributions of the excess deferrals, plus earnings.
Corrective distribution amounts (determined by a required leveling method) are allocated among the HCEs based on the dollar amount of their deferrals or contributions. If the plan permits catch-up contributions and the participant is 50 or older and has unused catch-up contributions remaining, the ADP refund is first offset by the unused catch-up contributions.
These distributions must be made within 2½ months of the plan year-end in order to avoid a 10% penalty (this deadline is extended to six months for plans that meet the eligible automatic contribution arrangement requirements). The final deadline for making corrective distributions with the penalty is the last day of the following plan year.
How to Prevent ADP Test Failures
Become a Safe Harbor Plan
Retirement plans have some options for becoming “Safe Harbor”, which means the plan gets a free-pass for the ADP test. However, Safe Harbor status requires a certain level of employer contributions and some notice requirements. Your plan can become Safe Harbor and eliminate corrective refunds by adding any of the following features:
- Safe Harbor Match – two formula options (basic and enhanced)
- Qualified Automatic Contribution Arrangement
- Safe Harbor Non-Elective – 3% for all eligible employees, regardless of participation
How do you know whether Safe Harbor is worth it? You can easily conduct a cost-benefit analysis by running some basic calculations for each type of Safe Harbor option. Simply compare the added cost of the the employer contributions under a Safe Harbor formula against the employer contributions that your plan is already making (if any) and weigh that against the total amount of the corrective refunds that are being paid out each year. If the added cost of employer contributions doesn’t substantially exceed the total corrective refund amount, then it may make sense for your plan to become Safe Harbor.
You can also factor in how important it is for your HCEs to save as much as they want for retirement. Benefits like these are what help attract and retain top talent, and usually your HCEs are the driving force behind your business. This may mean that the cost of becoming Safe Harbor is worth it even if the cost far exceeds the total corrective refund amount because of the goodwill it will extend to your organization’s HCEs.
Safe Harbor Alternatives
Another way to prevent ADP test failures without your plan becoming Safe Harbor is to impose deferral limits in your plan document that will prevent HCEs from contributing at a level that will cause the ADP test to fail. However, this method presents some administrative challenges because it will require your payroll department to monitor the year-to-date deferrals of your HCEs very closely so that they don’t violate your plan document. Plan document failures can also present an additional set of corrections that are usually less common than an ADP test correction, which means that your service provider may charge your plan extra for assisting with an uncommon correction procedure.
If your plan is failing the ADP test year after year, there’s something you can do about it. It important to include additional factors beyond just hard dollar costs when considering Safe Harbor status for your plan because the retirement security of your plan’s HCEs may have a significant impact on your company’s ability to compete.