In order to ensure a 401(k) plan is not favoring owners or highly paid employees, the IRS requires the 401(k) nondiscrimination testing is performed. The Actual Deferral percentage Test (ADP) measures the employee deferral contributions and the Actual Contribution Percentage Test (ACP) measures the employer matching contributions. ADP/ACP testing must be completed annually.
Both tests take the average contribution rates of the Highly Compensated Employee (HCE) group of participants and compare to the average contribution rate of the Nonhighly Compensated Employee (NHCE) group of participants.
WHO ARE HIGHLY COMPENSATED EMPLOYEES (HCEs)?
The IRS defines a Highly Compensated Employee (HCE) as an owner of more than 5% of the company in the current or previous plan year or an employee who received compensation in excess of an indexed compensation limit in the previous plan year. The IRS adjusts the compensation limit annually for cost-of-living increases but has remained $120,000 since 2015. Family attribution rules treat a spouse, child, parent or grandparent of someone who is a 5% owner as an HCE, regardless of that individual’s compensation or ownership. If the plan document allows, HCEs can be limited to the top-paid 20% group of employees when ranked by pay. Employees may move from the HCE group to the NHCE group (and vice versa) in different plan years, so this classification is determined annually.
PASSING ADP/ACP TESTING
In order to pass the tests, the HCE average contributions (deferrals or match) must be within a certain percentage of the average contributions of the NHCEs (usually within 2%). To run an ADP/ACP test, each eligible participant’s total contribution is divided by his compensation as defined in the plan document. The individual contribution ratios are then averaged for the separate HCE and NHCE groups. It is important to note that employees who are eligible but not contributing are included in the calculations with a 0% ratio which lowers the average percentage for that group. The ADP test does not include catch-up contributions.
CORRECTING A FAILED TEST
There are potentially two ways to correct a failed ADP/ACP test:
- Return the excess contributions, including earnings, to HCEs. The distributions are first made to HCEs who deferred the highest dollar amounts, not the highest percentage, lowering the average percentage contribution until the test passes. The return of excess amounts must be done within 2½ months of the close of the plan year to avoid an IRS excise tax of 10%. The corrective distribution amount returned is taxable to the participant in the calendar year in which the distribution is received and a Form 1099-R is issued for tax reporting.
- The employer makes an additional fully vested contribution. The contribution must be sufficient enough to increase the average rate of the NHCE group to the level needed to pass the ADP and/or ACP test.
If failing the ADP/ACP tests concerns you, please check out What a Failed ADP/ACP Test Means. Please contact Watkins Ross Retirement Plan Administrator if you have questions regarding your plan’s ADP/ACP testing.