By Mishelle Becker, QKA, Retirement Plan Administrator
The IRS requires regular 401k plan nondiscrimination testing to ensure retirement plans do not favor owners or highly paid employees. The Actual Deferral Percentage Test (ADP) measures employee deferral contributions, while the Actual Contribution Percentage Test (ACP) measures employer matching contributions. ADP/ACP testing must be completed annually.
Both 401k plan nondiscrimination tests take the average contribution rates of the Highly Compensated Employee (HCE) group of participants and compare them to the average contribution rate of the Non-Highly 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 retirement plan year or an employee who received compensation in excess of an indexed compensation limit in the previous retirement plan year.
The IRS adjusts the compensation limit annually for cost-of-living increases; the 2022 limit is $135,000 and will increase to $150,000 for 2023. 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 retirement 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 the classification of employees is determined annually.
Passing 401k Plan Nondiscrimination Testing
HCE average contributions (deferrals or matches) must be within a certain percentage (usually within 2%) of the average contributions of NHCEs to pass 401k plan nondiscrimination testing. When running an ADP/ACP test, each eligible participant’s total contribution is divided by their 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 401k Plan Nondiscrimination Test
There are potentially two ways to correct a failed 401k plan nondiscrimination test:
- Return excess retirement plan contributions, including earnings, to HCEs. The distributions are first made to HCEs who deferred the highest dollar amounts, not the highest percentage, consequently lowering the average percentage contribution until the test passes. Excess amounts must be returned 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.
Do you have questions pertaining 401k plan nondiscrimination testing? Watkins Ross’ experienced team of Retirement Plan Administrators specializes in assisting employers with retirement plan compliance. Together we can ensure your plan is up-to-date with the latest ADP/ACP testing requirements. Connect with us here for more information.