What A Failed ADP/ACP Test Means
401(k) plan nondiscrimination testing is complex (for a review of the ADP/ACP tests, please read 401(K) Plan Nondiscrimination Testing). Many financial advisors and plan sponsors want to maximize deferrals for the Highly Compensated Employee (HCE) group, yet feel stressed (and even panicked!) at the thought of failing the ADP/ACP testing.
Failure is defined as a lack of success so, we get it, no one likes to fail. But, it’s important to remember that the goal of a 401(k) plan is to provide your employees with an opportunity to save the maximum amount legally allowed for retirement. The reality is, when your plan passes ADP/ACP testing, your HCE group probably could have contributed more than what they did, so they miss out deferring those additional savings. On the other hand, a failed test means your HCE group was able to defer the maximum amount legally allowed. You should really view this excess as an overage and not a failure since the “failed” test means you succeeded in maximizing the HCE deferrals into the plan during that year.
It’s also important to remember that a failed test does not signal your plan for an IRS/DOL audit. It merely indicates that the HCE group contributions were disproportionately larger than the NHCE group. As long as you correct the failure in a timely manner, your plan remains in good standing with the IRS/DOL.
However, before you toast to a failed test, it’s still important to analyze why the test failed. For example, if the ADP test failed due to poor participation from the NHCE group, then strategies can be discussed with your Third Party Administrator (TPA) to increase NHCE participation, such as implementing an automatic enrollment feature. By increasing the NHCE participation, you will increase the amount the HCE group can defer.
Several strategies can be discussed with your TPA. For example, a mid-year test can be used to estimate if the plan is going to pass or fail ADP/ACP testing for the year. This snapshot provides the opportunity to discuss the results with your TPA to determine if your plan is optimized for your participants or if changes should be considered. You can also discuss adding a safe harbor feature to the plan, which eliminates the need for ADP/ACP testing.
Contact Watkins Ross to discuss testing solutions to optimize your employee retirement savings.
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