The Employee Retirement Income Security Act (ERISA) requires several tests each year to prove that 401(k) plans do not discriminate in favor of employees with higher incomes. These nondiscrimination tests for 401(k) plans are called the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. For these tests, employees are divided between non-highly compensated employees (NHCEs) and highly compensated employees (HCEs). The IRS defines “highly compensated employee” as an individual who:
• Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received; or
• For the preceding year, received compensation of more than $115,000 (if the preceding year is 2014) or $120,000 (if the preceding year is 2015), and, if the employer elects, was in the top 20% of employees when ranked by compensation.
The ADP test counts elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of the HCEs and NHCEs. Dividing a participant’s elective deferrals by the participant’s compensation gives you that participant’s Actual Deferral Ratio. The average ADR for all NHCEs (even those who chose not to defer) is the ADP for the NHCE group. Do the same for the HCEs to determine their ADP.
Calculate the ACP the same way, instead dividing each participant’s matching and after-tax contributions by the participant’s compensation.
The ADP test is met if the ADP for the eligible HCEs doesn’t exceed the greater of:
• 125% of the ADP for the group of NHCEs, or
• the lesser of:
o 200% of the ADP for the group of NHCEs, or
o the ADP for the NHCEs plus 2%.
The ACP test is met if the ACP for the eligible HCEs doesn’t exceed the greater of:
• 125% of the ACP for the group of NHCEs, or
• the lesser of:
o 200% of the ACP for the group of NHCEs, or
o the ACP for the NHCEs plus 2%.
For example, if the average contribution for NHCEs is 3%, then the average contribution for the HCEs may not exceed 5% (being the average contribution of NHCEs plus 2%). If the average contribution for NHCEs is 1%, then the average contribution for the HCEs may not exceed 2% (being 200% of the average contribution of the NHCEs).
How to fix the mistake
Corrective action
If your plan fails the ADP or ACP test, you must take the corrective action described in your plan document during the statutory correction period to cause the tests to pass. The statutory correction period is the 12-month period following the close of the plan year for which the test failed. If you do this, you don’t need IRS’s Employee Plans Compliance Resolution System (EPCRS).
If you take corrective action after the first 2 ½ months of the correction period, you are also liable for an excise tax (in addition to being required to make the correction).
If correction is not made before the end of the 12-month correction period, the plan may lose its tax-qualified status. You may correct this mistake through EPCRS.
There are two different methods to correct ADP and ACP mistakes beyond the 12-month period. Both require the employer to make a qualified non-elective contribution (QNEC) to the plan for NHCEs. A QNEC is an employer contribution that is always 100% vested and subject to the same distribution restrictions as elective deferrals. Forfeitures can’t be used to pay for QNECs.
• Method 1:
o Determine the amount necessary to raise the ADP or ACP of the NHCEs to the percentage needed to pass the tests.
o Make QNECs for the NHCEs to the extent necessary to pass the tests.
You must generally make QNECs for all eligible NHCEs.
These contributions must be the same percentage for each participant.
• Method 2:
o Excess contributions (adjusted for earnings) are assigned and distributed to the HCEs.
o That same dollar amount is contributed as a QNEC to the plan and allocated based on compensation to all eligible NHCEs.
Matching contributions (and earnings) related to the excess contributions distributed to the HCEs are forfeited.
Correction programs available
Example: A 401(k) plan fails the ADP test for the plan year ending December 31, 2014
Plan year tested 12/31/2014
Statutory correction period (12 months) 01/01/2015 to 12/31/2015
If correction occurs by 03/15/2015 No further action required
If correction occurs after 03/15/2015 but before 12/31/2015 Employer is required to file a Form 5330 and pay a 10% excise tax on the excess
If correction occurs between 01/01/2016 and 12/31/2017 May use Self-Correction Program (SCP) or Voluntary Correction Program (VCP) to correct mistakes determined to be insignificant or significant
If correction occurs after 12/31/2017 • May only use SCP to correct mistakes determined to be insignificant
• May use VCP to correct both insignificant and significant mistakes
Audit Closing Agreement Program (CAP)
Most plans are eligible for Audit CAP, which allows the plan sponsor to correct the mistake and pay a negotiated sanction. This sanction would bear a reasonable relationship to the nature, extent and severity of the mistake, considering many factors, including the extent to which correction occurred before audit. Sanctions under Audit CAP are a negotiated percentage of the maximum payment amount.
How to avoid the mistake
One way to avoid this type of mistake is by establishing a safe harbor 401(k) plan or by changing an existing plan from a traditional 401(k) plan to a safe harbor 401(k) plan. Under a safe harbor 401(k) plan, the employer isn’t required to perform the ADP and ACP tests, if it meets certain requirements.
Problems may happen when there’s a communication gap between the employer and plan administrator regarding what the plan document provides and what documentation is needed to ensure compliance. Several main areas where these communication problems may occur:
• Count all eligible employees in testing
o Share information with the plan administrator on all employees eligible to make an elective deferral (including all eligible employees who terminated before the end of the year).
• Share information with the plan administrator about any related companies with common ownership interests
o Your plan document may require these employees to be eligible to participate in the plan, and, therefore, included in the tests.
• Definition of compensation
o Be familiar with the terms of your plan document to ensure that you use the proper definition of compensation.
o It’s important to know whether compensation is:
Excluded for certain purposes,
Limited for certain purposes, or
Determined using a different computation period (for example, plan year vs. calendar year).
o If the compensation amounts sent to the plan administrator don’t meet the plan definitions, the ADP and ACP tests will be inaccurate and will provide false results.
• Identification of HCEs:
o An important aspect of performing the ADP and ACP tests is properly identifying HCEs. It’s especially important to consider family members of owners.
o Don’t assume that once a non-highly compensated employee, always a non-highly compensated employee.
In summary, you should ensure that you’re familiar with your plan’s terms, and provide your plan administrator with the information needed to make a proper determination of each employee’s status.
If either the ADP or the ACP test fails, to avoid correcting under EPCRS, implement procedures to ensure that you correct excess contributions timely. Excess contributions result from plans failing to satisfy the ADP test and should be distributed to the applicable HCEs within 12 months following the close of the plan year. Excess aggregate contributions are contributions resulting from a plan that has failed the ACP test. The law generally treats them same as excess contributions. However, if the excess aggregate contributions consist of matching contributions that aren’t fully vested then reallocate the unvested portion to the accounts of the other plan participants or put them in an unallocated suspense account to use to reduce future contributions.
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