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Plan sponsors must test traditional 401(k) plans each year to ensure that the contributions made by and for rank-and-file employees (non-highly compensated employees (NHCE)) are proportional to contributions made for owners and managers (highly compensated employees (HCE)). As the NHCEs save more for retirement, the rules allow HCEs to defer more. These nondiscrimination tests for 401(k) plans are called the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests.
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 (ADR). The average ADR for all eligible 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 Actual Compensation Percentage the same way, instead dividing each participant’s matching and after-tax contributions by the participant's compensation. The Actual Deferral Percentage test is met if the ADP for the eligible HCEs doesn't exceed the greater of:
The ACP test is met if the ACP for the eligible HCEs doesn't exceed the greater of:
You may base the ADP and ACP percentages for NHCEs on either the current or prior year contributions. The election to use current or prior year data is in the plan document. Under limited circumstances, the election may be changed.
An important aspect of performing the ADP and ACP tests is to properly identify the HCEs, who are generally any employee who:
Family attribution rules treat an employee who is a spouse, child, grandparent or parent of someone who’s a 5% owner, as a 5% owner. Each of these individuals is an HCE for the plan year.
Complete an independent review to determine if you properly classified HCEs and NHCEs, including all employees eligible to make a deferral, even if they chose not to make one. Plan administrators should pay special attention to:
Review the rules and definitions in your plan document for:
If incorrect data is used for the original testing, then you may have to rerun the tests. If the original or corrected test fails, then corrective action is required to keep the plan qualified.
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 plan has 2 ½ months after the end of the plan year being tested to correct excess contributions. The plan can distribute excess contributions any time during the 12-month period. If correction is not made before the end of the 12-month correction period, the plan’s cash or deferred arrangement (CODA) is no longer qualified and the entire plan may lose its tax-qualified status. You may correct this mistake through EPCRS. If the employer doesn't distribute/recharacterize excess contributions by 2 ½ months (six months for certain EACAs) after the plan year of excess, the employer is liable for a 10 percent excise tax on excess contributions.
The tax doesn't apply if the plan sponsor makes corrective qualified non-elective contributions within 12 months after the end of the plan year if the plan uses current year testing. However, if the corrective contributions are insufficient for the CODA to pass the ADP test, the tax applies to the remaining excess contributions.
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 to the plan for NHCEs. A qualified non-elective employer contribution (QNEC) is an employer contribution that is always 100% vested and subject to the same distribution restrictions as elective deferrals.
For mistakes corrected within two years after the end of the 12-month correction period:
For mistakes corrected more than two years after the end of the 12-month correction period: