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401(k) Fix It #5

The plan failed the 401(k) ADP and ACP nondiscrimination tests.

It's complicated, but this is how it works.

It's complicated, but this is how it works.

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:

  • 125% of the ADP for the group of NHCEs, or
  • the lesser of:
    • 200% of the ADP for the group of NHCEs, or
    • 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:
    • 200% of the ACP for the group of NHCEs, or
    • the ACP for the NHCEs plus 2%.

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:

  • Was a 5% owner, directly or by family attribution, at any time during the current or prior year (a 5% owner is someone who owns more than 5% of the employer), or
  • For the prior year, was paid by the employer more than $130,000 for 2021 and  for 2020 ($125,000 for 2019, and $120,000 for 2015-2018); subject to cost-of-living adjustments in later years) and, if the employer elects, was in the top-paid (top 20%) group of employees.

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.

How to find the mistake: 

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:

  • Prior year compensation
  • The rules related to ownership when identifying 5% owners.
    • Plan administrators need access to ownership documents to identify 5% owners.
    • Take care to identify family members of the owners, as many will have different last names.

Review the rules and definitions in your plan document for:

  • Determining HCEs
  • Testing compensation
  • ADP testing
  • ACP testing
  • Prior or current year testing

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.


Client Centered

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 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.

  • Method 1 – Revenue Procedure 2019-19, Appendix A, Section .03:
    • Determine the amount necessary to raise the ADP or ACP of the NHCEs to the percentage needed to pass the tests.
    • 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 – one-to-one method under Revenue Procedure 2019-19, Appendix B, Section 2.0:
    • Excess contributions (adjusted for earnings) are assigned and distributed to the HCEs.
      • You should notify the employee that the excess contribution is not eligible for favorable tax-free rollover. The refunded excess contribution is taxable to the HCE in the year of distribution. You should report the refunded excess on a Form 1099-R.
    • 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.
  • If the Plan provides for catch-up contributions, the refund may be recharacterized as a catch-up contribution (up to the catch-up limit) provided:
    • The affected HCE participant is age 50 or older, and
    • The participant has not already used up the catch-up limit for the year.


Correction programs available:

Less than two years from end of statutory period

For mistakes corrected within two years after the end of the 12-month correction period:

  • SCP may be used to correct both significant and insignificant mistakes
  • VCP may also be used to correct this mistake

More than two years from end of statutory period

For mistakes corrected more than two years after the end of the 12-month correction period:

  • SCP may still be used to correct if the mistake can be classified as insignificant
  • VCP may be used to correct both insignificant and significant mistakes