Since it’s time for most 401(k) plans to perform annual nondiscrimination testing, it makes sense to review the requirements for the Average Deferral Percentage/Average Contribution Percentage (ADP/ACP) tests and the options for plans that fail one or both tests.
Note: Plans that provide for safe harbor matching or safe harbor nonelective contributions are generally deemed to satisfy both tests.
What are the ADP and ACP tests?
The ADP/ACP tests are performed to demonstrate that the plan does not discriminate in favor of highly compensated employees (HCEs) with respect to 401(k)/Roth deferrals and employer matching contributions. The ADP test compares the average deferral rates of the HCEs to that of the non-highly compensated employees (NHCEs); the ACP test does the same for matching contributions. Plans may use either the current year or prior year average of the NHCEs for this purpose; however, the method selected must be specified in the plan document.
In general, a plan passes these tests if the average of the HCEs does not exceed the lesser of (1) the NHCE average plus 2%, or (2) 2 times the average of the NHCEs.
Do catch-up contributions get counted in the ADP test?
No. If a participant makes catch-up contributions by either exceeding the statutory limit ($19,000 for 2019/$19,500 for 2020) or a plan-imposed limit, the amounts are excluded from the ADP test.
What happens if a plan fails these tests?
The plan sponsor must take corrective actions which typically involves issuing corrective distributions to certain HCEs. Although this is the most common way to correct failures, many plans also allow for the employer to make an additional contribution to the plan on behalf of certain NHCEs. These amounts, known as QNECs (Qualified Nonelective Contributions) and QMACs (Qualified Matching Contributions), must be 100% vested and are subject to certain distribution restrictions.
Note: It may be possible to correct or reduce the impact of an ADP testing failure by “reclassifying” deferrals of eligible HCEs as catch-up contributions. When this occurs, corrective distributions are reduced by the reclassified amounts to the extent they do not exceed the catch-up limit ($6,000 for 2019, $6,500 for 2020).
Is there a deadline for correcting failures?
Yes. Generally, corrective distributions must be issued within 2 ½ months following the close of the plan year to avoid a 10% excise tax imposed on the excess amounts. Plan sponsors of 401(k) plans that include an “eligible automatic contribution arrangement” have up to 6 months to issue corrective distributions without incurring excise taxes.
Regardless of the method chosen (i.e. corrective distributions or QNEC/QMACs), corrections must be made no later than the last day of the plan year following the plan year in which the testing failure occurred.
What happens if a plan doesn’t correct the failure in a timely manner?
In short, the qualified status of the plan may be jeopardized, and “late” corrections are much costlier for the employer. The IRS provides two methods for making late corrections under its Employee Plans Compliance Resolution System (EPCRS). Under the first option, the employer must make a QNEC on behalf of the NHCEs. This method is often more expensive than making a “normal” QNEC because the contribution must be made on behalf of all eligible NHCEs. Under the second option (the “one-to-one” correction method), the plan sponsor must issue corrective distributions and must make a QNEC in an amount equal to the corrective distributions. The QNEC is then allocated to the NHCEs.
Can a plan do anything to prevent failures?
Yes. As mentioned above, plans that provide for either safe harbor matching or safe harbor nonelective are generally deemed to pass these required tests. Additionally, there are other options available that may help reduce or eliminate ADP/ACP testing failures such as adding automatic enrollment, making a top-paid group election, or adding a plan-imposed limit for HCEs.
If you would like to learn more about these options or if you have any questions, please contact us.