Since it’s time for most 401(k) plans to perform annual nondiscrimination testing, it makes sense to review the requirements for the 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 ($18,500 for 2018/$19,000 for 2019) 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 2018 and 2019).
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.