As a business owner offering your employees a 401(k) retirement plan, it is crucial to understand the various compliance tests required by the Internal Revenue Service (IRS) to maintain its tax-qualified status.
Among them are the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, which are designed to ensure that highly compensated employees (HCEs) do not disproportionately benefit from the plan compared to non-highly compensated employees (NHCEs).
This article will explain the importance of these tests, how they are conducted, and the necessary steps to take if your plan fails either test.
The History
The IRS introduced the ADP and ACP tests as part of the Tax Reform Act of 1986. The primary objective of these tests is to maintain fairness in retirement plans and to prevent discrimination in favor of highly compensated employees.
Before the implementation of the ADP and ACP tests, 401(k) plans often disproportionately benefited HCEs, who were able to make larger contributions and, as a result, reap greater tax advantages.
These tests were introduced to prevent this, becoming an essential part of maintaining the plan’s tax-qualified status.
When a plan passes the ADP and ACP tests, employer and team member contributions and investment gains remain tax-deferred until withdrawal, providing a valuable incentive for retirement savings.
Furthermore, these tests were designed to encourage employers to promote retirement plan participation among lower-earning employees. By ensuring that HCEs do not disproportionately benefit from the plan, they incentivize employers to educate and motivate NHCEs to join, thus improving overall retirement readiness in the workforce.
Understanding The ADP And ACP Tests
As mentioned above, the ADP and ACP tests are essential to the IRS’ efforts to ensure that 401(k) plans stay equitable. The tests compare the average contributions made by HCEs and NHCEs to the 401(k) plan to determine if the plan is discriminatory in favor of the former.
The ADP test examines team member deferral contributions, including pre-tax elective deferrals and team member contributions to the plan.
In contrast, the ACP test focuses on employer-matching contributions and employee after-tax contributions.
Both tests are conducted annually and are required for all 401(k) plans, except for Safe Harbor and SIMPLE 401(k) plans, which are exempt.
The 401(k) percentage test helps maintain the plan’s fairness and tax-qualified status by ensuring that HCEs do not receive a disproportionate share of the plan’s benefits. To conduct the tests, the plan sponsor must first identify HCEs and NHCEs. The IRS defines an HCE as a team member who either:
- Owned over 5% of the business during the current or preceding year
- Received compensation exceeding a specified threshold (adjusted annually) during the preceding year from the business (in 2021, the threshold was $130,000)
Once the HCEs and NHCEs are identified, the plan sponsor calculates the ADP and ACP for each group by determining the average deferral and contribution percentages. These percentages are derived by dividing the total contributions for each team member by their respective annual compensation.
The ADP and ACP tests are considered ‘passed’ if the plan meets one of the following criteria:
- The ADP or ACP of the HCE group is not more than 125% of the NHCE group’s ADP or ACP.
- The ADP or ACP of the HCE group is not more than 200% of the NHCE group’s ADP or ACP, and the difference between the two groups’ percentages does not exceed 2%.
If a plan fails to meet either of these metrics, the plan sponsor must take corrective action to bring it back into compliance.
Corrective Actions For Failed ADP And ACP Tests
Suppose a 401(k) plan fails the ADP or ACP test. In that case, the plan sponsor must rework it within a specific timeframe, typically 12 months after the close of the plan year in which the test failure occurred.
The most common corrective actions include:
- Refunding excess contributions: The plan sponsor can return the excess contributions made by HCEs, thus reducing the ADP or ACP of that group. These refunded amounts, also known as ‘corrective distributions,’ are taxable to the HCEs in the year they receive the refund.
- Increasing NHCE contributions: Alternatively, the plan sponsor can make additional contributions, called ‘qualified nonelective contributions’ (QNECs) or ‘qualified matching contributions’ (QMACs), to the accounts of NHCEs to increase their ADP or ACP. These contributions must be fully vested and subject to the same withdrawal restrictions as other plan contributions.
- Recharacterizing excess deferrals: For the ADP test, another option is to recharacterize excess deferrals made by HCEs as after-tax contributions, which are not subject to the ADP test. However, this option may not be available if the plan does not permit after-tax contributions or if the recharacterization would cause the plan to fail the ACP test.
- Adopting a Safe Harbor Plan design: To avoid future ADP and ACP test failures, the plan sponsor may amend the plan to adopt a Safe Harbor 401(k) design. Safe Harbor plans require the employer to make specific contributions to NHCEs, such as a matching or nonelective contribution. In return, the plan is exempt from ADP and ACP testing, provided certain criteria are met. Keep in mind that this option addresses future compliance issues but does not resolve any existing test failures.
It is essential to take corrective action promptly to avoid plan disqualification and potential penalties. Plan sponsors should work with third-party administrators and other retirement plan professionals to ensure they understand the testing requirements and implement the appropriate measures.
Compliance Is Important
The ADP and ACP tests are critical to maintaining a compliant 401(k) plan, ensuring its benefits are distributed equitably among all employees. Business owners should familiarize themselves with these tests and the steps to address failures.
By understanding the purpose and mechanics of the ADP and ACP tests and the options available for correcting failed tests, business owners can better manage their 401(k) plans and reduce the risk of plan disqualification. Moreover, maintaining a compliant and equitable plan contributes to a positive work environment, fostering goodwill and loyalty, and ultimately benefiting the business’s overall success.
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