401(k): Your Plan Failed ADP and/or ACP testing! Now what?

In the beginning, 401(k) retirement plans were designed to encourage mid to lower level income workers to save for their retirement years by offering a tax advantaged method of socking away cash for the golden years. With this goal in mind, and because they were granting an opportunity for tax savings, the government wanted to make sure plans did not favor the higher compensated employees. In other words, they wanted to make sure employees earning lower income levels were not discriminated against and were receiving similar tax savings. To meet this objective nondiscrimination testing was born.

In simplistic terms, this testing looks at the saving patterns of highly compensated employees (“HCEs”) compared to non-highly compensated employees (“NHCEs”) to ensure that the NHCEs are within a certain range of the HCEs. If an employee does not meet the definition of HCE, the employee is an NHCE.  Before nondiscrimination testing can be completed, it is important to properly identify the HCEs, which generally includes any employee who:

• Was a 5% owner of the company at any time during the current plan year or the preceding plan year, or
• Had compensation from the employer in the preceding plan year in excess of a specified amount (which is adjusted each year). For example, if an employee was paid more than $115,000 in 2014, the employee is a HCE for 2015.  The plan may limit the number of employees in this category to the top 20% of the employees when ranked by compensation paid for the year.

Unless your 401(k) plan provides a safe harbor level of contributions that automatically complies with the nondiscrimination tests, the plan’s third party administrator will likely contact you in January or February to request the testing data needed to complete the plan’s annual ADP test and (if applicable) ACP test.

The Actual Deferral Percentage (“ADP”) test compares the 401(k) deferrals of the HCEs to the deferrals of the NHCEs. Similarly, the Actual Contribution Percentage (“ACP”) test compares the matching and voluntary after-tax contributions (if any) of the two groups. It is to the benefit of HCEs to encourage NHCE participation because the amount of HCE contributions may be limited based on the amount of contributions made and received by NHCEs.  {A bit of poetic justice for the lower level earners.}

Under both the ADP test and the ACP test, the contribution averages for the HCE group may not exceed the contribution averages of the NHCE group by more than a specified amount, as follows:

• If the NHCE % is 0 to 2%, the HCE % cannot exceed 2 times the NHCE percentage
• If the NHCE % is greater than 2%, but no more than  8%, the HCE % cannot exceed the NHCE percentage plus 2%
• If the NHCE % is more than 8%, the HCE% cannot exceed 1.25 times the NHCE percentage

If the contribution percentage for the HCE group tests above these stated limits, then the plan fails the test.  If your plan fails the ADP and/or ACP testing, corrective action must be taken to avoid losing the plan’s tax-qualified status. There are various methods for correcting testing failures, and when you correct the failure impacts the cost of the action, including whether a tax must be paid. You must refer to your plan document and take the corrective action described by it.  Possible correction methods include:

Correction BEFORE the end of the 12-month Correction Period:

The permitted correction period is the 12-month period following the end of the plan year for which the test was failed. For example, if the test is failed for 2014 for a calendar year plan, correction can be made until as late as December 31, 2015.  Ideally, you want to make corrections within the first 2½ months of this correction period to avoid paying an excise tax. If correction is made after the first 2 ½ months, but before the end of the 12-month period, in addition to making the correction, the employer must pay a 10% excise tax on the amount of the excess contributions.  The failed ADP and/or ACP test can be corrected by:

• returning the excess HCE contributions that are causing the plan to fail the test back to the HCEs, or
• contributing additional amounts to the NHCEs.

Note:  If the plan returns the excess contributions to the HCEs, it must also return any income (or offset any net loss) allocable to the excess contributions, and there may be tax consequences to the HCEs.

Also note:  for calendar year plans, March 15 is the 2 1/2 month deadline to correct a failed ADP or ACP test in order to avoid the 10% excise tax!

Correction AFTER the 12-month Correction Period: 

If the ADP and/or ACP testing correction is not made within the permitted 12-month correction period, the plan could lose its tax-qualified status.  If this situation occurs, the employer still can make corrections, but the course of action is escalated to the Employee Plans Compliance Resolution System (EPCRS). This is a much more cumbersome process and results in more significant fees. If either the ADP or the ACP test fails, to avoid correcting under EPCRS, implement procedures to ensure that you correct excess HCE contributions timely.

See 401(k): Find and Fix Compensation Mistakes for more useful information and guidance for employers who sponsor 401(k) plans.

Additional resources:

401(k) Plan Fix-It Guide
401(k) Plan Overview
EPCRS Overview
401(k) Plan Fix-It Guide
401(k) Plan Checklist
Additional Resources
Correcting Plan Errors