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What Happens When Our ADP Test Fails

As we shall see, 401(k) plan testing can be a headache for human resource managers. But, it is the correction of 401(k) test failures that often makes them sick.

In order to satisfy the ADP test, elective contributions (employee salary deferrals) under a 401(k) plan must satisfy one of the following limits:

  1. The ADP for the group of eligible HCEs cannot be more than 125% of the ADP for the group of eligible non-highly compensate employees (NHCEs). We’ll call this limit the basic limit.

  2. The ADP for the group of eligible HCEs cannot be more than 2 percentage points greater than the ADP for the group of eligible NHCEs and the ADP for the group of eligible HCEs cannot be more than 2 times the ADP for the group of eligible NHCEs. This second limit is called the alternative limit.

For purposes of the ADP test, the ADP for a group of eligible employees refers to the average of the actual deferral ratios of the eligible employees in that group. For purposes of determining the actual deferral ratios for eligible employees who are HCEs, you first determine the actual deferral ratio for each HCE by taking the amount of his or her elective contributions for the current plan year divided by the eligible employee’s compensation for the plan year (but not counting compensation in excess of the current annual compensation limit under Code section 401(a)(17): $160,000 for 1998). For most plans, the ADP for the group of NHCEs will be determined by averaging the actual deferral ratios for each of the NHCEs with respect to the prior plan year. Therefore, most 401(k) plans will determine whether they meet the 401(k) ADP test by comparing the ADP of the eligible NHCEs for the prior plan year with the ADP for the eligible HCEs for the current plan year.

As you might have suspected, it is possible to compare and combine the results of the basic and alternative limits mentioned above into a single table as follows:

ADP for NHCEs

Maximum ADP for HCEs

1%

2%

2%

4%

3%

5%

4%

6%

5%

7%

6%

8%

7%

9%

8%

10%

9%

11.25%

10%

12.50%

11%

13.75%

12%

15.00%

As many 401(k) sponsors know, the reason that the ADP for NHCEs is usually much lower than the ADP for its HCEs is because many companies have NHCEs who are eligible to participate in the 401(k) plan, but who, for a myriad of reasons, do not to make elective contributions. Many of the workers at Ahab’s can’t afford tuna fish let alone contribute to the Ahab Company Employee 401(k) Plan. Because these NHCEs are eligible to participate, but elect not to participate, their actual deferral ratio is 0%.

Most 401(k) plans, though not all, provide for some type of employer matching contribution. The employer matching contributions (like employee elective contributions) under the plan are also subject to a nondiscrimination test, the ACP test. The ACP test is almost identical to the ADP test except that it compares the actual contribution percentage (ACP) for the group of eligible HCEs to the ACP for the group of eligible NHCEs. In similar fashion, the ACP for the group of HCEs is generally the actual contribution ratio for HCEs for the current plan year, while the ACP for NHCEs is typically the actual contribution ratio for the NHCEs for the prior plan year. The ACP test uses the same limits as the ADP test.

To make things worse, if a 401(k) plan provides for employee elective contributions as well as employer matching contributions, the plan oftentimes is subject to a third test known as the “multiple-use test.” Basically, the purpose of the multiple-use test is to prevent a 401(k) plan which also allows matching contributions to utilize the alternative limit — that is the 2 percentage points greater than or 200% limit set forth under each of the ADP and ACP tests — more than once. Essentially, the multiple-use test places an overall limit or “aggregate limit” on the ADP and ACP for HCEs under a plan. Without getting capsized by the details of the multiple-use test, suffice it to say, if this test is not met, one of the various corrective mechanisms presented here must be utilized.

What Happens If A Plan Fails The ADP Test?
At a minimum, the portion of the 401(k) plan relating to elective contributions will no longer be qualified and the entire plan may, as a result, lose its qualification. Fortunately, the IRS regulations on 401(k) plans provide for a number of corrective mechanisms whereby a plan sponsor can correct an ADP test that does not initially satisfy the applicable limits. Basically, there are three ways to correct an ADP test which does not satisfy the applicable limits:

  1. The employer can make additional contributions to the plan (in the form of qualified non elective contributions (QNECs) or qualified matching contributions (QMCs)) that are treated as elective contributions for purposes of the ADP test and that, when combined with the existing elective contributions, cause the ADP test to be satisfied.

  2. The amount of elective contributions which are in excess of the applicable nondiscrimination limits (excess contributions) can be re-characterized and treated as employee after-tax contributions.

  3. Excess contributions, together with the earnings relating to such excess contributions, can be distributed to HCEs in accordance with IRS regulations.

In most cases, a failed ADP test usually is corrected either through the return of Excess Contributions to HCEs or by the employer making a QNEC to the plan. Many human resource managers dread the first form of correction since it often involves their having to tell the CEO, and members of the company’s top management team, that a portion of the elective deferrals they made for the past year will have to be returned to them. As described in our earlier article, Good Heavens Watson! They’ve Actually Simplified The Tax Code!, Focus On Benefits, Fall/Winter 1996, some of the difficulties associated with ADP testing have been eliminated under the 1996 Act by allowing plan sponsors to compare the current plan year’s ADP for its HCEs with the prior year’s ADP for the NHCEs. Therefore, at or near the beginning of each plan year, a company should know what the overall limit is for its HCEs for that plan year. Nonetheless, this type of plan design requires fairly careful and constant monitoring of the ADP for HCEs along with any changes to the deferral rates which occur during the year.

If the ACP test is not met, then one of the following corrective mechanisms must be utilized:

  1. The employer makes QNECs that are treated as matching contributions for purposes of the ACP test and that such QNECs when combined with existing employee and matching contributions cause the ACP test to be satisfied.

  2. Elective contributions are re-characterized as matching contributions for purposes of the ACP test and, when combined with employee and matching contributions cause the ACP test to be satisfied.

  3. Excess aggregate contributions, together with earnings relating thereto, are distributed to HCEs.

  4. Excess aggregate contributions, and the earnings attributable to those contributions, may, to the extent not vested, be forfeited in accordance with the terms of the plan.

What To Do?
If you want to avoid getting headaches and seasickness due to your 401(k) plan’s testing failures and corrections, consider adopting a safe-harbor design. Otherwise, test early and test often.

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Revised July 18, 2005

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Information is provided for review and consideration only. Please consult legal and tax advisors for practical advice pertaining to your business and personal situations.

This page was last reviewed and/or updated on Friday, July 03, 2015 05:22 PM

 

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