Plan sponsors should check their calendars and be aware that the deadline for making corrective distributions to HCEs (without an excise tax penalty) for a failed ADP or ACP test is quickly approaching.
– General deadline is within 2 ½ months after end of plan year (i.e., March 15th for calendar year plans).
– The deadline is extended to 6 months after end of plan year for plans with an Eligible Automatic Contribution Arrangement (EACA, i.e. an automatic enrollment provision which meets certain criteria).
The Actual Deferral Percentage (ADP) test is an annual assessment which compares the percentage of compensation deferred into a 401(k) plan by Non-Highly Compensated Employees (NHCEs) versus the percentage for HCEs. IRS rules state that if the HCE percentage exceeds the NHCE percentage by too much, then the plan fails the ADP test. The intent is to make sure that HCEs are not disproportionately benefiting from a 401(k) plan compared to NHCEs.
When a plan fails the ADP test, the most common correction method is to refund a portion of HCE deferrals as taxable income. Another option is for the employer to make additional Qualified Non-Elective Contributions (QNECs) to NHCE 401(k) accounts and treat those as elective deferrals for the test, but this method is more costly.
With the economic downturn of recent years, many NHCEs have reduced the amount they are saving in their 401(k) plan. There is also less incentive for them to save if the employer match has been suspended. A decrease in NHCE deferrals can cause an ADP testing failure, with the result that 401(k) deferral opportunities may be limited for HCEs until the NHCE savings rate increases.
Similarly, the Actual Contribution Percentage (ACP) test compares the extent to which NHCEs benefit from a 401(k) match compared to HCEs. Since the 401(k) match is highly dependent upon participant deferrals, a drop in NHCE deferral rate can cause an ACP testing failure too.
In future posts, we’ll examine ways of designing plans to minimize the likelihood of ADP and ACP testing failures on a prospective basis.