As a small business owner, you already juggle numerous responsibilities. One of the last things you want is to deal with the complexities of 401(k) compliance, especially when it comes to IRS nondiscrimination tests like the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. If your 401(k) plan fails these tests, however, it’s essential to act quickly to avoid penalties and maintain the plan’s compliance.
Approximately 30% of small business 401(k) plans subject to ADP/ACP testing fail at least one of the tests annually. Failing these tests can mean contribution refunds for you and your top employees, leading to dissatisfaction and possibly larger tax burdens. Understanding your options when a test fails can help you avoid these issues.
Here’s what you need to know about ADP/ACP testing and your options for correcting a failed test.
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are IRS nondiscrimination tests that apply to traditional (non-safe harbor) 401(k) plans. These tests ensure that the benefits of the plan don’t disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs).
For 2024, an HCE is defined as an individual who meets one of the following two criteria:
The Actual Deferral Percentage (ADP) test compares the average percentage of salary deferrals made by HCEs and NHCEs. For purposes of the test, salary deferrals include pre-tax and Roth deferrals, but not catch-up contributions. To pass the ADP test, the ADP of HCEs cannot exceed the greater of:
The ADP test may be completed using the “prior year” or “current year” method. Under the current year method, deferrals and compensation for the current year are used to determine the averages for both the HCE and NHCE groups. Under the prior year method, prior year deferrals and compensation are used for the NHCE group, while current year deferrals and compensation are used for the HCE group. The plan document will specify which method to use.
|
Employee |
Compensation |
Deferral |
Deferral Percentage |
|
HCE 1 |
$200,000 |
$20,000 |
10% ($20,000/$200,000) |
|
HCE 2 |
$180,000 |
$14,400 |
8% ($14,400/$180,000) |
|
HCE ADP = 9% ((10% + 8%) / 2) |
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|
Employee |
Compensation |
Deferral |
Deferral Percentage |
|
NHCE 1 |
$50,000 |
$2,500 |
5% ($2,500/$50,000) |
|
NHCE 2 |
$40,000 |
$2,000 |
5% ($2,000/$40,000) |
|
NHCE 3 |
$30,000 |
$1,500 |
5% ($1,500/$30,000) |
|
NHCE ADP = 5% ((5% + 5% + 5%) / 3) |
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Test Result: Test fails because the HCE ADP (9%) exceeds the allowable limit of 7% (5% NHCE ADP + 2%).
The ACP test compares the average matching and voluntary after-tax contributions of HCEs and NHCEs for nondiscrimination. The test is calculated the same as the ADP test, but substitutes matching and voluntary after-tax contributions for salary deferrals.
If your plan fails the ADP or ACP test, corrective action must be taken to protect the qualified status of the plan. The statutory correction period is the 12-month period following the close of the plan year in which the failure occurs. Depending upon the testing method used (prior or current), you can have up to three correction options - refund excess contributions to HCEs, allocate a QNEC to NHCEs, or retroactively amend the plan to safe harbor.
The most common method for correcting a failed ADP or ACP test is refunding contributions (including earnings) to HCEs in the amount necessary to pass the test. This option is the one available when a test fails using the prior year testing method.
To correct the above ADP test, a $7,860 refund (plus earnings) to HCEs would be necessary.
|
Employee |
Compensation |
Deferral |
Refund |
Adjusted Percentage |
|
HCE 1 |
$200,000 |
$20,000 |
($6,730) |
6.64% ($13,270/$200,000) |
|
HCE 2 |
$180,000 |
$14,400 |
($1,130) |
7.37% ($13,270/$180,000) |
|
HCE ADP = 7% ((6.64% + 7.37%) / 2) |
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Refunds must be made within 2½ months after the plan year ends (March 15 for calendar year plans) to avoid a 10% excise tax. If the plan includes a qualifying automatic enrollment feature, this deadline is extended to six months (June 30).
If a plan fails the ADP or ACP test using the current year method, another correction option is allocating a Qualified Nonelective Contribution (QNEC) to NHCEs. A QNEC is an employer contribution that is 100% vested and subject to the same distribution restrictions as elective deferrals. The same percentage of compensation must be allocated to each NHCE. This option is unavailable if the test failed using the prior year method.
To correct the above ADP test, a $2,400 QNEC to NHCEs would be necessary.
|
Employee |
Compensation |
Deferral |
QNEC |
Deferral Percentage |
|
NHCE 1 |
$50,000 |
$2,500 |
$1,000 |
7% ($3,500/$50,000) |
|
NHCE 2 |
$40,000 |
$2,000 |
$800 |
7% ($2,800/$40,000) |
|
NHCE 3 |
$30,000 |
$1,500 |
$600 |
7% ($2,100/$30,000) |
|
NHCE ADP = 7% ((7% + 7% + 7%) / 3) |
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If a plan fails the ADP or ACP test using the current year method, another correction option is retroactively amending the plan to a safe harbor plan for the year. For this option to be possible, the employer must allocate (at least) a 4% nonelective contribution to each eligible NHCE. Allocating the contribution to HCEs is optional.
After the 12-month statutory correction period, a failed ADP or ACP test must be corrected through the IRS’ Employee Plans Compliance Resolution System (EPCRS), specifically using the Voluntary Correction Program (VCP) or Self-Correction Program (SCP).
ADP/ACP testing is a crucial part of maintaining your 401(k) plan’s compliance, but failing the test doesn’t have to spell disaster. By understanding your options—whether refunding excess contributions, allocating QNECs, or adopting a safe harbor plan—you can take timely corrective action and prevent future issues.
Need assistance correcting a failed ADP/ACP test or navigating your 401(k) compliance? Contact your 401(k) provider. They should be able to help.