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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:
-
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.
-
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 elect not to make elective contributions. (Many of the
workers at Ahab’s can’t afford tuna fish let alone contribute to the
Ahab’s 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 (of course!) as well as employer matching contributions
(of course!), 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:
-
The employer can make additional contributions to
the plan (in the form of qualified nonelective 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.
-
The amount of elective contributions which are in
excess of the applicable nondiscrimination limits (excess
contributions) can be recharacterized and treated as employee
after-tax contributions.
-
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
making of a QNEC to the plan by the sponsor. 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:
-
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.
-
Elective contributions are recharacterized as
matching contributions for purposes of the ACP test and, when
combined with employee and matching contributions cause the ACP test
to be satisfied.
-
Excess aggregate contributions, together with
earnings relating thereto, are distributed to HCEs.
-
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.
Revised July 18, 2005
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