How are corrections for a failed ADP test calculated?
Updated over a week ago

If your plan fails the Actual Deferral Percentage (ADP) compliance test, your company will be able to choose one of two corrective action options:

Provided you make your choice timely, you can choose which way you want to correct the failure each year.

Important deadlines for ADP testing

There are different deadlines to keep in mind when faced with ADP testing failures. Note these deadlines are based on your plan year ending on December 31.

  • March 15 (June 30 for eligible automatic contribution arrangement plans and qualified automatic contribution arrangement plans) of the following year – the deadline to complete the correction by refunding HCEs without owing an excise tax.

  • December 31 of the following year – the deadline to complete the correction by refunding HCEs, an excise tax will be owed.

  • After December 31 of the following year – must be corrected under the IRS’ EPCRS correction program.

Provided we have received all necessary data, a task will be available on your Guideline administrator dashboard in late Q1 to select your desired corrective action. The task will outline the exact dollar amounts for each option by individual.

If you choose to refund excess deferrals to HCEs, checks will be mailed to the affected participants in the weeks following the completion of your task. Affected employees will receive an IRS Form 1099-R in the following year for tax filing purposes.

The first option for correcting a failed ADP test is to refund enough of the deferrals from the HCEs to reduce their average deferral rate (ADR) to the percentage necessary to pass the test. However, you will not have any discretion in deciding which of the HCEs will be refunded or how much that refund will be, as the IRS has a very specific procedure that must be used.

This procedure is called the leveling method, and there are generally four steps:

  1. Determine the HCE ADR needed to pass the test

  2. Hypothetically decrease the deferral rates for applicable HCEs until the ADR passes

  3. Determine the total dollar amount of deferrals that need to be refunded based on the hypothetically decreased deferral rates

  4. Allocate that dollar amount based on the HCEs deferral amounts in dollars

Because this method is not intuitive, let's look at the steps in an example. Please note that the first three steps are hypothetical only. No amounts are actually refunded during these steps, and they are only used to determine the total dollar amount that needs to be refunded.

Here’s an example:
Bad Wolf Inc. has three HCEs: Rose, Mickey and Jackie. Their deferral rates and compensation are shown below.

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Step 1: For this specific plan, the testing calculations show that in order to pass the ADP test, the ADR for HCEs needs to be 7%.

Step 2: Now that we know what the combined ADR is for the HCEs, we need to lower their deferral percentages from the top down, beginning with the highest deferral percentage.

In this example, reducing Rose's percentage to match Jackie's would only bring the ADR to 9.04%, so both Rose’s and Jackie's percentages must be reduced to 7.67% to pass. Because Mickey is already under the 7%, we do not have to adjust his percentage.

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Step 3: Using the adjusted deferral percentages, we can now determine how much in excess contributions needs to be refunded. Important note: The amounts in the final column are NOT the actual refunds; the amounts are used only to determine the total excess deferral amounts that will need to be refunded in step 4.

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Step 4: Now, we know $14,689 needs to be refunded. The final step is to allocate the refund based on the dollar amount deferred. We follow the same top-down logic from step 2, but this time we start with the largest deferral amount instead of the highest deferral percentage.

First, we will look at Jackie’s deferral amount and reduce it to either (1) the amount of the excess that needs to be refunded or (2) to the same dollar amount that Rose has deferred. That gives us $4,000, but we need an additional $10,689 in refunds, so we need to go on.

This time, we decrease Jackie’s and Rose’s deferral amount equally to either (1) the amount of the excess that needs to be refunded or (2) to the same dollar amount that Mickey has deferred. At this step, we will reach the total refund amount by removing an additional $5,344.50 for both Jackie and Rose.

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The second option is to provide an additional employer contribution to certain NHCEs to bring their ADR up enough to pass. Please note that Guideline uses a pro-rata qualified non-elective contributions (QNEC) method that includes the ability to permissively disaggregate testing so those who have not reached age 21 or do not have at least one year of service will be tested in their own group.

The system will run the test both ways and provide you with the least expensive option. When permissively disaggregated, each group is tested separately so only those NHCEs in the group that fails will receive the QNEC.

Here’s an example:
Ood Sphere Industries has six employees: one HCE and five NHCEs. We are going to permissively disaggregate so we have two testing groups. By using disaggregation, the cost of the QNEC will be significantly lower for the employer.

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The first group will be those who would be excludable if the plan imposed the maximum age and service requirements; this includes Charlotte (who is under 21 years old) and Lee (who has less than a year of eligibility service). Because both Charlotte and Lee are NHCEs, and HCEs are excluded from disaggregation, that portion of the plan passes ADP testing automatically. We can disregard them for the remainder of the ADP test and correction.

The second group will include River (HCE), Donna, Wilfred, and Sylvia. The ADR for HCEs is 11.99% while the ADR for NHCEs is 1.85%. This fails the ADP test.

River does not want to give up any of her deferrals, so she chooses to make QNEC contributions for Donna, Wilfred, and Sylvia.

To enable the plan to pass, the ADR for the NHCEs must be increased to 9.59%. That will allow the HCEs ADR to remain at 11.99% (9.59% * 125% = 11.99%). Because the ADR was already 1.85%, that means each of the NHCEs will need to receive an additional 7.74% as a QNEC.

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To pass the ADP test using QNECs, Ood Sphere will need to make a contribution of $20,879.52.

Please note that the QNEC contributions are not treated the same as other employer contributions as they must always be 100% vested and follow the same distribution rules as elective deferrals.

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