All 401(k) plans that do not have a Safe Harbor provision are required to undergo Actual Deferral Percentage (ADP) testing each year. If the plan has a discretionary (or non-Safe Harbor) matching contribution, the plan is also required to run the Actual Contribution Percentage (ACP) test each year. The two tests compare 401(k) contributions of highly compensated employees (HCEs) against the contributions of non-highly compensated employees (NHCEs).
You can learn more about who is considered an HCE or NHCE here. Please note that when the term “compensation” is used, it is compensation as defined by the plan document.
What are the ADP and ACP tests?
The ADP test compares the average deferral (payroll reduction contribution) percentage of HCEs against the average deferral percentage of NHCEs. Each participant’s ADP is calculated by taking their total deferrals to the plan for the calendar year (excluding catch-up contributions) and dividing by their compensation for the same year.
The ACP test compares the average employer matching contribution percentage of HCEs against the average of NHCEs. Each participant’s ACP is calculated by taking the amount of employer matching contributions they received during the year and dividing this number by their compensation for the year.
Highly compensated employee ADP/ACP limits
HCEs are limited to an average deferral or match rate that is determined by the average NHCE rate as shown in the table below.
If the average NHCE deferral or match rate is: | Then, the maximum HCE rate is: |
Between 0%-2% | NHCE rate multiplied by 2 |
Between 2%-8% | NHCE rate plus 2% |
Greater than 8% | NHCE rate multiplied by 1.25 |
For example, if NHCEs deferred an average of 1%, the HCEs will be limited to a 2% average deferral for the year (1% x 2). If HCEs have deferred more than an average of 2%, the plan will fail the ADP test.
What happens if the plan fails ADP or ACP testing
If your plan falls outside permissible ADP and/or ACP limits, as noted above, Guideline will provide you with correction options and steps to take in the first quarter of the following year (as long as you provide compensation data in a timely manner, if applicable).
You will see a task on your Guideline dashboard and receive an email notification informing you that corrective action is needed. Generally, you can select one of the two options below to correct any ADP/ACP failure.
Refund HCE excess contributions: To bring the HCE ADP ratio to the applicable limit, you can choose to refund excess deferrals to HCEs. The IRS states the method that must be used to determine which HCEs will receive refunds and what the amounts of those refunds will be. The HCEs who have contributed the largest dollar amounts will receive larger refunds. Similarly, for a failed ACP test, you can choose to refund vested employer matching contributions (note that unvested matching contributions will also be forfeited in this scenario), to bring the HCE ACP ratio to the applicable limit. OR
Make employer contributions to NHCEs: As an alternative to refunding excess contributions to HCEs, you can make qualified non-elective contributions (QNECs) to the 401(k) accounts of NHCEs, which would effectively increase the deferral or match percentage of NHCEs and bring the plan within ADP/ACP limits.
In general, most plans choose to refund excess contributions because it is the less expensive option for employers. However, refunding excess contributions has more strict timing rules than the alternative option to make employer contributions.
Timing
Refunds distributed after March 15 for an automatic contribution arrangement (ACA) plan or June 30 for an eligible automatic contribution arrangement (EACA) plan are subject to a 10% excise tax. (You can learn more about ACA and EACA plan designations here.)
Employer contributions to fix the test (QNECs), on the other hand, must be contributed to the plan by December 31 of the year following the test year (for example, plans will have until December 31, 2023 to contribute QNECs for testing performed in 2022).
To prevent you from incurring possible excise taxes, Guideline must receive compensation information about your plan in a timely manner, if applicable.
Taxation on refunded contributions
If you choose to refund excess contributions to HCEs, refunds are taxable as ordinary income for those individuals in the year distributed (not the year of the original contribution). Any gains or losses are also calculated and included in ADP/ACP refunds.
ADP/ACP refunds do not affect the W-2 income of the employees receiving a refund. Instead, the employees will receive 1099-R forms the following January to report the taxable amount when preparing their tax returns for the year they received the refunds. For example, if excess contributions must be returned to HCEs for the 2022 plan year, these funds will typically be refunded in early 2023, for which the employee will receive a 1099-R in early 2024 and would report on their 2023 tax return (filed in 2024).
Unlike other cash distributions, these excess contribution refunds are not subject to early distribution penalties. By default, federal tax of 10% is withheld.
Adopt a Safe Harbor plan provision and never worry
401(k) plans with Safe Harbor provisions are exempt from ADP, ACP, as well as Top Heavy tests. However, if the plan makes additional employer contributions other than the Safe Harbor contributions (like a profit sharing contribution), the plan will be subject to Top Heavy testing.
Generally, Safe Harbor matching contributions should be added to your plan 30 days before the start of the calendar year. To allow adequate time for amending plan documents and providing required notices to participants (at least 30 days prior to the new year), please start the process before November 1.
If you’ve missed the deadline to add a Safe Harbor matching contribution for the year, the Secure Act allows plans to add a Safe Harbor non-elective contribution of at least 3% up until December 1 of the year in which it will apply, as long as it is effective for the entire year. Additionally, the Secure Act allows plans to add a Safe Harbor non-elective contribution of at least 4% after December 1 of the year in which it will apply up until December 31 of the following year.
Guideline can assist with implementing a compliance strategy or crafting a solution that’s right for your company. Feel free to contact us, and we’ll be happy to help.