Because the IRS gives 401(k) plans tax-favored status, they want to ensure all employees have the opportunity to benefit fairly. The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are used to ensure that a plan is not operated in a way that overly favors owners and highly paid individuals, called highly compensated employees (HCEs), or in a way that works to the detriment of rank-and-file employees, called non-highly compensated employees (NHCEs).
The ADP test is performed to determine if HCEs are contributing via salary deduction in too great an amount when compared to NHCEs, while the ACP test looks at whether employer matching contributions overly favor HCEs when compared to NHCEs.
If you’re a participant of a plan that’s subject to these compliance tests, and the plan fails, it could impact you in several ways. So, here’s when this might occur and what you can expect as a result of a failed employer’s plan.
Highly compensated vs. non-highly compensated employees
For the purpose of the ADP and ACP compliance tests, it’s helpful to understand whether you’re considered a HCE or a NHCE. Depending on your status, will determine how you may be impacted by a failed test.
When deciding who is an HCE due to compensation, we always look at the compensation for the prior year.
An HCE for testing the 2023 plan year is:
An employee who made over $135,000 in 2022 (this limit increases to $150,000 when testing for the 2024 plan year)); AND
An employee who is in the top 20% when ranked by compensation; OR
Someone who owns more than 5% of the business in the current (2023) or prior (2022) year; OR
A family member of someone who owns more than 5% of the business.
A NHCE is simply everyone else.
Why does this matter to me as a participant?
While your employer is responsible for managing compliance testing for your company's 401(k) plan, there are certain scenarios when compliance testing may impact you. This generally will occur only if your employer's plan fails certain tests and they need to make corrective action. In this case, they generally have two options:
Refunding excess contributions to HCEs; OR
Providing additional contributions to NHCEs
Refund of excess contributions to HCEs
The first option for correcting a failed ADP test is for your employer to refund enough employee contributions from the company’s HCEs to reduce their average deferral rate to the percentage necessary to pass the test.
In this case, if you are an HCE, you may receive a refund of some of your contributions after the end of the year, typically in February or March. The amount will be taxable as ordinary income in the year distributed for any pre-tax deferrals. Any gains you may have received will also be calculated and refunded within the check.
If you receive a refund, your W-2 income will remain unchanged, but you will receive a 1099-R the following January to report the taxable amount. This will be used in preparing the tax return for the year in which you received the refund.
For example, if excess contributions must be returned to you for the 2023 plan year, these funds will typically be refunded in February 2024 and reported on your 2024 tax return when it is prepared in 2025.
Unlike other cash distributions, these 401(k) refunds are not subject to early distribution penalties if they are made by the applicable date (March 15 for most plans) and the amounts cannot be rolled over to an IRA. By default, federal tax of 10% is withheld. However, you can elect to have additional tax withheld.
If the refund of your elective deferrals had a match associated with it, that amount may be forfeited back to your employer’s plan.
Additional employer contributions to NHCE
The other option your employer can choose as corrective action for a failing test is to make what’s known as qualified non-elective contributions (QNECs) to the 401(k) accounts of NHCEs. This effectively increases the deferral percentage or matching rate of NHCEs to bring a plan within allowable limits.
In this scenario, if you are a NHCE, you may receive additional contributions from your employer.
This article is for informational purposes and is not intended to be interpreted or construed as tax or investment advice. Please consult a qualified tax or investment professional.