Employees who qualify to be part of an organization’s 401(k) plan must defer a percentage of their income to the 401(k) plan every month. This amount is known as the actual deferral percentage (ADP) amount. There is a tax code that governs the operations of 401(k) plans from qualified retirement plans and aims to prevent these plans from favoring highly compensated employees (HCEs) over non-highly compensated employees (NHCEs).
Employers are responsible for determining the actual deferral percentage (ADP) rate, which must meet and comply with IRS and the Employee Retirement Income Security Act (ERISA) rules and standards.
There are non-discriminatory tests that help to determine whether the contributions made by rank-and-file employees (NHCEs) are proportionate to the contributions made by HCEs. Two tests help to determine this:
- Actual Deferral Percentage (ADP) tests
- Actual Contribution Percentage (ACP) tests
In some cases, tests may indicate that a qualified retirement plan does not adhere to the rules and standards, resulting in an ACP test failure. This may be a cause for concern, resulting in employers and business owners asking themselves:
How do I fix a failed average deferral percentage test?
These tests measure three benefits:
- Coverage
- Contributions
- Accumulated assets
How do you fix an ACP failure?
The plan operators have different options that they can exercise if a plan fails the test. However, the options that are selected will be based on which test failed.
Correcting an ADP test failure
The ADP test aims to ensure that the HCEs are limited in how much they contribute. In other words, to pass the test, the ADP of the HCEs must fall within a certain range of the ADP of the NHCEs.
In essence, this means that the average number of all HCEs’ actual deferral percentages must not exceed the actual deferral percentage (plus an additional determined amount) of the NHCEs. Here is an example: if the ADP of the NHCEs is 3.5%, then the ADP of the HCEs must not exceed 5%.
The options to correct test failures are as follows:
- HCEs are refunded the excess contributions.
- Qualified non-elective contributions are made.
- If the plan makes provision for catch-up contributions, the refund is re-characterized accordingly.
- Other corrective contributions are made.
Corrections for ACP test failures
In the case of a qualified retirement plan, the actual contribution percentage (ACP) is applied to the 401(m) arrangement to ensure that the plan is compliant. The ACP test is the only available test to determine whether the 401(m) arrangement in a defined contribution plan meets the rules, standards, and requirements to be considered non-discriminatory by the IRS.
The options to correct test failures are as follows:
- Excess contributions may be distributed
- Apply a series of corrective approaches/shifting
- Qualified matching contributions (QMAC) are made
It is imperative to ensure timely corrections are made to avoid disqualification.