A failed 401(k) compliance test can create an immediate problem for CPAs, plan sponsors, and business owners, especially when deadlines are approaching. For Phoenix employers with growing teams, changing ownership structures, or a mix of highly compensated and nonhighly compensated employees, an ADP or ACP failure deserves prompt attention.
The good news is that failing a test does not automatically mean the retirement plan is beyond repair. The right response starts with confirming the data, identifying why the test failed, reviewing the plan document, and determining which permitted correction method fits the situation.
Quick answer: When a 401(k) plan fails ADP or ACP testing, CPAs should first verify employee classifications, compensation, eligibility, deferrals, and matching data. Depending on the plan terms and timing, correction may involve distributing excess contributions to highly compensated employees, making qualified nonelective contributions, or using an applicable IRS correction program.
What Phoenix CPAs and employers should know
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ADP testing generally compares elective deferral rates of highly compensated employees, or HCEs, with those of nonhighly compensated employees, or NHCEs.
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ACP testing generally performs a similar comparison using applicable matching and after-tax employee contributions.
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Ownership and family attribution can affect who must be classified as an HCE, making accurate ownership information particularly important.
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Phoenix-area companies experiencing rapid hiring, turnover, ownership changes, or compensation growth should make sure their census and payroll data reflect those changes.
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Correction deadlines matter, so businesses should address a failed test as soon as it is identified rather than waiting until the next annual compliance cycle.
Why Does a Failed ADP or ACP Test Matter for Phoenix Employers?
A failed ADP or ACP test matters because it indicates that a traditional 401(k) plan did not satisfy applicable nondiscrimination testing requirements for the plan year, requiring the sponsor to determine and complete an appropriate correction. Waiting can narrow correction options and potentially increase the administrative and tax consequences involved.
The IRS requires traditional 401(k) plans subject to these rules to compare contributions for HCEs and NHCEs. In practical terms, a plan can run into trouble when owners and higher-paid employees contribute at substantially higher rates than the rest of the eligible workforce.
For businesses throughout Phoenix, Scottsdale, Tempe, Mesa, Chandler, and the broader Maricopa County area, workforce changes can make testing more complicated from one year to the next.
Fiduciary Advisors, LTD. works with retirement plan stakeholders navigating these compliance issues. We can help evaluate the situation in coordination with the professionals responsible for the plan’s administration, testing, and tax matters.
What Do IRS Rules Say About Failed ADP and ACP Tests?
IRS guidance provides correction methods for failed ADP and ACP tests, including corrective distributions and qualified nonelective contributions, depending on the circumstances and timing. Before selecting a correction, the underlying testing data and the specific terms of the plan document should be reviewed carefully.
The IRS describes the Actual Deferral Percentage test as a comparison involving elective deferrals. The Actual Contribution Percentage test applies a similar calculation to applicable matching and after-tax employee contributions.
One particularly important step is confirming who belongs in each testing group.
HCE status can be affected by compensation, ownership, and family attribution rules. A relative of an owner may need to be treated as an HCE even when that relationship is not obvious from a payroll report.
The IRS also advises plan administrators to review compensation definitions, eligibility, HCE classifications, and whether the plan uses current-year or prior-year testing data.
How Does a Failed Test Affect Local Businesses?
A failed test can affect a local business by creating unexpected distributions, employer contribution costs, additional administrative work, and potential tax consequences if correction is delayed. For an owner or finance team already managing payroll, tax filings, and benefits, discovering the problem late can make year-end or tax-season workloads more difficult.
Consider a growing professional practice near Downtown Phoenix or the Camelback Corridor. Several owners and senior employees may maximize or heavily fund their 401(k) accounts while participation among newer employees remains relatively low.
That imbalance may contribute to an ADP testing problem in a traditional plan.
The result can affect more than the plan administrator. CPAs may need accurate correction amounts and tax reporting information, payroll teams may need updated records, and participants may have questions about corrective distributions.
What Are the Warning Signs of an ADP or ACP Problem?
Warning signs of an ADP or ACP problem include low participation among NHCEs, high contribution rates among owners, incorrect HCE classifications, incomplete census information, and significant changes in the workforce. Spotting these issues before testing is completed can give the plan’s professional team more time to review the data.
Watch for:
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Owners and senior employees contributing substantially more than other eligible employees.
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Low 401(k) participation among rank-and-file employees.
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Missing or inaccurate compensation information in the annual census.
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Ownership changes that were not communicated to the plan administrator.
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Family members of owners who may have been classified incorrectly.
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Employees incorrectly excluded from eligibility or testing data.
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Payroll and plan records that do not reconcile.
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A prior-year testing issue that was corrected but never addressed through plan design or improved procedures.
These warning signs can occur in businesses throughout the Valley, from established companies in Central Phoenix to expanding employers in Tempe and Chandler.
When Should a CPA Escalate a Failed Compliance Test?
A CPA should escalate a failed ADP or ACP test as soon as the failure is confirmed, particularly when correction deadlines are approaching or the underlying employee data may be inaccurate. The immediate goal is to determine whether the test itself is correct before implementing a correction based on potentially flawed information.
Start with the plan document and testing report.
Then reconcile the employee census against payroll and ownership records. Verify compensation, eligibility, deferrals, matching contributions, ownership, and HCE classifications.
If the data is correct and the test still fails, the plan sponsor and its retirement plan professionals can determine which permitted correction method applies.
For Phoenix employers, this coordinated review can be especially useful after rapid hiring, acquisitions, ownership transitions, or major changes in compensation.
What Commonly Causes ADP and ACP Failures?
The most common causes of ADP and ACP failures involve contribution disparities, low NHCE participation, employee classification errors, inaccurate compensation data, or plan designs that do not align well with the employer’s workforce. Understanding the cause is essential because correcting this year’s test does not necessarily prevent the same result next year.
1. Low NHCE participation
If eligible NHCEs defer little or nothing, their average deferral percentage can remain low. That can restrict how much HCEs can contribute while still satisfying ADP testing.
2. High owner and executive deferrals
Owners and executives may be more likely to contribute aggressively. A large difference between HCE and NHCE deferral rates can contribute to a failed test.
3. Incorrect HCE classification
Ownership and family attribution rules deserve careful attention. A classification error can change the testing results and may require the test to be rerun.
4. Incorrect compensation
The compensation used for testing must follow the applicable plan terms and rules. Incorrect payroll feeds or compensation definitions can produce inaccurate results.
5. Workforce changes
Phoenix-area companies can add employees quickly as they expand across Maricopa County. New locations, acquisitions, turnover, and changing employee demographics can alter testing outcomes.
How Can Employers Reduce Future Testing Problems?
Employers can reduce future ADP and ACP problems by improving payroll data controls, reviewing workforce changes during the year, encouraging broader participation, and evaluating whether the current plan design remains appropriate. Prevention should begin well before annual testing results arrive.
Useful practices include reviewing census information before submission, confirming ownership annually, checking family relationships relevant to attribution rules, and reconciling payroll totals with plan records.
Employers may also want to discuss plan-design alternatives with their retirement plan professionals.
For example, the IRS identifies safe harbor plan design as one approach employers may consider for avoiding recurring ADP and ACP testing problems. Whether that structure makes sense depends on the employer’s goals, workforce, costs, and plan terms.
What Results Can Employers Expect After Correction?
A properly completed correction should address the identified testing failure according to the applicable plan terms and correction rules, but the exact financial result varies by plan. Some HCEs may receive corrective distributions, while other correction approaches can require employer contributions for eligible NHCEs.
There is no universal correction amount.
The result depends on factors including the number of participants, compensation, contribution percentages, testing methodology, plan provisions, and how far the plan is from passing.
That is why Phoenix employers should avoid estimating correction amounts without a complete testing analysis.
What Mistakes Slow Down ADP or ACP Corrections?
The mistakes that most often slow a correction are acting on incomplete data, overlooking ownership relationships, missing deadlines, and treating the failed test as an isolated administrative problem. A better approach is to verify the failure, correct it appropriately, document the process, and evaluate why it occurred.
Mistake: Immediately accepting the original test without reviewing census data.
Consequence: The company could base its correction on incorrect employee classifications or compensation.
Better approach: Reconcile the testing data first.
Mistake: Ignoring family attribution.
Consequence: An employee may be placed in the wrong testing group.
Better approach: Review ownership and relevant family relationships.
Mistake: Waiting until the correction deadline is close.
Consequence: Available time to coordinate calculations, contributions, distributions, and reporting becomes limited.
Better approach: Begin the review when the failed result is received.
Mistake: Fixing the test without reviewing plan design.
Consequence: The employer may face another failure in a later year.
Better approach: Determine whether participation strategies, administration changes, or plan-design alternatives deserve consideration.
What Is a Common Phoenix ADP Failure Scenario?
A common Phoenix scenario is a growing business where owners and senior employees save at high rates while participation among newer or lower-paid employees remains comparatively low. This is an illustrative scenario, not a Fiduciary Advisors, LTD. client case study.
Imagine a professional services firm with employees working across Phoenix and Scottsdale. The owners contribute heavily to the traditional 401(k), but a recent expansion brought in a larger group of eligible employees with lower participation.
Annual testing shows an ADP failure.
The appropriate response is not simply to issue refunds automatically. The professional team should first verify eligibility, compensation, ownership, and contribution data. Once the failure is confirmed, the applicable correction can be calculated and implemented, followed by a review of ways to reduce recurrence.
What Service Solutions Help Address Failed Testing?
Retirement plan consulting and fiduciary support can help employers understand the broader plan implications of a failed test and coordinate next steps with the professionals responsible for administration, tax reporting, and compliance. The goal should include both correcting the immediate issue and reducing the chance of repeating it.
We can help plan stakeholders evaluate issues surrounding plan governance, fiduciary responsibilities, participant outcomes, and plan design considerations while coordinating with the appropriate service providers.
Should You Correct the Test or Change the Plan?
Most employers need to correct the current failure first and then decide whether administrative improvements or a different plan design could reduce future testing problems. A current compliance issue and a long-term plan-design issue are related, but they are not the same decision.
Corrective distributions may resolve an immediate failure but can frustrate HCEs who intended to keep more money invested for retirement.
Employer-funded correction methods may preserve more participant savings but create an additional employer cost.
A plan-design change, including consideration of a safe harbor structure where appropriate, may reduce future testing exposure but introduces its own contribution and administrative requirements.
The best option depends on the plan document, workforce, objectives, and economics.
Where Do We Serve Local Retirement Plan Stakeholders?
We support retirement plan stakeholders in Phoenix and the surrounding area who need help evaluating fiduciary and plan-related concerns. Businesses in nearby communities such as Scottsdale, Tempe, Mesa, and Chandler can face many of the same challenges as employers throughout Maricopa County.
Local growth, ownership transitions, and changing employee populations make periodic plan review particularly valuable.
What Can Happen If an ADP or ACP Failure Is Ignored?
Ignoring an ADP or ACP failure can turn a correctable testing problem into a more complicated compliance matter, particularly when statutory correction periods expire. Prompt action gives the plan sponsor and its professional team more time to verify the failure, determine the proper correction, and complete required administrative steps.
IRS guidance states that plans generally have a correction period for excess contributions following the end of the tested plan year. Certain late corrections can create a 10 percent excise tax, and failures remaining beyond normal correction periods may need to be addressed through applicable IRS correction procedures.
The specific deadlines and consequences depend on the plan and circumstances, so CPAs and sponsors should verify the dates applicable to the particular failure rather than relying on a general timeline.
Frequently Asked Questions About ADP and ACP Testing
What should a Phoenix CPA do first after an ADP test fails?
A Phoenix CPA should first verify the testing data and determine whether employees were correctly classified before treating the result as final. Review compensation, eligibility, elective deferrals, ownership, and HCE status against the plan document and payroll records. If errors are found, the test may need to be rerun before correction amounts are calculated.
Can a failed ADP or ACP test be corrected?
Yes, a failed ADP or ACP test can generally be corrected using methods permitted under the plan and applicable IRS rules. Depending on the circumstances, correction may include distributions of excess amounts to HCEs, employer QNECs for eligible NHCEs, or correction through applicable IRS procedures when normal correction periods have passed.
How quickly should Phoenix employers address a failed test?
Phoenix employers should address a failed test promptly because the timing of correction can affect the available process and potential tax consequences. The IRS provides specific correction periods, and waiting can make the process more complicated. Employers should identify the applicable plan-year deadlines as soon as a failure is reported.
Why do growing Maricopa County businesses fail ADP testing?
Growing Maricopa County businesses may encounter ADP failures when workforce changes cause HCEs and NHCEs to contribute at significantly different average rates. Rapid hiring, low participation among newer employees, changing compensation, or ownership changes can all affect testing. Accurate census information becomes increasingly important as an organization grows.
Does a safe harbor 401(k) plan require ADP and ACP testing?
A properly structured safe harbor 401(k) can generally avoid the traditional ADP and ACP testing requirements when applicable safe harbor conditions are satisfied. Employers considering this option should review contribution requirements, plan provisions, notices where applicable, and other administrative obligations with their retirement plan professionals before making a change.
Can incorrect payroll data cause a failed test?
Yes, incorrect payroll or census data can produce an inaccurate ADP or ACP test result. Compensation, deferrals, matching contributions, eligibility, and employee classifications all need to be accurate. Phoenix employers using multiple payroll systems or managing substantial workforce changes should pay particular attention to reconciling plan and payroll information.
What is a QNEC?
A QNEC is a qualified nonelective employer contribution that can be used in certain retirement plan corrections, including some ADP and ACP failures. IRS guidance describes QNECs used for these corrections as fully vested contributions subject to applicable distribution restrictions. The required contribution depends on the particular correction method and testing results.
Can Scottsdale or Tempe employers use the same correction options?
Employers in Scottsdale, Tempe, and elsewhere in the Phoenix metropolitan area generally operate under the same federal ADP and ACP requirements applicable to qualified 401(k) plans. The appropriate correction still depends on the employer’s plan document, testing results, workforce data, and timing, so each failure should be reviewed individually.
Get Your 401(k) Plan Back on Track
A failed compliance test calls for accurate data, timely decisions, and coordination among the professionals serving the plan. We help Phoenix-area retirement plan stakeholders evaluate plan issues and consider practical next steps without treating compliance as a one-time checkbox.