Compliance testing for a 401(k) retirement plan ensures the plan adheres to Internal Revenue Service (IRS) regulations, preventing discrimination against non-highly compensated employees.
These tests, including the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, assess whether contributions and benefits are provided proportionately across all employees.
Plans failing to meet these standards may require corrective actions—such as refunding contributions to highly compensated employees—in order for the plan to maintain tax advantages and regulatory compliance. Compliance testing is essential to protect the tax benefits for the employer and employees alike.
Why does nondiscrimination testing exist for 401(k) plans?
Nondiscrimination testing for 401(k) plans ensures fairness and regulatory compliance, ensuring that the benefits of the plan do not disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs).
These tests, like the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, help companies ensure their plans keep the tax-qualified status of the plan by verifying that contributions are equitable. By enforcing these requirements, the IRS promotes broader employee participation and prevents the misuse of tax benefits intended for retirement savings.
What are highly compensated employees (HCEs) and non-highly compensated employees (NHCEs)
In the context of 401(k) plans, employees are categorized as either highly compensated employees (HCEs) or non-highly compensated employees (NHCEs) to facilitate nondiscrimination testing.
Highly Compensated Employees (HCEs)
These are individuals who either own more than 5% of the business at any time during the year or the preceding year, regardless of how much compensation they received, or they receive compensation above a certain threshold set by the IRS in the preceding year (for 2023, this is $135,000). This category also includes the top 20% of employees ranked by compensation.
Non-Highly Compensated Employees (NHCEs)
This group includes all other employees who do not meet the criteria to be classified as HCEs. These are typically employees who earn less than the predefined threshold for HCEs and do not hold significant ownership in the company.
The distinction between HCEs and NHCEs is crucial for conducting ADP and ACP tests to ensure that the 401(k) plan complies with IRS rules and operates fairly, offering equitable benefits to all employees, regardless of their compensation levels.
The nondiscrimination tests in action
The Actual Deferral Percentage (ADP) test
The Actual Deferral Percentage (ADP) test is a critical component of compliance testing for 401(k) plans, designed to ensure the contributions made by highly compensated employees (HCEs) are not disproportionately higher than those made by non-highly compensated employees (NHCEs). This test compares the average deferral percentages of HCEs and NHCEs:
- Calculation: The ADP for each group is calculated by dividing the total elective deferrals by the total compensation of all employees in the group.
- Comparison: The ADP for HCEs should not exceed that of NHCEs by more than a specific allowable percentage. Generally, the ADP for HCEs can be no more than 125% of the NHCEs' ADP or not more than 2 percentage points higher if the NHCEs' ADP is less than 2%.
- Correction Measures: If the plan fails the ADP test, the employer must take corrective actions, such as refunding excess contributions to HCEs or making additional contributions to NHCEs to bring the plan into compliance.
The purpose of the ADP test is to maintain fairness and encourage broad participation across all salary levels, supporting the plan’s qualification for tax benefits.
The Actual Contribution Percentage (ACP) test
The Actual Contribution Percentage (ACP) test is another crucial compliance measure for 401(k) plans, similar to the Actual Deferral Percentage (ADP) test. It ensures that employer matching contributions and after-tax employee contributions are distributed fairly between highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). Here's how it works:
- Calculation: The ACP for each group is determined by dividing the total of employer matching contributions and after-tax employee contributions by the total compensation of all employees within that group.
- Comparison: Like the ADP test, the ACP test compares the average contribution percentages of HCEs against those of NHCEs. The ACP for HCEs should not exceed the ACP of NHCEs by more than a specified percentage. Typically, the ACP for HCEs can be no more than 125% of the NHCEs' ACP or not more than 2 percentage points higher if the NHCEs' ACP is less than 2%.
- Correction Measures: If a plan fails the ACP test, the employer may need to refund some contributions to HCEs or make additional contributions for NHCEs to balance the percentages and comply with IRS regulations.
The ACP test is essential for maintaining the equitable treatment of all employees under a 401(k) plan and ensuring that the plan remains eligible for its tax-advantaged status.
Applying the ADP/ACP Tests
Applying the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests to a 401(k) plan involves a series of steps aimed at ensuring compliance with IRS nondiscrimination requirements. Here's how these tests are typically conducted:
- Data Collection: Gather accurate data on all eligible employees, including their compensation, elective deferrals (for the ADP test), and employer matching contributions plus after-tax employee contributions (for the ACP test).
- Group Classification: Divide employees into two groups—highly compensated employees (HCEs) and non-highly compensated employees (NHCEs)—based on IRS definitions for the plan year.
- Percentage Calculation:
- ADP Calculation: Calculate the ADP for each group by dividing the sum of elective deferrals by the sum of compensation for all group members.
- ACP Calculation: Similarly, calculate the ACP for each group by dividing the sum of employer matches and after-tax contributions by the sum of compensation for all group members.
- Comparison and Analysis: Compare the ADP and ACP of HCEs with that of NHCEs. The ADP and ACP for HCEs should not exceed those of NHCEs by more than the allowed percentages or points:
- The ADP for HCEs can be no more than 125% of the NHCEs' ADP or not more than 2 percentage points higher if the NHCEs' ADP is less than 2%.
- The same thresholds apply to the ACP test.
- Corrective Actions:
- If either the plan fails either ADP or ACP tests, the employer must undertake corrective measures to bring the plan into compliance. This may involve refunding excess contributions to HCEs to reduce their ADP or ACP or making additional contributions to NHCEs.
- Employers have a period of time—typically until the end of the following plan year—to make these corrections.
- Documentation and Reporting: Keep detailed records of the testing process and any corrective actions taken. This documentation is crucial for IRS compliance audits and for maintaining the integrity of the plan.
By conducting the ADP/ACP tests annually, employers ensure their 401(k) plan remains fair and compliant, thereby securing the tax-qualified status of the plan and ensuring its benefits are equitably available to all employees.
Top-Heavy Test
The Top-Heavy Test is another important compliance requirement for 401(k) plans, designed to ensure that the plan's benefits do not disproportionately favor key employees, including owners and officers of the company. Here's how the Top-Heavy Test is conducted:
- Definition of Key Employee:
- Calculation:
- Annual Requirement:
- Implications of Failing the Top-Heavy Test:
- Corrective Actions:
Employers must take corrective actions by making the necessary contributions to the accounts of non-key employees or adjusting future contributions to ensure more balanced funding.
Correcting a failing 401(k) plan
There are several steps a company needs to make in order to bring its 401(k) plan back into compliance after it fails a nondiscrimination test such as the ADP, ACP, or Top-Heavy Test. Here’s a concise guide on how to address these issues. You’ll want to discuss any actions with a retirement professional:
Identify the Failure:
Determine which test(s) the plan has failed—ADP, ACP, or the Top-Heavy Test. Analyzing the results will help identify the necessary corrections.
Refund Excess Contributions:
For ADP or ACP test failures, excess contributions made by or on behalf of highly compensated employees (HCEs) may need to be refunded to bring their contribution percentages in line with those of non-highly compensated employees (NHCEs).
Refunds should be made before the close of the following plan year to avoid additional tax penalties.
Make Corrective Contributions:
If the plan fails the Top-Heavy Test, the employer may need to make minimum required contributions to the accounts of NHCEs to ensure the plan does not disproportionately favor key employees.
Amend Plan Policies:
Consider revising contribution formulas or plan provisions to prevent future failures. This might include changing matching contributions or updating plan entry requirements.
Communicate with Employees:
Inform affected employees about any corrections or adjustments to their 401(k) accounts, in order to ensure transparency and maintain trust.
Document Corrections:
Keep thorough records of all corrective actions taken, including calculations and communications. This documentation is essential for IRS compliance and potential audits.
Review Annually:
Conduct annual reviews of the plan’s design and operation to anticipate potential compliance issues and adjust strategies as needed to avoid repeated failures.
Adopt Safe Harbor Plan Provisions:
Switching to a Safe Harbor plan design can automatically satisfy ADP and ACP testing requirements. Safe Harbor 401(k) plans require employers to provide matching contributions to all employees, and the contributions are immediately fully vested.
Read more: What is a Vested Balance In a Retirement Account
Correcting an ADP Failure
Correcting an Actual Deferral Percentage (ADP) failure in a 401(k) plan involves a few specific steps to ensure the plan remains compliant with IRS nondiscrimination requirements. Here's a focused approach to addressing an ADP failure:
Identify Excess Contributions:
Calculate the excess amount that HCEs contributed beyond what is allowed. This involves identifying the maximum allowable ADP for HCEs based on the NHCEs' ADP and determining how much the HCEs' contributions exceed this threshold.
Distribute Excess Contributions:
The excess contributions, along with any earnings on those contributions, must be returned to the HCEs. This needs to be done before the close of the following plan year to avoid additional taxes. The deadline to avoid a 10% excise tax on these excess contributions is the 15th day of the third month following the end of the plan year.
Recharacterize Excess Contributions:
If applicable, excess deferrals can be recharacterized as after-tax contributions to avoid further penalty, provided this aligns with the plan's features and rules.
Implement Corrective Contributions for NHCEs:
In some cases, increasing the NHCEs' ADP by making additional employer contributions can help the plan pass the ADP test. This involves calculating the necessary contribution rate and making those contributions to the NHCEs' accounts.
Communicate with Affected Employees:
Notify HCEs about the excess contributions and the need for refunds or recharacterizations. Ensure transparency in how the ADP failure is being corrected.
Adjust Future Contributions:
Review and possibly adjust the contribution rates for HCEs to prevent future ADP failures. This might include setting provisional contribution limits for HCEs based on projected NHCE participation rates.
Document All Actions:
Maintain comprehensive records of the correction process, including calculations, communications, and corrective distributions. This documentation is crucial for IRS compliance and potential audits.
Would you like to skip the headaches of compliance testing? Choose a Starter 401(k) or Safe Harbor plan. Find out about the best options for you: speak to one of our experts.
