This article builds upon the Compliance Testing Basics article by focusing on two tests that frequently affect small businesses: the Actual Deferral Percentage (ADP) and the Actual Contribution Percentage (ACP). Each test is described below, along with recommendations to improve your chances of passing.
- Defining Highly Compensated Employees
- What is a Top Paid Group?
- Testing Method
- Deferral Limits
- Fix it
- Correcting via Refund
- Correcting via a Qualified Non-Elective Contribution
- Correct it Before it Fails
- How a Safe Harbor Plan can Help
Because the IRS gives 401(k) plans tax-favored status, they want to ensure all employees in a plan benefit fairly. The Actual Deferral Percentage and Actual Contribution Percentage (ADP/ACP) tests are both used to ensure that a plan is not operated in such a way that 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 the plan is allowing HCEs to contribute via salary deduction in too great an amount when compared to NHCEs, while the ACP test looks at whether employer matching contributions favor HCEs when compared to NHCEs. Note that, if you have a Safe Harbor plan design, you will NOT need to perform these tests every year.
The ADP/ACP compliance tests use Highly Compensated Employees in their calculations. A Highly Compensated Employee (HCE) is:
- An employee making over $130,000 in the 2021 year (limit is the same $130,000 in the 2020 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 or prior year; OR
A family member of someone who owns more than 5% of the business.
A Non-Highly Compensated Employee (NHCE) is simply everyone else.
*HCE designations are based on prior-year compensation - not current year compensation. Thus, new hires are never HCEs in their first year (unless the individual owns more than 5% of the company). i.e.., An employee hired today with a $150,000 salary would be designated as NHCE this year rather than HCE. Likewise, employees who terminate employment during the year may be considered HCEs if their compensation exceeded $120,000 in the prior year. For ownership percentages please note that familial attribution rules can apply. Visit this article to learn more about how company ownership and familial relations should be reported for your plan.
What Is a Top Paid Group?
Plans with a high number of HCEs may benefit from having a Top Paid Group provision for their Guideline 401(k) plan. This provision is automatically included in all Guideline plans.
Under this provision, if more than 20% of the employees earn over $125,000 (as adjusted annually by the IRS), only the top paid 20% will be considered Highly Compensated Employees.
How to calculate Top Paid Group:
- Rank all employees who are 21+ and have worked at the company for 6 months by their compensation for the PRIOR year.
- Multiply the total employee count by 20% (or .20) to obtain the number of employees in the Top Paid Group. Round that number up if it’s a decimal.
- The employees who are paid the most, counted down, as long as they are making more than $125,000 (as adjusted by the IRS annually) per year, are in the Top Paid Group.
- Even if an owner, or a family member of an owner, does not meet the compensation threshold, they may need to be included in the Top Paid Group due to familial attribution rules.
Actual Deferral Percentage (ADP) Test. This test compares the average “deferral” (payroll reduction contribution) percentages of HCEs against the average deferral of NHCEs. Each participant’s ADP is calculated by taking their total salary contributions for the calendar year (not including catch-up contributions) and dividing this number by their compensation for the same year.
Actual Contribution Percentage (ACP) Test. This test compares the average employer matching contribution percentages 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.
The permissible limit for HCE deferrals is determined by the average NHCE deferral rate as shown in the table below.
If the Average NHCE Deferral Rate is...
Then the maximum HCE rate is:
NHCE rate multiplied by 2
NHCE rate plus 2%
Greater than 8%
NHCE rate multiplied by 1.25
For example, if your NHCEs have only deferred an average of 1% for the first part of 2021, your HCEs are currently projected to be limited to a 2% average deferral for the year. If your HCEs have deferred more than an average of 2%, your plan is at risk for failure.
Don’t worry, there are no IRS penalties for exceeding ADP/ACP limits as long as corrections are made in a timely manner. However, corrections need to be made the year after testing concludes either by March 15 for an ACA plan, or June 30 for an EACA plan (learn more about these plan designations here). Failure to complete corrections by the deadline can result in IRS penalties including double taxation, additional contributions being owed and/or possible plan disqualification.
The ADP/ACP test concludes as of December 31 of the current calendar year.
If your plan is found to be outside ADP limits on December 31, Guideline will provide you with the correction options and steps to take in the first quarter of the following year. 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 for any over-contribution.
Generally, to correct the plan, you will need to make corrections by:
Refunding excess contributions to HCEs; OR
Funding Employer contributions (QNEC) to NHCEs.
Refund Excess Contributions: Before any refunds are issued, the plan administrator will have the opportunity to review the correction and HCEs receiving refunds will be notified.The HCEs who have contributed the largest dollar amounts will receive larger refunds. Refunds are issued after the end of the year, typically in February or March the following year, and are taxable as ordinary income in the year distributed (not the year contributed). Any gains for ADP/ACP refunds are also calculated and refunded with the check. For the employee receiving a refund, their W-2 income remains unchanged, but the employee 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 they received the refund. For example, if excess contributions must be returned to HCEs for the 2021 plan year, these funds will typically be refunded in February 2022, which they would report on their 2022 tax return when they prepare taxes in 2023.
- Unlike other cash distributions, these 401(k) refunds are not subject to early distribution penalties if they are made by the applicable date (March 15th for most plans). By default, federal tax of 10% is withheld. Employees can elect to have additional tax withheld, and please note there is also a $50 disbursement fee for processing the refund check.
- Employer Contributions: The employer can make Qualified Non-Elective Contributions (QNECs) to the 401(k) accounts of NHCEs, effectively increasing the deferral percentage of NHCEs to bring a plan within ADP/ACP limits. Contributions can be allocated in a number of different ways including:
- pro-rata based on compensation,
- targeting the NHCEs with the lowest compensation or deferral rates first,
- matching the NHCEs who contributed, or
- contributing the same dollar amount to all NHCEs.
Correct It Before It Fails
If your plan is currently outside the permitted ratio, you can close the gap by a combination of:
- Encouraging NHCEs to increase contributions and/or
- Requesting that HCEs reduce their contribution
Some effective ways to boost NHCE participation in your plan may include:
- Educating NHCEs on the importance of retirement saving
- Increasing your plan’s default automatic enrollment contribution rate.
- Implementing employer matching contributions up to a certain percentage of employee deferrals to encourage participation.
- Using a combination of employer matching and vesting schedules to encourage participation and employee retention.
If measures to boost NHCE participation fall short, then placing a cap on HCE contributions can help. In most cases, simply letting HCEs know they may receive year-end taxable refunds if they continue contributing at their current rates can help encourage a contribution adjustment. For more information on your company’s compliance status, please review your compliance testing dashboard to see your projected year-end results.
Implement Vesting to Control Costs Matching contributions can be made subject to a vesting schedule to reward longer-tenured employees. Implementing a vesting schedule in conjunction with employer matching means that, if an employee terminates employment before their employer contributions fully vest, they will forfeit some or all of the employer match back to the plan, which can then be used to pay plan expenses.
Use a Safe Harbor Plan and Never Worry
401(k) plans with Safe Harbor provisions are exempt from ADP, ACP, and Top Heavy tests (please note if you make additional employer contributions other than the Safe Harbor contributions, you are no longer within the “Safe Harbor” and will be subject to Top Heavy Testing). Safe Harbor provisions must be added 30 days before the start of the year. Alternatively, a mid-year Non-Elective contribution of at least 3% can be added under the SECURE Act as long as it remains effective for the entire year. You can add a Safe Harbor provision to your plan for the coming year by contacting Guideline Support. 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 1st.
Guideline can assist with implementing a compliance strategy or crafting a solution that’s right for your company. You can contact us at firstname.lastname@example.org and we’ll be happy to help!