In 44 B.C. a soothsayer advised Julius Caesar to “Beware the Ides of March.” It’s an admonition that can still apply to 401(k) plan administration today when it comes the to Actual Deferral Percentage Test (ADP).
What is the ADP test?
Simply stated, 401(k) plans must pass this test in order to retain their qualified status. The test itself is designed to ensure that highly compensated employees (HCEs) aren’t contributing to the plan at a disproportionate rate compared with that of the non-highly compensated employees (NHCEs). If a retirement program doesn’t pass that test — the Ides of March (March 15) — is a critical date in remedying that situation.
How does the ADP test work?
You first start by determining what the ADP of both the HCE and NHCE groups is by dividing the individual elective deferral contributions divided by the employee’s compensation, and then averaging that result in each of the two groups. You then compare the HCE ADP with the NHCE ADP (after awhile the acronyms will roll off your tongue).
In order to pass, the ADP of the eligible HCEs cannot exceed 125% of the ADP of the eligible NHCEs, OR the ADP of the eligible HCEs cannot exceed two percentage point of the ADP of the eligible NHCEs, and the ADP of the eligible HCEs cannot exceed two times the ADP of the eligible NHCEs (with luck, the plan’s accountant or recordkeeper will be the one performing the test, though it’s not quite as complicated as it sounds).
What if the plan doesn’t pass the ADP test?
There are several ways to remedy a failed ADP test, generally either by reducing the amount of HCE deferrals, or by putting more money into the NHCE accounts. Specific strategies include:
- The employer can make special qualified matching contributions (QMACs) or qualified nonelective contributions (QNECs) to the accounts of some or all of the NHCEs.
- Excess contributions of HCEs can be recharacterized as after-tax contributions (if the plan allows for these type contributions).
- Excess contributions are distributed to HCEs within 2 1/2 months after the end of the plan year (for plans with a December 31 year-end, this is March 15). Rules mandate that beginning after December 31, 1996, excess contribution refunds are to be made first to the HCE deferring the largest dollar amount instead of the HCE with the largest deferral percentage.
- The plan can be restructured and retested. For example, the portion of employees who do not meet the statutory minimum age and service requirements, but do meet the plan eligibility requirements, may be tested as a separate group from those employees meeting both plan and statutory eligibility requirements.
Currently, if the excess contributions are not made within the 2 1/2 months after the end of the plan year (March 15 for 12/31 year-ends), the employer is on the hook for a penalty of 10% on the excess contributions. If the test failure isn’t remedied by the end of the next plan year, the plan could be disqualified.