You Failed your Nondiscrimination Testing?  Now what?

Kimberly A. Reed
Principal, CPA

20 May 2019

Do you get the results of your nondiscrimination testing each year and do not quite understand why you failed or why refunds need to be issued to certain employees? Each year, plan sponsors must test traditional 401(k) plans to ensure that the contributions made by the nonhighly compensated employees (NHCE) are proportional to contributions made for highly compensated employees (HCE). The nondiscrimination tests include the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests.

The ADP test counts elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of the HCEs and NHCEs. Dividing a participant’s elective deferrals by the participant’s compensation gives you that participant’s Actual Deferral Ratio (ADR). The average ADR for all eligible NHCEs (even those who chose not to defer) is the ADP for the NHCE group. Do the same for the HCEs to determine their ADP.

Calculate the ACP the same way, but instead divide each participant’s matching and after-tax contributions by the participant’s compensation.

The ADP test is met if the ADP for the eligible HCEs doesn’t exceed

the greater of:

• 125{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} of the ADP for the group
of NHCEs, or

the lesser of:

• 200{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} of the ADP for the
group of NHCEs, or

• the ADP for the NHCEs plus
The ACP test is met if the ACP for the
eligible HCEs doesn’t exceed

the greater of:

• 125{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} of the ACP for the group
of NHCEs, or

the lesser of:

• 200{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} of the ACP for the
group of NHCEs, or
• the ACP for the NHCEs
plus 2{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c}.

You may base the ADP and ACP percentages for NHCEs on either the current or prior year’s contributions.  The election to use current or
prior year data is in the plan document.  Under limited circumstances, the election may be changed.

An important aspect of performing the ADP and ACP tests is to properly identify the HCEs, who are generally any employee who:

• Was a 5{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} owner, directly or by family attribution, at any time during the current or prior year (a 5{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} owner is someone who owns more than 5{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} of the employer), or

• For the prior year, was paid by the employer more than $125,000 for 2019 ($120,000 for 2015-2018); subject to cost-of-living adjustments in later years) and, if the employer elects, was in the top-paid (top 20{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c}) group of employees.

Family attribution rules treat an employee who is a spouse, child, grandparent or parent of someone who’s a 5{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} owner, as a 5{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} owner. Each of these individuals is an HCE for the plan year. 

If your plan fails the ADP or ACP test, you must take the corrective action described in your plan document during the statutory correction period to cause the tests to pass.

The plan has 2 ½ months after the end of the plan year being tested to correct excess contributions. The plan can distribute excess contributions any time during the 12-month period. If a correction is not made before the end of the 12-month correction period, the plan’s cash or deferred arrangement (CODA) is no longer qualified and the entire plan may lose its tax-qualified status.  You may correct this mistake through Internal Revenue Service correction programs. If the employer doesn’t distribute/characterize excess contributions by 2 ½ months (six months for certain EACAs) after the plan year of excess, the employer is liable for a 10 percent excise tax on excess contributions.

The tax doesn’t apply if the plan sponsor makes corrective qualified nonelective contributions within 12 months after the end of the plan year if the plan uses current year testing.  However, if the corrective contributions are insufficient for the CODA to pass the ADP test, the tax applies to the remaining excess contributions. 

There are two different methods to correct ADP and ACP mistakes beyond the 12-month period. Both require the employer to make a qualified nonelective contribution to the plan for NHCEs. A qualified nonelective employer contribution (QNEC) is an employer contribution that is always 100{dbc2a7977897ed6bb279211f092ba1f542e4cbaf62b292c7a918387c014c548c} vested and subject to the same distribution restrictions as elective deferrals. Forfeitures can’t be used to pay for QNECs.

• Method 1 – Revenue Procedure 2013-12, Appendix A, section .03:

• Determine the amount necessary to raise the
ADP or ACP of the NHCEs to the percentage needed to pass the tests.

• Make QNECs for the NHCEs to the extent necessary to pass the tests.

• You must generally make QNECs for all eligible NHCEs.

• These contributions must be the same percentage for each participant.

• Method 2 – One-to-one method under Revenue Procedure 2013-12, Appendix B, section 2.0:

• Excess contributions (adjusted for earnings) are assigned and distributed to the HCEs.

• You should notify the employee that the excess contribution is not eligible for favorable tax-free rollover.  The refunded excess contribution is taxable to the HCE in the year of distribution. You should report the refunded excess on a Form 1099-R.

• That same dollar amount is contributed as a QNEC to the plan and allocated based on compensation to all eligible NHCEs.

• Matching contributions (and earnings) related to the excess contributions distributed to the HCEs are forfeited.

• If the Plan provides for catchup contributions, the refund may be recharacterized as a catch-up contribution (up to the catch-up limit) provided:

• The affected HCE participant is age 50 or older, and

• The participant has not already used up the catch-up limit for the year. 

There are a number of things you can do to make sure the testing is done correctly.

• Count all eligible employees in testing:

• Share information with the plan administrator on all employees eligible to make an elective deferral (including all eligible employees who terminated before the end of the year).

• Share information with the plan administrator about any related companies with common ownership interests.

• Your plan document may require these employees to be eligible to participate in the plan, and, therefore, included in the tests.

• Definition of compensation:

• Be familiar with the terms of your plan document to ensure that you use the proper definition of compensation.

• It’s important to know whether compensation is:

• Excluded for certain purposes,

• Limited for certain purposes, or

• Determined using a different computation period (for example, plan year vs. calendar year).

• If the compensation amounts sent to the plan administrator don’t meet the plan definitions, the ADP and ACP tests will be inaccurate and will provide false results.

• Identification of HCEs:

• An important aspect of performing the ADP and ACP tests is properly identifying HCEs. It’s especially important to consider family members of owners.

• Don’t assume: once a nonhighly compensated employee, always a nonhighly compensated employee.

It is important to make sure you understand the testing as well as each component that goes into the testing. Failure to properly complete and correct testing can have significant consequences for both you and your employees.

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