401(k) Find and Fix: Failed ADP and/or ACP Testing

Plan sponsors must test traditional (i.e., non-safe harbor) 401(k) plans each year to ensure that the contributions made by and for rank-and-file employees (non-highly compensated employees –NCHEs) are proportional to contributions made for owners, managers and other highly paid employees (highly compensated employees — HCEs). As the NHCEs save more for retirement, the rules allow HCEs to defer more as well. These nondiscrimination tests for 401(k) plans are called the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests.(See ADP / ACP Testing.)

The ADP test takes into account elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of both the HCEs and NHCEs. Dividing an eligible employee’s elective deferrals by the participant’s compensation (as defined in the plan for testing purposes) gives you that participant’s Actual Deferral Ratio (ADR). The average ADR for all NHCEs (even those who chose not to defer) is the ADP for the NHCE group. The ADP for the HCEs is determined in the same way.

The ACP test is performed in the same way, except each eligible employee’s employer matching and after-tax contributions, instead of elective deferrals, are divided by the participant’s compensation.

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

• 125% of the ADP for the group of NHCEs, or
• the lesser of:
  • 200% of the ADP for the group of NHCEs, or
  • the ADP for the NHCEs plus 2%.

The ACP test is met if the ACP for the eligible HCEs doesn’t exceed the greater of:

• 125% of the ACP for the group of NHCEs, or
• the lesser of:
  • 200% of the ACP for the group of NHCEs, or
  • the ACP for the NHCEs plus 2%.

You may base the ADP and ACP percentages for NHCEs on either the current year or prior year contributions. Whether the plan will use current year or prior year data should be stated in the plan document, and there are restrictions on amending plans to switch between the two methods.

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

• Was a 5% owner of the sponsoring employer at any time during the current or prior year (regardless of whether the plan uses current or prior year testing for ADP and ACP testing purposes)(a 5% owner is someone who owns more than 5% of the employer), or

For the prior year, was paid by the employer more than $150,000 (for 2023; subject to cost-of-living adjustments in later years) and, if the employer so elects, was in the top-paid (top 20%) group of employees in such year.

Family aggregation rules treat a spouse, child, grandparent or parent of someone who is a 5% owner as also being considered to be as a 5% owner (and, therefore, an HCE) for the plan year.

How to find the mistake

Complete an independent review to determine if you properly classified HCEs and NHCEs, including all employees eligible to make an elective deferral, even if they chose not to make one. Plan administrators should pay special attention to:

• Prior year compensation
• The rules related to ownership when identifying 5% owners:
  • Plan administrators need access to ownership documents or similar information to identify 5% owners.
  • Take care to identify family members of the owners, as many will have different last names.

Review the rules and definitions in your plan document for:

• Determining HCEs;
• Definition of compensation used for ADP and ACP testing;
• ADP testing;
• ACP testing; and
• Whether the plan uses prior or current year data.

If you discover that incorrect data was used for the original testing, then you will need to rerun the tests. If the original or corrected test (if applicable) fails, then corrective action is required to keep the plan qualified.

How to fix the mistake

Corrective Action:
If your plan fails the ADP or ACP test, you should make every effort to take the corrective action prescribed for this purpose in the Internal Revenue Code and contained in your plan document prior to the end of the statutory correction period in order to cause the tests to pass. The statutory correction period is the 12-month period following the close of the plan year in which the test was failed. If the correction is properly completed within this time frame, then the plan should avoid having to use the IRS EPCRS Program to correct the mistake. (See “401(k) EPCRS Overview” and discussion, below.)

Generally stated, the failed tests may be corrected by either (1) making a fully vested qualified non-elective contribution (QNEC) to the plan on behalf of the NHCEs to the extent necessary to raise the contribution level to a passing percentage; or (2) using the “one-to-one correction method”, whereby excess contributions, plus earnings, are distributed to the HCEs, and that same dollar amount is then contributed to the plan to the NHCEs. These methods are more fully described below. If they are properly completed within the statutory 12-month period, they are considered to have been duly corrected without having to make use of the EPCRS program.

• Method 1 – See Revenue Procedure 2021-30, Appendix A, section .03 (based on Internal Revenue Code):
  • 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 made in the same percentage for each eligible NCHE.
• Method 2 – one-to-one method described in Revenue Procedure 2021-30, Appendix B, section 2.0 (based on Internal Revenue Code):
  • Excess contributions (adjusted for earnings) are assigned and distributed to the HCEs.
  • That same dollar amount is contributed as a QNEC to the plan and allocated based on compensation to all eligible NHCEs.
    • Any matching contributions (and earnings) related to the excess contributions distributed to the HCEs are must be forfeited.

If the sponsoring employer fails to take the above the above corrective action within the first 2 ½ months of the correction period, it may also be liable for a 10% excise tax on excess contributions (in addition to being required to eventually make the correction, either within the 12-month period or via EPCRS).
If correction is not made before the end of the statutory 12-month correction period, the plan may is in potential jeopardy of losing its tax-qualified status. You then need to correct this mistake through EPCRS, as described below.

Correction under EPCRS:
There are two different methods under the IRS EPCRS program to correct ADP and ACP mistakes beyond the statutory 12-month period. These methods are essentially the same methods as Methods 1 and 2 described above which may be employed prior to the expiration of the 12-month statutory period without using EPCRS; however, after the 12-month period, they would need to be employed as correction methods in conjunction with the EPCRS Self-Correction Program (SCP) or Voluntary Correction Program (VCP) (see discussion below).

The two methods are set forth in Revenue Procedure 2021-30, which is the current IRS document containing the rules and procedures concerning the EPCRS program. As further discussed below, this Revenue Procedure has not yet been updated for changes to EPCRS made by the SECURE 2.0 Act; however, these correction methods are currently still available.

Example:
Employer G maintains a 401(k) plan for its employees. In March 2023, G performed a review of the plan’s operations for the 2020 plan year. During this review, Employer G discovered that one participant, identified as an NHCE, was the child of a 5% owner, thereby making the employee a de facto HCE. When the employer reran the ADP test using the corrected classification, HCEs had an ADP of 7% and NHCEs had an ADP of 4%. The plan failed the ADP test because the ADP percentage for HCEs exceeded the ADP percentage for NHCEs by more than 2 percentage points. There were no matching or other employee contributions for the 2020 plan year. The plan has $450,000 in plan assets.

Correction programs available:

The IRS Employee Plans Compliance Resolution System (EPCRS) includes three separate programs, briefly described below, which may apply in this situation:

Self-Correction Program (SCP):
EPCRS defines this as an operational failure (the EPCRS term for mistake). Employer G determined that the plan had established practices and procedures designed to keep it compliant and otherwise met all relevant criteria and could, therefore, use SCP to correct the failure:

• No fees for self-correction, and no advance IRS approval required;
• Practices and procedures reasonably designed to facilitate compliance must be in place and must be followed;
• Prior to December 29, 2022, the EPCRS rules provide that if the mistakes are significant in the aggregate:
  • They must be corrected by the last day of the third plan year following the plan year in which the failure occurred. In our example, under the pre-SECURE 2.0 rules, Employer G would need to complete correction by December 31, 2023
  • If not corrected by December 31, 2023, under the old rules, Employer G isn’t eligible for SCP and must correct under VCP (see discussion, below).
• If the mistakes are insignificant in the aggregate, Employer G can correct beyond the three-year correction period for significant errors. Whether a mistake is insignificant depends on all facts and circumstances.
• Effective December 29, 2022, the SECURE 2.0 Act made substantial changes to the rules regarding SCP – notably, the former distinction between “significant” and “insignificant” mistakes has been eliminated.
• Prior to the enactment of SECURE 2.0, the rules regarding correction of 401(k) plan compliance mistakes were set out in a document known as Revenue Procedure 2021-30. SECURE 2.0 directs the IRS to issue an updated Revenue Procedure to replace Rev. Proc. 2021-30 within two years of the December 29, 2022 effective date. In the meantime, interim guidance in the form of IRS Notice 2023-43 provides that a plan sponsor is not prevented from self-correcting a mistake using the SECURE 2.0 rules on or after December 29, 2022 merely because the mistake occurred prior to December 29, 2022.
• Accordingly, since the failure in the present example occurred prior to, but was not discovered until, after December 29, 2022, Employer G should be able to correct the mistake within a “reasonable period” after the mistake has been identified. Notice 2023-43 provides that “reasonable period” means that failures of this type must be corrected by the last day of the 18th month following the date the mistake is discovered by the plan sponsor (not the date the mistake occurred).
• The failure must be due to an error or oversight and cannot be “egregious” (as defined in Rev. Proc. 2021-30); for example, the plan must not have consistently and improperly favored highly compensated employees or improperly benefited the owner or employer. (A simple ADP failure is not likely to be considered “egregious” under these criteria.)
• Because certain questions remain unanswered, pending issuance of the updated Revenue Procedure that fully incorporates the new SECURE 2.0 provisions, plan sponsors are strongly advised to consult with their legal counsel or other professional ERISA advisor prior to using SCP to correct mistakes.
• Employer G should fully and carefully document the steps taken to make the correction under SCP.

As explained previously under “Corrective Action,” above, correction could involve one of two methods:

• Under Method 1, Employer G could make QNECs to the NHCEs to raise the ADP to a percentage that would enable the plan to pass the test.
  • In this Example, each NHCE would receive a QNEC equal to 1% of the employee’s compensation (to bring the ADP for the NCHE group up to a passing percentage of 5%; i.e., within 2 percentage points of the 7% ADP for the HCEs).
  • Employer G must make these contributions for each eligible NHCE (assuming the contribution does not cause the Internal Revenue Code Section 415 limit to be exceeded – see 415 Testing for details.
• Under Method 2, the plan could use the one-to-one correction method.
  • Excess contribution amounts are determined.
  • The amount is assigned to HCEs and adjusted for earnings and this total amount is distributed to the HCEs.
  • An amount equal to the distributed amount is contributed to the plan and allocated based on compensation among the eligible NHCEs.

Under the pre-SECURE 2.0 rules, if Employer G determined the mistake to be significant, it must make the correction by the last day of the third plan year following the plan year that includes the last day that Employer G could have corrected the ADP/ACP mistake within the statutory period (see “Corrective Action,” above). In our Example, the mistake occurred in 2020, with the 12-month statutory correction period ending in 2021, so the correction period under SCP for significant mistakes (three years) ends on the last day of the 2023 plan year. But recall that, since the mistake was discovered after December 29, 2022, under SECURE 2.0 and the IRS interim guidance, the distinction between “significant” and “insignificant” is no longer relevant, and Employer G should have until the end of a “reasonable period” (i.e., until the last day of the 18th month following the month of the failed test) to correct the mistake.

Voluntary Correction Program (VCP):
If Employer G determined that the mistake was not eligible for correction under SCP (for example, because the plan did not have established compliance procedures in place), or if it elected to correct the mistake under VCP, the method of correction in this Example would be the same as under SCP. Employer G would need to file a VCP submission in accordance with Revenue Procedure 2021-30. Based on the amount of plan assets in our Example, $450,000, Employer G would pay a fee of $1,500. When making its VCP submission, Employer G must include Forms 8950 and 8951 and consider using the IRS Model VCP Compliance Statement and other forms and schedules that are referred to in Revenue Procedure 2021-30 Appendix C 2021-30, along with any related supporting documents. These must be submitted electronically in PDF format.

Audit Closing Agreement Program (CAP):
SCP and VCP are generally only available if the plan identifies the error before the IRS discovers it on plan audit or otherwise. Under Audit CAP, the correction method may be the same as under SCP or VCP, but this will be subject to negotiations with the IRS. Most plans are eligible for Audit CAP, which allows the plan sponsor to correct the mistake and pay a negotiated sanction, even if the IRS discovered the error first. This sanction would generally bear a reasonable relationship to the nature, extent and severity of the mistake, considering many factors, including the extent (if any) to which correction occurred before audit. Sanctions under Audit CAP are a negotiated percentage of the maximum payment amount.

Here, Employer G and the IRS would enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount — which will be greater than the VCP user fee would have been. Since the plan sponsor is responsible for the correct administration of the plan, expenses such as fees and sanctions under Audit CAP are generally not payable out of plan assets. (See “Plan Assets” for details.) Further, after the IRS finds the mistake on plan audit or otherwise, Audit CAP is the only correction method available, so it is important to self-identify and correct errors using SCP or VCP as soon as possible!

How to avoid the mistake

• One way to avoid this type of mistake is by establishing a safe harbor 401(k) plan or by changing an existing plan from a traditional 401(k) plan to a safe harbor 401(k) plan. (See 401(k) Safe Harbor Overview for details.) Under a safe harbor 401(k) plan, the employer is not required to perform the ADP and ACP tests, if the plan meets certain minimum contribution, vesting and notice requirements.
• Problems may happen when there is a lack of adequate communication between the employer and a third-party plan administrator regarding what the plan document provides, what documentation is needed to ensure compliance, salary and earnings data, elective deferral amounts, and other necessary information. Several main areas where these communication problems may occur, and suggested ways to help avoid mishaps, are summarized below:
  • Provide accurate count of all eligible employees for testing purposes:
    • Share accurate, up-to-date information with the third-party 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 third-party plan administrator about any related companies having common ownership interests with the plan sponsor.
    • Your plan document may require these employees to be eligible to participate in the plan, and, therefore, to be included in the tests.
  • Properly define compensation:
    • Be familiar with the terms of your plan document to ensure that you use the proper definition of compensation for all applicable purposes, including testing.
    • It’s important to know whether a particular form of compensation is:
      • Excluded for plan certain purposes (for example, not counted for purposes of determining any employer non-discretionary contributions),
      • Limited for certain plan purposes, or
      • Determined using a different computation period (for example, plan year vs. calendar year).
    • If the compensation amounts provided to the third-party plan administrator do not match up precisely with the plan definitions, the ADP and ACP tests will be inaccurate and will provide false results.
  • Properly identify HCEs:
    • An important aspect of performing the ADP and ACP tests is properly identifying HCEs. It’s especially important to identify and take into account all family members of owners who would meet the definition of HCE.
    • Don’t assume that once a person is a non-highly compensated employee, they are always a non-highly compensated employee.

  In summary, you should ensure that both you and your third-party plan administrator are familiar with your plan’s terms, and make sure that you always provide your plan administrator with complete and accurate information needed to make a proper determination of each employee’s status as an HCE or a NHCE.

  If either the ADP or the ACP test fails, to avoid having to correct under EPCRS if at all possible, implement procedures to ensure that you correct the mistake by either of the two methods previously discussed under “Corrective Action,” above, well within the 12-month statutory period.

  Excess Aggregate Contributions

  “Excess aggregate contributions” are contributions resulting from a 401(k) plan that has failed the ACP test, as opposed to the ADP test (as addressed in the Example above). The Internal Revenue Code generally treats them in the same fashion as excess contributions (which are contributions resulting from a plan that has failed the ADP test). However, if any excess aggregate contributions consist of matching contributions that are not fully (100%) vested, then the plan must reallocate the unvested portion to the accounts of the other eligible NCHEs, or, alternatively, put them in an unallocated suspense account to use to reduce future employer contributions. (See the IRS 401(k) Plan Fix-It Guide for more information.)
   

   

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