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

Geek Out!


MISTAKE: The plan failed the 401(k) ADP and ACP nondiscrimination tests.
Find the Mistake Fix the Mistake Avoid the Mistake
Conduct an independent review to determine if highly compensated and nonhighly compensated employees are properly classified. Make qualified nonelective contributions for the nonhighly compensated employees. Follow the Compliancedashboard testing activities. Consider a safe harbor plan design or using automatic enrollment. Communicate with plan administrators to ensure proper employee classification and compliance with the plan terms.


Plan sponsors must test traditional 401(k) plans each year to ensure that the contributions made by and for rank-and-file employees (nonhighly compensated employees) are proportional to contributions made for owners and managers (highly compensated employees). As the NHCEs save more for retirement, the rules allow HCEs to defer more. These nondiscrimination tests for 401(k) plans are called the Actual Deferral Percentage and Actual Contribution Percentage 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. The average ADR for all 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, instead dividing 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:

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

You may base the ADP and ACP percentages for NHCEs on either the current or prior year 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:

For the prior year, was paid by the employer more than $130,000 (for 2020 and 2021; subject to cost-of-living adjustments in later years) and, if the employer elects, was in the top-paid (top 20%) group of employees.

Family aggregation rules treat a spouse, child, grandparent or parent of someone who’s a 5% owner, as a 5% owner. Each of these individuals is 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 a deferral, even if they chose not to make one. Plan administrators should pay special attention to:

Review the rules and definitions in your plan document for:

If incorrect data is used for the original testing, then you may have to rerun the tests. If the original or corrected test 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 must take the corrective action described in your plan document during the statutory correction period to cause the tests to pass. The statutory correction period is the 12-month period following the close of the plan year for which the test failed. If you do this, you don’t need the IRS EPCRS Program. (See “401(k) EPCRS Overview”)

If you take corrective action after the first 2 ½ months of the correction period, you are also liable for an excise tax (in addition to being required to make the correction).

If correction is not made before the end of the statutory 12-month correction period, the plan may lose its tax-qualified status. You may correct this mistake through EPCRS.

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

Employer G maintains a 401(k) plan for its employees. During 2020, G performed a review of the plan’s operations for the 20172 plan year. During this review, G discovered one participant, identified as an NHCE, was the child of a 5% owner. When the employer reran the ADP test with the corrected classification, HCEs had an ADP of 7% and NHCEs had an ADP of 4%. The maximum passing ADP for the HCE group is 6%; and the plan failed the ADP test. There were no matching or other employee contributions for the 2017 plan year. The plan has $450,000 in plan assets.

Correction programs available:

Less than two years from end of statutory period

For mistakes corrected within three years after the end of the 12-month correction period:

More than three years from end of statutory period

For mistakes corrected more than three years after the end of the 12-month correction period:

Example: A 401(k) plan fails the ADP test for the plan year ending December 31, 2017

Plan year tested: 12/31/2017
Statutory correction period (12 months): 01/01/2017 to 12/31/2017
If correction occurs by 03/15/2017 No further action required
If correction occurs after 03/15/2017 but before 12/31/2017 Employer is required to file a Form 5330 and pay a 10% excise tax on the excess
If correction occurs between 01/01/2018 and 12/31/2018 May use SCP or VCP to correct mistakes if determined to be insignificant or significant
If correction occurs after 12/31/2021
  • May only use SCP to correct mistakes determined to be insignificant
  • May use VCP to correct both insignificant and significant mistakes

Self-Correction Program:
EPCRS defines this as an operational error. G determined the plan had established practices and procedures designed to keep it compliant and that the mistake wasn’t significant. Correction could involve one of two methods:

If G determined the mistake to be significant, it must make the correction by the end of the SCP correction period. Under EPCRS, the SCP correction period for an ADP/ACP testing failure ends on the last day of the third plan year following the plan year that includes the last day that G could have corrected the ADP/ACP mistake within the statutory period (see “Corrective Action,” above). In our example, the mistake occurred in 2017, with the normal correction period ending in 2018, so the correction period under SCP for significant mistakes (three years) ends on the last day of the 2021 plan year.

Voluntary Correction Program:
If G determined the mistake wasn’t correctible under SCP, or if it elected to correct the mistake under VCP, the method of correction would be the same as under SCP. G would need to file a VCP submission. Based on the number of participants in our example, 21, the amount of plan assets, G would pay a fee of $1,500. When making its VCP submission, 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. These must be submitted electronically in PDF format.

Audit Closing Agreement Program:
SCP and VCP are generally only available if the plan identifies the error before the IRS discovers it. 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 bear a reasonable relationship to the nature, extent and severity of the mistake, considering many factors, including the extent to which correction occurred before audit. Sanctions under Audit CAP are a negotiated percentage of the maximum payment amount.

How to avoid the mistake