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

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:

• 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 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:

• Was a 5% owner at any time during the current or prior year (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 $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:

• Prior year compensation
• The rules related to ownership when identifying 5% owners.
  • Plan administrators need access to ownership documents 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
• Testing compensation
• ADP testing
• ACP testing
• Prior or current year testing

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.

• Method 1 – Revenue Procedure 2021-30, 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 2021-30, Appendix B, section 2.0:
  • 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.
    • Matching contributions (and earnings) related to the excess contributions distributed to the HCEs are forfeited.

Example:
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:

• EPCRS Self-Correction Program (“SCP”) may be used to correct both significant and insignificant mistakes
• EPCRS Voluntary Correction Program (“VCP”) may also be used to correct this mistake

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:

• SCP may still be used to correct as long as the mistake can be classified as insignificant
• VCP may be used to correct both insignificant and significant mistakes

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

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:

• • 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.
    • G must make these contributions for each eligible NHCE (if the contribution doesn’t cause the 415 limit to be exceeded).
  • Under the second method, 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.

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

• 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. Under a safe harbor 401(k) plan, the employer isn’t required to perform the ADP and ACP tests, if it meets certain requirements. Problems may happen when there’s a communication gap between the employer and plan administrator regarding what the plan document provides and what documentation is needed to ensure compliance. Several main areas where these communication problems may occur:
  • 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 that once a nonhighly compensated employee, always a nonhighly compensated employee.

  In summary, you should ensure that you’re familiar with your plan’s terms, and provide your plan administrator with the information needed to make a proper determination of each employee’s status.

  If either the ADP or the ACP test fails, to avoid correcting under EPCRS, implement procedures to ensure that you correct excess contributions timely. Excess contributions result from plans failing to satisfy the ADP test and should be distributed to the applicable HCEs within 12 months following the close of the plan year. Excess aggregate contributions are contributions resulting from a plan that has failed the ACP test. The law generally treats them same as excess contributions. However, if the excess aggregate contributions consist of matching contributions that aren’t fully vested then reallocate the unvested portion to the accounts of the other plan participants or put them in an unallocated suspense account to use to reduce future contributions.