Each year non-safe harbor 401(k) plans must satisfy an Average Deferral Percentage (”ADP”) test. If they provide matching contributions, they must also satisfy an Average Contribution Percentage (“ACP”) test. If either or both tests fail, the failed tests must be corrected.
The ADP test looks at the average savings rate of eligible highly paid employees and owners. It compares their average savings rate to all other employees. The highly paid employees and owners cannot save too much more, on average, than the lower paid employees. Doesn’t sound too hard, right?
First of all, the correct deferrals must be used in the test. Does that mean the amount taken out of employees checks? What if a different amount was deposited to the plan, for example somehow one deposit never got made during the year? Next, the correct compensation must be used in the test. There are many possible definitions of compensation, so the plan document must be consulted to determine which definition is used to perform the ADP test. Then, those employees who are considered highly compensated (the highly paid employees and owners) must be determined. Did you know that stock ownership is sometimes attributed to family members even if the family member doesn’t directly own any stock? Lastly, the determination of who was eligible for the plan at any time during the year, and therefore must be included in the test, must be done.
The same rules apply to the ACP testing substituting matching contributions for deferrals.
Once the testing is completed, it will either pass or fail. If it fails, that means the highly compensated employees saved or received matching that was substantially more on average than everyone else.
To fix the test, either:
- the plan sponsor must contribute more money to the non-highly compensated employees to increase their average; or
- the amounts saved or matched to the highly compensated employees must be taken away from the highly compensated employees to lower their average.
Deferrals that are taken away from highly compensated employees are returned to them. Matching money taken away from highly compensated employees is distributed to them if they are vested or forfeited if they are not. And, the amounts returned may need to be adjusted for earnings.
These rules are very complex. It is not uncommon in this age of technology for plan sponsors to be given a website and told to generate their own ADP or ACP testing results based on what was actually deposited to the plan. No one asks if any deferrals or match are missing. No one confirms the compensation used in the test matches what the plan document says must be used. No one checks the highly compensated employee determination. Etc. Then, on audit, the IRS agent determines the test was done improperly. Are we really surprised?