What Can Be Done to Help Pass ADP/ACP Testing?
By Kyle Hause, JD
Are there any techniques that can be used to help pass an otherwise failing ADP or ACP test?
When conducting actual deferral percentage (ADP) and actual contribution percentage (ACP) testing for a plan that does not use a safe harbor 401(k) design, there are several ways to structure a test to enhance the chances of passing. For example, a plan that has liberal eligibility rules allowing employees who could be statutorily excluded (i.e., participants with less than 1,000 hours and one year of service, or those below age 21) to enter may treat them differently from other participants in the testing process. In many plans these excludable employees may be contributing at lower rates than longer tenured employees, and under normal testing procedure could contribute to testing failures.
One testing alternative allows the plan to simply ignore—not count—the otherwise-excludable non-highly compensated employees (non-HCEs) for the test, even though they may be both deferring into the plan and receiving matching contributions. Yet another alternative testing method is permissive disaggregation. Under this method, one plan may be treated as two plans and each employee group tested separately. The more tenured employees—who are more likely to be actively deferring—are tested in one group. The less tenured employees—those who could have been excluded by plan design—are tested as a separate group.
In addition to these alternative testing methods, a plan may employ the “borrowing” method to pass a test. For example, if a plan passes the ADP test “with room to spare,” non-HCE deferrals beyond what is necessary to pass the test may be shifted to the ACP test and treated as matching contributions in the ACP test to help it pass.
Finally, some deferrals of HCEs age 50 or older may potentially be treated as catch-up contributions and excluded from testing. ADP testing failure is one of the three conditions that can reclassify some deferrals as catch-up contributions (the maximum is currently $6,000).
What are the options to correct a failed ADP or ACP test?
To correct a failing test, the plan sponsor may distribute testing excesses to HCEs within two and a half months after the end of the plan year (March 15 for a calendar year plan). This distribution is not subject to the early distribution penalty tax, but distributions of pretax contributions are subject to income tax in the year of the distribution. If the excess is not distributed by March 15, the plan sponsor may still fund a qualified nonelective contribution (QNEC) or a qualified matching contribution (QMAC) to non-HCEs to pass the test. However, depending on the method of testing elected, this option may not be available.
How does a plan’s testing method affect its correction options?
The decision for a plan to use prior year or current year testing can affect the corrective options available for failing tests. To correct a failing test with a QNEC or a QMAC, a plan must make the contribution within 12 months of the end of the plan year from which the HCE data is used. Thus, if a calendar year plan is using prior year data, the corrective contribution must be made by December 31 of the year being tested. It is often difficult to do this, as not all year-end figures may be ready in order to complete the test, and not all plan documents permit this method. Also, plans that apply different methods for ADP testing and ACP testing have additional limitations. These plans cannot employ the borrowing method to pass the ACP test, nor can they make QMACs to pass the ADP test.
Can one QNEC or QMAC be applied to multiple tests?
No. The “double counting” of QNECs and QMACs is not permitted in testing. For example, this means that a contribution made to pass a failing ADP test cannot also be used to satisfy a failing ACP test. This also applies if a plan switches testing methods from current year to prior year method, resulting in the same year’s HCE data being tested twice—once when the plan is using the prior year data, and once when it is using the current year data. If the plan uses a QNEC or QMAC to pass testing the first time a year is tested, it may not use that same contribution to help pass testing the second time the year is tested. If the plan fails both testing both years, separate contributions must be made to pass each year’s test.
What happens if the test is not corrected timely?
If testing failures are not corrected within 12 months following the end of the plan year being tested. the plan sponsor is responsible for a 10 percent excise tax on the excess contribution. In addition, the plan sponsor must still correct the test under the IRS Employee Plans Compliance Resolution System (EPCRS). The sponsor may either distribute the excess to the HCEs or the plan can make a QNEC to pass testing. If distributing the corrective amount to HCEs, the plan sponsor must also make a QNEC contribution to non-HCEs equal to that amount.
Note that making QNECs and QMACs to pass testing is always permissible under the EPCRS, even if they were not otherwise permitted under timely correction methodology (e.g., for a plan that uses the prior year testing method).