Using Safe Harbor Contributions to Pass ADP Testing
By Ethan Branum, CIP
We have a retirement plan that has failed its ADP test. I know there are distribution methods, or possible contribution methods, that can be used to correct an ADP failure. Is there anything else that can be done?
As you have noted, there is a path to correcting an actual deferral percentage (ADP) testing failure. First, you can distribute, or return, the excess amounts—adjusted for earnings—to the plan participant within two and a half months after the end of plan year. If the plan has an eligible automatic contribution arrangement, the excess amounts can be returned within six months after the end of the plan year.
If you fail to distribute, or return, the excess amounts within the applicable time frame, a qualified nonelective contribution (QNEC) can be made to achieve an ADP ratio that passes testing if the plan uses the current-year testing method for its ADP test. Otherwise, the excess can still be distributed, but penalties may apply. If neither is done by the end of the following plan year, then the testing failure becomes a plan failure and must be corrected under the IRS correction programs outlined in Revenue Procedure 2019-19.
A new option made available with the enactment of the Setting Every Community Up for Retirement Enhancement (SECURE) Act is to make the plan a safe harbor plan.
How can a plan become a safe harbor plan after the fact?
Before the SECURE Act, a plan would only have been allowed to add a safe harbor feature at the beginning of a plan year, or mid-year if a “maybe" notice had been given before the start of the plan year. The main restriction was having to provide a safe harbor notice within 30–90 days before the beginning of that plan year. The SECURE Act removed that notice requirement for a safe harbor plan that uses the nonelective contribution plan design.
The SECURE Act also changed the regulations to state that a safe harbor nonelective feature may be added to a plan by the end of the following plan year to be in effect for the prior plan year. For example, if a calendar year plan fails its 2020 ADP test, a safe harbor nonelective feature could be added by December 31, 2021, to be effective January 1, 2020, thereby making the plan a safe harbor plan for 2020. Doing so would satisfy ADP testing and the plan would be considered to have passed its 2020 ADP test. This option applies to plan years beginning with 2020.
This seems too good to be true. Are there other requirements or restrictions?
If a plan is amended to have the safe harbor nonelective feature added retroactively, certain requirements must be met.
The safe harbor nonelective feature has to be in effect for the full plan year, meaning that the effective date would need to be the beginning of the plan year.
A nonelective contribution must be provided for the entire year based on the employee’s compensation for that full plan year. It generally must be a minimum of three percent, but if this feature is added after December 1 of the plan year in which it will be effective, it must be four percent.
Using the previous example, if the safe harbor feature is added by December 1, 2020, the nonelective contribution must be at least three percent. If the safe harbor feature is added after December 1, 2020, up until December 31, 2021, the nonelective contribution must be at least four percent. In the same example, if the safe harbor feature is added in 2021, the plan would be a safe harbor plan for both 2020 and 2021. There is not an option to make the safe harbor feature effective only for the plan year that the plan failed the ADP test. Removing the safe harbor feature would have to be done at the beginning of the next plan year. So in the same example, the feature could not be removed before January 1, 2022.
