ADP/ACP Testing

A guiding principal in the retirement plan industry (covering 401(k) plans) is that a plan must satisfy (pass) the non-discrimination testing with respect to elective deferrals, matching contributions, and/or after-tax contributions to continue to enjoy its tax preferential status. Of the numerous tests performed, ADP/ACP Testing is arguably one of the most concerning of all. This test compares the average ratio of contributions for Highly Compensated Employees (HCEs) to those of Non-Highly Compensated Employees (NHCEs). Should the HCE average ratio exceed a permissible level the testing will fail and corrections may be required. ADP stands for Actual Deferral Percentage and ACP stands for Actual Contribution Percentage.

Corrections

Plan Sponsors have a number of options available to them to correct non-discrimination test failure. These remedies depend upon which test has not passed. 

ADP Failure Corrections

If the HCEs’ average deferral rate fails the ADP test, the sponsor has options to correct. We should note here that the purpose of the ADP test is to set a limit on the for the HCE group. To pass the test, the ADP of the HCE group must be within a certain range of the ADP of the NHCE group. Meaning the average of all the HCE's actual deferral percentages does not exceed the NHCE's average plus a certain amount (determined at testing). For example, if the average ADP for all NHCE's is 5% the HCE group's average must not exceed 7%. 

ADP Correction Options

The sponsor has a number of options to correct test failure:

• Catch-Up re-characterized to pass, or
• Excess contributions are refunded to the HCEs, or
• Qualified Non-Elective Contributions (QNEC) are contributed, or
• Other corrective contributions or actions are taken - shifting or other combinations.

It is important to note that the ADP testing applies to all elective deferrals, regardless of whether they are pre-tax elective contributions or designated Roth contributions.

ACP Failure Corrections

The actual contribution percentage (ACP) test applies to the 401(m) arrangement in a qualified plan. If the plan includes employer matching contributions and/or after-tax 
employee contributions then it has a 401(m) arrangement. In a defined contribution plan (such as a 401(k) plan), the ACP test is the exclusive means of showing that the 401(m) arrangement satisfies the  nondiscrimination requirements of IRC §401(a)(4). 

The test calculations under ACP are the same as under ADP, ratios and averages are determined and HCE's are compared against NHCE averages to determined test failure or satisfaction. 

ACP Correction Options

The sponsor has a number of options to correct test failure:

• Distribute Excess Contributions, or
• Qualified Matching Contributions (QMAC) are contributed, or
• A combination of corrective approaches and/or Shifting.

It's good to note here that the ACP test covers employer matching contributions and any employee voluntary after-tax contributions, if permitted in the plan.

The Cost of Compliance

The ultimate cost paid for failing to make timely corrections is disqualification. For ADP testing, the underlying plan is not disqualified but rather the 401(k) (CODA) component of the plan is treated an nonqualified. However, should the ACP test not be corrected within the required timeframe, then the entire plan is disqualified. 

We're not going to sugar-coat it here, correcting compliance matters is costly, in terms of time, plan contributions, and fees; but, correcting is the only way to ensure the plan can continue on and participants are not subject to taxation on their entire account. 

What Can We Do Now?

Plan Ahead to Better Position 2022 Testing

• Check COLA Limits
  • The IRS has significantly increased limits; ensure you're not over-contributing this year - 2022 LIMITS 
• Spot Check Rates
  • Without Safe Harbor you may have to perform a mid-year test to see how on or off-track you are for 2022 testing. Let us know if we can help!
• Encourage Participation
  • Check in with Eligible Participants frequently to encourage enrollment in the plan
  • For those already contributing, remind them an annual increase to contribution rates is always an option
• Add Automatic Enrollment with Auto-Escalation
  • Adding Automatic Enrollment with Auto-Escalation is one way to boost participation, plus Employers may be eligible for a qualified tax credit for adding this feature.
• You Have Support
  • Connect with your TPA (Uniglobal, for instance), your Advisors, and/or your Record-Keeper to help you promote your plan and educate your employees on the value it brings

A Word or Two on Safe Harbor Plans

Safe Harbor plans automatically satisfy ADP and/or ACP testing, depending upon the design and arrangements within the plan documents. If you're considering shifting to a Safe Harbor plan, let us know! We'd be happy to review a cost/benefit analysis with you and your team.

Annual compliance testing, while required, does not have to be a grueling experience; with a few tweaks, we can have you well on your way to passing next year. we can