All qualified plans have a variety of regulations to follow.  401(k) and 403(b) plans have some unique testing requirements to test for non-discrimination in the amount of elective deferrals and/or matching contributions made to the plan.

Understanding the mechanics of the 401k compliance test called the Actual Deferral Percentage (ADP) test itself is fairly rudimentary.  If the test fails there are two options: 

• Allocate additional funds as a Qualified Non-Elective Contribution (QNEC) to the Non-Highly Compensated Employees (NHCE) to bring their average up, or
• Distribute funds to the Highly Compensated Employees (HCE) to bring their average down.

To correct a failed test using the distribution option includes some extra steps that can be very confusing.  This article discusses the process required for correcting an ADP test using the corrective distribution option

Step 1 – Determine the testing population

• Start with full employee census – all employees who worked for the plan sponsor during the year
• Apply eligibility and entry date provisions to determine which employees were eligible during the testing period
• HCEs are those who either:
  • Own more than 5% of the company in prior or current year (or spouse/child/parent of owner); or
  • Earned more than $120,000 from the company in the year prior to the testing year
• NHCEs are those who are not HCEs

Step 2 – Split testing population into separate/allowable groups.  Employees who are in one of the two categories below, may be tested separately (statutory exclusions)

• Employees who would not have been eligible for the plan assuming a requirement to work 1000 hours in 12 months with semi-annual plan entry dates, or
• Employees who are under age 21

Step 3 – Determine catch up contributions for HCEsParticipants who have attained age 50 or more during the testing period may have their catch-up contribution excluded from testing if they deferred the maximum contribution limit under §402(g) plus catch up

Step 4 – Compute the maximum contribution percentage for the HCE group based on the average of the NHCE group

• Calculate the deferral ratio for each participant (deferral amount divided by compensation)
• Compute the average of the deferral rates of both the HCE and NHCE groups
• The HCE group can defer more than the NHCE group based on the table below:

Step 5 – Determine the total amount needed to be refunded to HCE group to bring their percentage down to meet testing limits

• From the table above, determine the maximum HCE deferral
• Reduce the HCE with the highest deferral percentage first. Continue down the list until the HCE group average is within the correct testing parameter.
• Calculate the amount needed to be withdrawn from the HCE group once the percentages are dialed in

Step 6 – Reduce deferral from HCE with highest contribution amount first.  Continue until total refunded amount is reached

Step 7 – Allocate investment gain or loss to deferral accounts

Step 8– If additional catch up contributions remain after the amounts used in Step 3.  Those additional amounts may be used to reduce the corrective distribution for those participants.

• Catch up contributions may only be used once. If the catch up was reduced in the initial testing, then no additional amounts may be used to reduce corrective distribution

Example –corrective distributions for this HCE group based on NHCE group average deferral of 2.1%

The same process is performed on 401k matching contributions for the ACP test, except that catch up contributions do not apply to match. 403(b) plans have to pass the ACP test only; they are not subject to the ADP test.

There are a variety of nuances to ADP and ACP testing.  We can include or exclude elective deferrals from the compensation used in the denominator of the ratios.  In some cases we can include HCEs that would otherwise be excluded under the statute in the test with the main testing group.  At Benefit Resources we look at every option available to our clients to give them the best testing result.  If your plan has testing problems, let us take a look at it for you.  We may have a solution that can help!