What does it mean when a plan fails its ADP test? An ADP test, Actual Deferral Percentage, is a discrimination test required by the law to ensure that the Highly Compensated Employees (HCEs) are not deferring at a much higher rate than the Non-Highly Compensated Employees.  Let’s go back to basics for a minute.

In a 401(k) plan, every participant has the opportunity to contribute some amount from their paycheck once they meet eligibility and enter the plan. Every participant can defer up to the maximum limit, which is set at $19,500 for 2020. If you were born on or before December 31, 1970, you can defer an additional $6,500 as a catch-up contribution this year if your plan permits it. By contributing on a pretax basis, you are reducing your gross income and paying less in taxes.  This is very attractive to business owners and employees alike. 

Oftentimes, owners and other HCEs have the ability to contribute a high percentage annually or the maximum limit while several Non-Highly Compensated Employees (NHCEs) contribute less.  In some instances, staff is contributing significantly less, making it very disproportionate between the two classes of employees. The law considers this to be unfair, which is why the ADP test exists.  If there is no mechanism in place to bypass the test (which we will discuss soon), the plan has to be tested annually to see if the test passes or fails. In most instances, if the average of the HCEs is greater than two percentage points what the NHCEs contribute as a collective, the test fails and money may have to be returned to the HCEs.  Not ideal for anyone trying to save for retirement.

Is there anything you can do to be exempt from the ADP test?  Yes.  There are a few ways to bypass the ADP test and avoid the risk of having excess contributions returned to your HCEs.

1. Add a safe harbor component. There are two different safe harbor contributions you can add to your plan:

• Safe Harbor Match – A basic match formula is dollar for dollar on the first 3% of compensation and 50 cents per dollar on the next 2% of comp. Regardless of how much a participant defers into the plan, the maximum match would be 4% of compensation.
• Safe Harbor Nonelective – 3% of annual compensation. Unlike the safe harbor match, this contribution is not contingent on how much a participant defers into the plan. They would receive the contribution even if they did not make any contributions for the year.

Both types of safe harbor are given to all active employees.  A plan sponsor does not have the flexibility to add an hours provision as you can with a discretionary match. You also are prohibited from having a last-day provision to receive a safe harbor contribution. Lastly, this money type is immediately vested.

It is worth noting that until very recently a plan sponsor had to adopt a safe harbor provision at least 30 days prior to the beginning of their plan year.  Now, with the SECURE (Setting Every Community Up for Retirement Enhancement) Act, a plan may add a safe harbor nonelective provision at any time up to 30 days before the close of the plan year. Furthermore, a plan may add a safe harbor nonelective contribution after the 30^th day before the close of the plan year if you add a safe harbor by the end of the following plan year and the nonelective contribution is at least 4%. Once you declare your plan safe harbor, the plan is locked in for the following plan year.  Yes, there are couple of exceptions, but you should go in with the intention of making the contribution you promised participants.

2. If a plan sponsor is not interested in committing to a safe harbor contribution, amending the plan document to prior year testing is an alternative. With this plan provision, we would compare the ADP average of your NHCEs from last year and the ADP average of the HCEs from the current year. This methodology allows HCEs have some sense of their limit for the year.  For example, if we know that the NHCE average for 2019 was 2.4%, the average of HCEs cannot exceed 4.4% for 2020.  There are a few rules tied to this provision. Once you amend your plan to prior year testing, you have to keep it for five years. 
   
   
3. It may be an expensive solution, but a QNEC is also an option. When your plan is not safe harbor and you fail the ADP test, you can allocate an employer contribution to your NHCEs in lieu of returning money to your HCEs.  QNECs may appeal to some employers because the contribution is deductible and no refunds are required.  The purpose of this allocation is to increase the ADP of the NHCE group, thereby reducing the disparity between the two groups.  For example, an HCE average was 5.00% and the NHCE group was 2.00% for the year, therefore failing the ADP test.  The plan sponsor could allocate a 1% QNEC which will change the result of the discrimination test from a failing to a passing status. This option could be a less expensive – and less permanent-- than adding a safe harbor component.

There are a couple of events that could have unintended consequences when it comes to the result of your ADP test. 

New hires – If you hire an employee with an annual compensation of $135,000, they will not be an HCE until their second or possibly third year of employment. As you know from the HCE definition link above, compensation is always based on the year prior to the determination year.  This may be tricky if you historically had only HCEs (no NHCEs) and were not at risk for failing the ADP test. One new hire could wreck your methodology for a couple years.  Here is an example:

Terminated HCEs - Plan sponsors may not consider a participant front-loading their 401(k) contribution. If a participant has the ability to defer $5,000 per paycheck, this could be an issue. If the participant is an HCE and terminates employment early in the year, their deferral dollars divided by their annual salary may be significant.  Here is a quick comparison:

In the example with the terminated participant, it is very likely he will receive a majority portion of his contribution back.

The deadline to return excess contributions from a failed ADP test is March 15^th.  Recordkeepers also set their own processing deadlines (varies by recordkeeper) a few weeks prior to March 15^th.  An excise tax will be owed for any corrections that are not paid by the March 15^th deadline.  It is worth noting that the excise tax would not apply if the plan sponsor elects to make a QNEC versus issuing refunds.

While plan sponsors may find plan nuances like this confusing and frustrating, it does not have to be. Working with a Third Party Administrator that offers guidance throughout the year is key. If you have questions about your ADP failure or questions about how you can change your plan design to better align with your business objectives, call us today.