Bad news…you’ve just been informed by your Third-Party Administrator (TPA) that your 401(k) Plan failed its ADP/ACP tests. The good news…there are several ways to correct a failed ADP/ACP tests.
Failed ADP/ACP tests must be corrected within 12 months or the Plan will be disqualified.
To correct an excess, your company can make additional qualified non-elective or matching contributions to the accounts of non-highly compensated employees, or your company can, before March 15 of the new year, distribute the excess aggregate contributions made by highly compensated employees.
METHOD 1: Make Additional Contributions to Non-Highly Compensated Employees
The Plan can make additional contributions only for the lowest-paid employees. This often increases the non-highly compensated employees’ ADP or ACP at the lowest cost. You can also make additional contributions to all eligible non-highly compensated employees sufficient to pass the test. These contributions are 100% vested immediately. The employer can make additional contributions to the plan (in the form of qualified non elective contributions (QNECs) or qualified matching contributions (QMCs) that are treated as elective contributions for purposes of the ADP test and that, when combined with the existing elective contributions, cause the ADP test to be satisfied.
METHOD 2: Distribution of the Excess
Excess contributions, together with the earnings relating to such excess contributions, can be distributed to HCEs in accordance with IRS regulations.
Consequences to Employer
If the ADP or ACP excess is not corrected by March 15, the employer is subject to a 10% excise tax on the amount of the excess. If the excess contribution is not returned by the end of the year following the year of the excess, the plan is disqualified.
Consequences to Participants
Taxation of distributions depends on the timing of such distributions. Distributions of excess contributions made by March 15 (for calendar year plans) are taxable:
- In the case of an excess contribution, in the employee’s taxable year in which the amount would have been received in cash if he or she had not elected to contribute it to the plan
- In the case of an excess aggregate contribution, in the employee’s taxable year ending with or within the plan year for which the excess aggregate contribution was made.
The employer must provide the affected employee(s) with correct W-2s with compensation totals increased to reflect the addition of the excess.
If the corrective distributions are made after March 15, they are taxable in the year distributed.
Excluding Recent Hires in Nondiscrimination Testing
Another option for ADP/ACP testing is relevant to plans that allow employees to participate at an earlier age or with less service hours than the law requires (21 years of age and 1 year of service). Many companies now allow employees to become participants the day they’re hired, regardless of age.
A problem with immediate eligibility is that younger, short-service employees tend to have lower deferral rates, particularly in the lower-paid group, which adversely affects ADP/ACP testing. The new option allows all non-highly compensated employees with less than a year of service or under age 21 to be excluded from testing.
The rationale is that the plan sponsor should not be penalized for allowing employees to join the plan earlier than required.
There are other sophisticated testing options (like age banding, social security integration, and cross-testing), which illustrates why it is important to have a good Third Party Administrator.