The latest thinking from Greenspring Advisors.

Correcting A Failed ADP Test

Christian Stanley, CRPS®, AIF®

Testing…. testing…. testing…Bueller? Bueller? It’s that time of year again, the time we’ve all been waiting for — nondiscrimination testing for your corporate 401(k) plan. Oh, what fun, right? While not all plan sponsors fret at this time of year thanks to safe harbor provisions, strong participation and deferral rates, or effective plan design — for some, it can be a frustrating time.

Let’s first take a step back and outline what nondiscrimination testing is and how it relates to this time of year. The IRS has created a series of tests that must occur on an annual basis to ensure retirement plan benefits do not disproportionately favor highly compensated employees (HCEs)[1] over non-highly compensated employees (NHCEs). These tests occur at the conclusion of the plan year for plans under the current year testing format. While there are several tests that must occur, I’m going to focus on the plan that is typically the proverbial “thorn in the side” of sponsors: the Actual Deferral Percentage test, or ADP test.

The ADP test compares the actual deferral ratio (ADR) — the amount of compensation the employee defers into the plan — of all eligible HCEs with the ADR of all NHCEs. While there are other parameters, the one most commonly applied is the 2% rule. This rule states that the ADR of the HCEs cannot be more than 2% of those of the NHCEs. Below is a simple illustration of plans both passing and failing the ADP test:

Passing Scenario:

  • HCE ADR: 8.16%
  • NHCE ADR: 6.67%
    • Difference: 1.49%
      • 1.49% < 2% = Test Passed

Failing Scenario:

  • HCE ADR: 7.95%
  • NHCE ADR: 5.42%
    • Difference: 2.53%
      • 2.53% > 2% = Test Failed

If a plan passes the ADP test, no further action is required. Everybody can go on their merry way, or at least on to the next discrimination test. If a plan fails the ADP test, immediate action to address the issue is required on behalf of the plan sponsor and their administrator. Failure to comply with ADP test parameters can result in refunds to the HCEs for the amount contributed that put them over the 2% allowable disparity, plus investment earnings on that dollar amount. These refunds (called “corrective distributions”) can cause confusion and tax issues to the employees and possible penalties to your organization (i.e., 10% excise tax) if not handled appropriately nor in a timely fashion.  Plus, refunds tend to frustrate HCEs and can create benefits PR issues for your organization, making it difficult to attract and retain quality people.

In addition to corrective distributions, a plan can also utilize a Qualified Non-Elective Contribution (QNEC) or Qualified Matching Contribution (QMAC) to fix a failed test. However, both of these options involve companies forking over additional funds to the NHCEs to ensure the HCEs can keep their contributions in the plan. This can be quite costly, especially since these additional contributions must be vested immediately.

What if I told you there is another way to address the issue? One that doesn’t entail your company making additional contributions to the plan nor HCEs receiving a large refund check with possibly confusing tax consequences? Commonly overlooked due to its obscurity is the recharacterization of the “catch-up” contribution for plan participants aged 50 or older. Catch-up contributions refer to the additional $6,000 the IRS allows participants over 50 to defer into the plan over the 402(g) annual limit of $18,500 as indexed for 2018. Under IRS rule, catch-up contributions are excluded from discrimination testing. In other words, testing is capped at $18,500 worth of employee deferrals.

Now, here’s how it works. After the ADP test has been run and a failure has been detected, if participants 50 years or older have not already used up their allotted catch-up contribution amount, then the amount of money that would have been refunded as a result of the ADP failure can be recharacterized as catch-up contributions — thus remaining in the plan. This can be quite confusing, so let’s look at an example to bring the topic to life.

Suppose you have a small company of 50 employees. Of your 50 employees, 8 are considered HCEs. Of those 8, 4 are over 50, each contributing the maximum of $18,500. The ADR of the HCEs for the current plan year is 7.86% while the ADR for the NHCEs is only 5.37%. The 2.49% difference between the two groups exceeds the 2% allowable disparity. This results in the highest contributing HCEs (i.e., the 4 who maxed out the plan at $18,500) getting refunds on the excess .49% contributed. To make matters more complex, let’s assume those four individuals are the four owners of your company. (What can I say, I love a good story!)

Knowing that your owners do not want to receive money back nor do they want to make any additional contributions to the plan (as money is tight this year), the next step is to review their catch-up contributions. For the continued sake of the story, let’s say that each owner was eligible to make catch-up contributions but, for whatever reason, had not. The refunds needed to make the test compliant could be recharacterized as their catch-up contribution, thus being precluded from the 402(g) IRS limits and the ADP test altogether.

Simple, right? Not in the least. But luckily for you, chances are your administrator’s software has the recharacterization algorithm built in and they are applying this method to reduce or eliminate the potential of a refund. It is important to note that this recharacterization method may not be available if the HCEs have already utilized their catch-up contributions or if the refund amount exceeds the remaining amount available for catch-up. But, it never hurts to ask your administrator if this correction method has been applied when you run into a situation where your plan fails the test and your HCEs are required to receive a corrective distribution. Especially if those participants are your owners!

Plan testing is a very complex matter and could be the difference between maintaining your plan’s tax qualified status or not. Having the right professionals in place can make a world of difference when planning and preparing for end-of-year testing. While we are not plan administrators, we are experienced in designing first class retirement plans that can be what they were intended to be: a benefit for all your participants, regardless of income level.

Is your annual testing causing you heartburn? Let’s have a conversation and see if we can help.

 

[1] For the 2018 plan year, an employee who earns more than $120,000 in 2017 is an HCE.