401(k) plan Fix-it Guide — The plan failed the 401(k) ADP and ACP nondiscrimination tests

Mistake	Find the mistake	Fix the mistake	Avoid the mistake
5. The plan failed the 401(k) ADP and ACP nondiscrimination tests.	Conduct an independent review to determine if highly compensated and nonhighly compensated employees are properly classified.	Make qualified nonelective contributions for the nonhighly compensated employees.	Consider a safe harbor plan design or using automatic enrollment. Communicate with plan administrators to ensure proper employee classification and compliance with the plan terms.

Plan sponsors must test traditional 401(k) plans each year to ensure that the contributions made by and for rank-and-file employees (nonhighly compensated employees (NHCE)) are proportional to contributions made for owners and managers (highly compensated employees (HCE)). As the NHCEs save more for retirement, the rules allow HCEs to defer more. These nondiscrimination tests for 401(k) plans are called the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests.

The ADP test counts elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of the HCEs and NHCEs. Dividing a participant’s elective deferrals by the participant’s compensation gives you that participant’s Actual Deferral Ratio (ADR). The average ADR for all eligible NHCEs (even those who chose not to defer) is the ADP for the NHCE group. Do the same for the HCEs to determine their ADP.

Calculate the ACP the same way, instead dividing each participant’s matching and after-tax contributions by the participant's compensation.

The ADP test is met if the ADP for the eligible HCEs doesn't exceed the greater of:

• 125% of the ADP for the group of NHCEs, or
• the lesser of:
  • 200% of the ADP for the group of NHCEs, or
  • the ADP for the NHCEs plus 2%.

The ACP test is met if the ACP for the eligible HCEs doesn't exceed the greater of:

• 125% of the ACP for the group of NHCEs, or
• the lesser of:
  • 200% of the ACP for the group of NHCEs, or
  • the ACP for the NHCEs plus 2%.

You may base the ADP and ACP percentages for NHCEs on either the current or prior year contributions. The election to use current or prior year data is in the plan document. Under limited circumstances, the election may be changed.

An important aspect of performing the ADP and ACP tests is to properly identify the HCEs, who are generally any employee who:

• Was a 5% owner, directly or by family attribution, at any time during the current or prior year (a 5% owner is someone who owns more than 5% of the employer), or
• For the prior year, was paid by the employer more than $155,000 for 2024 ($150,000 for 2023; subject to cost-of-living adjustments in later years) and, if the employer elects, was in the top-paid (top 20%) group of employees.

Family attribution rules treat an employee who is a spouse, child, grandparent or parent of someone who’s a 5% owner, as a 5% owner. Each of these individuals is an HCE for the plan year.

How to find the mistake

Complete an independent review to determine if you properly classified HCEs and NHCEs, including all employees eligible to make a deferral, even if they chose not to make one. Plan administrators should pay special attention to:

• Prior year compensation
• The rules related to ownership when identifying 5% owners.
  • Plan administrators need access to ownership documents to identify 5% owners.
  • Take care to identify family members of the owners, as many will have different last names.

Review the rules and definitions in your plan document for:

• Determining HCEs
• Testing compensation
• ADP testing
• ACP testing
• Prior or current year testing

If incorrect data is used for the original testing, then you may have to rerun the tests. If the original or corrected test fails, then corrective action is required to keep the plan qualified.

How to fix the mistake

Corrective action

If your plan fails the ADP or ACP test, you must take the corrective action described in your plan document during the statutory correction period to cause the tests to pass.

The plan has 2 ½ months after the end of the plan year being tested to correct excess contributions. The plan can distribute excess contributions any time during the 12-month period. If correction is not made before the end of the 12-month correction period, the plan’s cash or deferred arrangement (CODA) is no longer qualified and the entire plan may lose its tax-qualified status. You may correct this mistake through EPCRS. If the employer doesn't distribute/recharacterize excess contributions by 2 ½ months (six months for certain EACAs) after the plan year of excess, the employer is liable for a 10 percent excise tax on excess contributions.

The tax doesn't apply if the plan sponsor makes corrective qualified nonelective contributions within 12 months after the end of the plan year if the plan uses current year testing. However, if the corrective contributions are insufficient for the CODA to pass the ADP test, the tax applies to the remaining excess contributions.

There are two different methods to correct ADP and ACP mistakes beyond the 12-month period. Both require the employer to make a qualified nonelective contribution to the plan for NHCEs. A qualified nonelective employer contribution (QNEC) is an employer contribution that is always 100% vested and subject to the same distribution restrictions as elective deferrals.

• Method 1 – Revenue Procedure 2021-30, Appendix A, Section .03:
  • Determine the amount necessary to raise the ADP or ACP of the NHCEs to the percentage needed to pass the tests.
  • Make QNECs for the NHCEs to the extent necessary to pass the tests.
    • You must generally make QNECs for all eligible NHCEs.
    • These contributions must be the same percentage for each participant.
• Method 2 – one-to-one method under Rev. Proc. 2021-30, Appendix B, Section 2.0:
  • Excess contributions (adjusted for earnings) are assigned and distributed to the HCEs.
    • You should notify the employee that the excess contribution is not eligible for favorable tax-free rollover. The refunded excess contribution is taxable to the HCE in the year of distribution. You should report the refunded excess on a Form 1099-R.
  • That same dollar amount is contributed as a QNEC to the plan and allocated based on compensation to all eligible NHCEs.
    • Matching contributions (and earnings) related to the excess contributions distributed to the HCEs are forfeited.
• If the Plan provides for catch-up contributions, the refund may be recharacterized as a catch-up contribution (up to the catch-up limit) provided:
  • The affected HCE participant is age 50 or older, and
  • The participant has not already used up the catch-up limit for the year.

Example:

Employer G maintains a 401(k) plan for its employees. In 2022, G performed a review of the plan’s operations for the 2020 plan year. During this review, G discovered one participant, identified as an NHCE, was the child of a 5% owner. When the employer reran the ADP test with the corrected classification, HCEs had an ADP of 7% and NHCEs had an ADP of 4%. The maximum passing ADP for the HCE group is 6%; and the plan failed the ADP test. There were no matching or other employee contributions for the 2020 plan year. The plan has 21 participants and assets of $1,234,567.

Correction programs available

Less than three years from end of statutory period

For mistakes corrected within three years after the end of the 12-month correction period:

• SCP may be used to correct both significant and insignificant mistakes
• VCP may also be used to correct this mistake

More than three years from end of statutory period

For mistakes corrected more than two years after the end of the 12-month correction period:

• SCP may still be used to correct if the mistake can be classified as insignificant
• VCP may be used to correct both insignificant and significant mistakes

Example:

A 401(k) plan fails the ADP test for the plan year ending December 31, 2017.

Plan year tested:	12/31/2020
Statutory correction period (12 months):	01/01/2021 to 12/31/2021
If correction occurs by 03/15/2021	No excise tax consequences under IRC Section 4979
If correction occurs after 03/15/2021 but before 12/31/2021	Employer is required to file a Form 5330 and pay a 10% excise tax on the excess contribution Note: The tax doesn't apply if the plan sponsor makes corrective qualified non-elective employer contributions within 12 months after the end of the plan year. However, if the corrective contributions are insufficient for the CODA to pass the ADP test, the tax applies to the remaining excess contributions.
If correction occurs between 01/01/2019 and 12/31/2019	May use SCP or VCP to correct mistakes even if the mistakes are determined to be significant
If correction occurs after 12/31/21	Use SCP to correct mistakes even if the mistakes are determined to be significant May use VCP to correct both insignificant and significant mistakes

Self-Correction Program

The EPCRS revenue procedure defines this as an operational error. Employer G determined the plan had established practices and procedures designed to keep it compliant and that the mistake wasn't significant. Correction could involve one of two methods:

• G could make QNECs to the NHCEs to raise the ADP to a percentage that would enable the plan to pass the test.
  • In this example, each NHCE would receive a QNEC equal to 1% of the employee’s compensation.
  • G must make these contributions for each eligible NHCE (if the contribution doesn't cause the 415 limit to be exceeded).
• Under the second method, the plan could use the one-to-one correction method.
  • Excess contribution amounts are determined.
  • The amount is assigned to HCEs and adjusted for earnings and this total amount is distributed to the HCEs
  • An amount equal to the distributed amount is contributed to the plan and allocated based on compensation among the eligible NHCEs.

If G determined the mistake to be significant, it must make the correction by the end of the correction period. The correction period for an ADP/ACP testing failure ends on the last day of the third plan year following the plan year that includes the last day that G could have normally corrected the ADP/ACP mistake. The mistake occurred in 2020, with the normal correction period ending in 2021, so the correction period under SCP for significant mistakes ends on the last day of the 2024 plan year. G may correct an insignificant mistake at any time.

Voluntary Correction Program

If G determined the mistake wasn't correctible under SCP, or if it elected to correct the mistake under VCP, correction would be the same as under SCP. If the plan is not under audit, Employer G makes a VCP submission via the Pay.gov website following the procedures set forth in Revenue Procedure 2021-30, Section 11. Consider using the Form 14568, Model VCP Compliance Statement PDF. Based on the amount of plan assets in our example, 21, G would pay a user fee of $3,000 for a 2022 submission.

Audit Closing Agreement Program

Under Audit CAP, correction is the same as under SCP or VCP. Employer G and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction. The sanction under Audit CAP is based on facts and circumstances, as discussed in Section 14 of Revenue Procedure 2021-30.

How to avoid the mistake

One way to avoid this type of mistake is by establishing a safe harbor 401(k) plan or by changing an existing plan from a traditional 401(k) plan to a safe harbor 401(k) plan. Under a safe harbor 401(k) plan, the employer isn’t required to perform the ADP and ACP tests, if it meets certain requirements.

Problems may happen when there’s a communication gap between the employer and plan administrator regarding what the plan document provides and what documentation is needed to ensure compliance. Several main areas where these communication problems may occur:

• Count all eligible employees in testing:
  • Share information with the plan administrator on all employees eligible to make an elective deferral (including all eligible employees who terminated before the end of the year).
• Share information with the plan administrator about any related companies with common ownership interests.
  • Your plan document may require these employees to be eligible to participate in the plan, and, therefore, included in the tests.
• Definition of compensation:
  • Be familiar with the terms of your plan document to ensure that you use the proper definition of compensation.
  • It’s important to know whether compensation is:
    • Excluded for certain purposes,
    • Limited for certain purposes, or
    • Determined using a different computation period (for example, plan year vs. calendar year).
  • If the compensation amounts sent to the plan administrator don't meet the plan definitions, the ADP and ACP tests will be inaccurate and will provide false results.
• Identification of HCEs:
  • An important aspect of performing the ADP and ACP tests is properly identifying HCEs. It's especially important to consider family members of owners.
  • It’s easy to miss the family members of the owner(s) with different last names.
  • Don’t assume that once a nonhighly compensated employee, always a nonhighly compensated employee.

In summary, you should ensure that you're familiar with your plan’s terms, and provide your plan administrator with the information needed to make a proper determination of each employee’s status.

If either the ADP or the ACP test fails, to avoid correcting under EPCRS, implement procedures to ensure that you correct excess contributions timely. Excess contributions result from plans failing to satisfy the ADP test and should be distributed to the applicable HCEs within 12 months following the close of the plan year. Excess aggregate contributions are contributions resulting from a plan that has failed the ACP test. The law generally treats them same as excess contributions. However, if the excess aggregate contributions consist of matching contributions that aren’t fully vested then reallocate the unvested portion to the accounts of the other plan participants or put them in an unallocated suspense account to use to reduce future contributions.