ADP/ACP Testing Part 2 — Comprehensive Study Notes

ADP/ACP Testing Part 2 — Comprehensive Study Notes

Overview

• This set of notes provides a comprehensive summary of correction procedures for ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) testing failures, as mandated by the Internal Revenue Code (IRC) and associated Treasury regulations. The goal is to ensure qualified plan status and avoid adverse tax consequences.

• Focus areas include a detailed examination of permitted correction methods, critical timelines for implementation, strategies for combining different correction approaches, practical operational techniques for plan administrators, and the specific tax and penalty consequences for both employers and participants.

• Key terms covered are central to understanding retirement plan compliance: ADP, ACP, ADR (Actual Deferral Ratio), ACR (Actual Contribution Rate), NHCE (Non-Highly Compensated Employee), HCE (Highly Compensated Employee), QNEC (Qualified Nonelective Contribution), QMAC (Qualified Matching Contribution), catch-up contributions, Roth contributions, CODA (Cash or Deferred Arrangement), and EPCRS (Employee Plans Compliance Resolution System).

Key Definitions and Concepts

• ADR (Actual Deferral Ratio): For an individual, the ratio representing their elective deferrals to their plan compensation. This ratio is fundamental for calculating the ADP for groups.

  $\text{ADR}_i = \frac{\text{Deferrals}_i}{\text{Compensation}_i}$

• ADP test: Compares the average ADR of HCEs to the average ADR of NHCEs. The HCE ADRs are aggregated to form the HCE ADP.

  • ADP for a group of HCEs: $\text{ADP} = \frac{1}{n}\sum_{i=1}^n \text{ADR}_i\text{(HCE)}$

• NHCE ADP: The analogous average computed for Non-Highly Compensated Employees. This serves as the benchmark against which HCE ADP is measured.

• CHOICE TESTS FOR ADP: To pass the ADP test, the HCE ADP must satisfy one of the following two safe harbor conditions:

  • 2% Spread Test: The ADP of the HCEs cannot exceed the NHCE ADP by more than 2 percentage points. This test provides a narrower band for HCE deferrals relative to NHCEs.

    $\text{ADP}_\text{HCE} \le \text{ADP}_\text{NHCE} + 2\%$

  • 1.25x Test (alternative ratio test): The HCE ADP cannot exceed 1.25 times the NHCE ADP. This test allows for a larger absolute difference, but a stricter proportional limit.

    $\text{ADP}_\text{HCE, avg} \le 1.25 \times \text{ADP}_\text{NHCE, avg}$

• ACP test: Compares the Actual Contribution Rate (ACR) of HCEs to NHCEs. The ACR is conceptually similar to ADR but includes employer matching contributions (including QMACs) and employee after-tax contributions. This test ensures non-discrimination in contributions beyond elective deferrals.

  • Two key ACP tests (mirroring ADP tests, used similarly in correction decisions):

  • 2% Spread Test for ACP: The ACP of HCEs cannot exceed the NHCE ACP by more than 2 percentage points.

    $\text{ACP}_\text{HCE} \le \text{ACP}_\text{NHCE} + 2\%$

  • 1.25x Test for ACP: The HCE ACP cannot exceed 1.25 times the NHCE ACP.

    $\text{ACP}_\text{HCE, avg} \le 1.25 \times \text{ACP}_\text{NHCE, avg}$

• Excess contributions vs. excess aggregate contributions:

  • Excess contributions (ADP context): Refers to the portion of elective deferrals made by HCEs that, when aggregated, cause the plan to fail the ADP test. These are the amounts that need to be corrected.

  • Excess aggregate contributions (ACP context): Refers to the portion of employer matching contributions and/or employee after-tax contributions that, when aggregated for HCEs, cause the plan to fail the ACP test. These also require correction.

• QNECs (Qualified Nonelective Contributions): These are employer contributions made to employee accounts that are 100% vested immediately and are not conditioned on employee contributions or deferrals. QNECs are often used strategically to help satisfy the ADP or ACP tests by boosting the NHCE average contribution ratios, thus bringing the plan into compliance.

• QMACs (Qualified Matching Contributions): These are employer matching contributions that are 100% vested immediately and are not subject to a withdrawal restriction (besides those applicable to elective deferrals). QMACs can be treated as QNECs for ADP or ACP testing purposes, offering flexibility; they may be shifted between ADP and ACP tests under specific controlled rules, but the same QMAC dollars cannot be used in both tests simultaneously for satisfying compliance.

• Catch-up contributions: Additional elective deferrals allowed for participants aged 50 or older, beyond the standard IRC annual deferral limits. These contributions are generally excluded from the ADP test initially. However, starting in 2026, catch-up contributions for high earners (those with prior-year FICA wages exceeding $$145,000, subject to COLA adjustments) must be designated Roth contributions. This new requirement introduces complexities for pre-tax/post-tax characterization and potential recharacterization under correction rules.

• Recharacterization: A specific correction method where excess contributions (which are normally pre-tax deferrals) are treated as after-tax employee contributions. This is a permissible correction method for ADP failures if the plan document explicitly allows after-tax contributions and such recharacterization.

• Leveling method: A two-step methodological approach used to determine the total excess amount to be distributed to HCEs and then to allocate this amount among them. It ensures a fair and non-discriminatory distribution of excess amounts, typically starting with those HCEs with the highest deferral or contribution ratios.

• CODA (Cash or Deferred Arrangement): Refers to a 401(k) plan feature. Failure to correct ADP/ACP test failures within the prescribed timelines (e.g., beyond 2.5 months for excise tax purposes, or 12 months for disqualification) can lead to the plan’s CODA becoming nonqualified, resulting in punitive tax consequences. EPCRS provides a structured system for rectifying such failures post-correction period.

• EPCRS (Employee Plans Compliance Resolution System): A comprehensive IRS program that provides various correction options for qualified plans that have failed to meet compliance requirements. Utilizing EPCRS (particularly SCP, VCP, or Audit CAP) can help plans avoid disqualification or nonqualified CODA consequences, although these options often come with higher costs (e.g., IRS fees, sanctions, or more substantial correction contributions like QNECs) compared to timely correction within the regulatory period.

• Davis-Bacon contributions: Special rules under the Davis-Bacon Act allow certain contributions (e.g., to satisfy prevailing wage requirements) to be treated as QNECs for ADP/ACP testing. For ADP or ACP testing, up to 10% of NHCE compensation in QNECs can be disregarded from the general nondiscrimination rules, provided other conditions are met. If both tests use Davis-Bacon contributions, the combined limit can theoretically reach 20% (10% for each test), but each must independently satisfy separate nondiscrimination considerations beyond the 10% allowance.

• Allocable earnings: These are the net gains or losses attributable to the excess contributions or excess aggregate contributions from the period they were in the plan until the date of distribution. Plans can calculate these earnings using actual investment returns or an alternative simplified formula provided by regulations. If the investments experienced a net loss, the amount distributed to correct the failure may be reduced accordingly.

• Tax treatment: Corrective distributions of excess contributions from elective deferrals (pre-tax) are generally taxable to the participant in the year they are distributed. However, if the excess contributions were designated Roth contributions, the distributed amount may be non-taxable to the extent it represents a return of the participant's Roth basis. Excess aggregate contributions (matching or after-tax contributions) also have specific tax treatments depending on their source.

• Form 1099-R and codes: All corrective distributions are reported to the IRS and the participant on Form 1099-R. A specific distribution code (typically Code 8) is used to flag these corrections. Portions attributable to designated Roth contributions (basis vs. earnings) are often reported separately to clearly indicate their non-taxable or taxable components. Importantly, these distributions are not subject to the 10% early withdrawal penalty (if applicable to regular distributions) and do not require employee consent.

• Timing: Corrective distributions must generally be made within 12 months after the close of the plan year for which the failure occurred. If distributions are made more than 2.5 months after the plan year-end, an excise tax (IRC §4979) of 10% of the uncorrected excess contributions (before allocable earnings) is imposed on the employer. The EACA rule offers a limited extension.

• EACA (Enhanced Administering Cash or Deferred Arrangement): A specific plan design feature that, if implemented, can extend the excise tax-free refund period for ADP/ACP failures from 2.5 months to 6 months after the close of the plan year. This provides plan sponsors with more time to process corrections without incurring the 10% penalty.

Correction Methods—ADP Testing

When the ADP test fails, plans have four primary permitted methods to correct the failure, as outlined in the regulations:

1. Distribution of excess contributions: This is the most common method. The excess elective deferrals are identified and returned to the affected HCEs. The amount distributed generally includes the excess deferral plus any allocable earnings or losses.

2. Contributing QNECs (Qualified Nonelective Contributions): The employer can make additional nonelective contributions to the accounts of eligible NHCEs (or potentially all NHCEs) to increase their ADRs. By boosting the NHCE group's average deferral percentage, the gap between HCE and NHCE deferrals can be narrowed, helping the plan pass the ADP test. These contributions must be 100% vested immediately.

3. Shifting QMACs into the ADP test: Qualified Matching Contributions (QMACs) that were initially intended for the ACP test can be reclassified and used to help satisfy the ADP test instead. This offers flexibility in test satisfaction, but the same QMACs cannot be used to pass both tests simultaneously in the same plan year.

4. Recharacterization of excess contributions as after-tax employee contributions: If the plan document permits after-tax employee contributions, excess pre-tax elective deferrals for HCEs can be recharacterized as after-tax contributions. This effectively removes them from the ADP test calculation (as after-tax contributions are tested under ACP), assuming the ACP test is passed post-recharacterization. This method requires specific plan language and timely notification to affected HCEs.

• Timelines and prioritization:

  • Corrections must generally be completed within 12 months after the close of the plan year being tested. Failing to do so can have severe consequences, including the plan becoming a nonqualified CODA.

  • If the correction is not performed within the 12-month period, the plan's qualified status is jeopardized, and formal correction under EPCRS (likely through the Voluntary Correction Program - VCP) may be required. This typically involves paying a sanction to the IRS in addition to making the required correction.

  • When corrections involve participants eligible for catch-up contributions, federal regulations (IRC §414(v)(3)) prioritize the recharacterization of excess contributions as catch-up contributions before any amounts are distributed, if the plan allows for and the participant has unused catch-up limits. This optimizes the deferral for the HCE.

• Combination of correction methods permitted: Plans are not limited to a single correction method. For example, an employer might use a combination of contributing QNECs to increase NHCE percentages and also distributing some excess contributions to HCEs to achieve compliance efficiently.

• Operational techniques to facilitate passing ADP test:

  • Prospective reduction of HCEs’ elective deferral rates: During the plan year, if it becomes apparent that the ADP test might fail, employers can act proactively by reducing the elective deferral percentages for HCEs for the remainder of the year. This helps to reduce their projected ADRs and the overall HCE ADP. This strategy is particularly effective when using prior-year testing data for NHCEs, as the plan has early knowledge of the NHCE ADP limit, allowing for mid-year adjustments.

  • Reduction of HCEs’ deferrals as a plan-imposed limit: If an HCE's deferrals are automatically reduced by the plan to pass the ADP test, this employer-imposed limit can be treated as a plan deferral limit for catch-up contribution purposes, potentially allowing those excess amounts to be recharacterized as catch-up contributions if the HCE is eligible and has remaining catch-up capacity.

• Nonqualified CODA and EPCRS:

  • If an ADP failure is not corrected within the 12-month regulatory period, the cash or deferred arrangement component of the plan (CODA) may become nonqualified for the entire plan year, potentially leading to disqualification for that year. This means all pre-tax deferrals for all employees (HCEs and NHCEs) could become taxable income, a severe penalty.

  • EPCRS provides various pathways (such as the Self-Correction Program (SCP) for minor errors, or the Voluntary Correction Program (VCP) with IRS approval) to fix compliance failures after the standard correction period. While EPCRS can prevent immediate disqualification, it often entails higher costs, including IRS fees, or requires more substantial QNECs or QMACs than would have been needed for timely correction.

• Leveling method details (Step 1 and Step 2):

  • The leveling method is a systematic approach to determine the exact amount of excess contributions to distribute to each HCE. It aims for the least disruptive correction by targeting the highest deferrals first.

  • Step 1: Determine total excess amount: This involves hypothetically reducing HCE ADRs starting with the highest ADR, successively reducing each HCE's ADR until either the target ADP (NHCE ADP plus 2%, or 1.25 times NHCE ADP, whichever allows more) is met, or the HCE's ADR equals the next highest HCE's ADR (or the average of all lower HCEs). This process continues until the overall HCE ADP satisfies the test.

  • Step 2: Allocate the total amount for distribution among HCEs: Once the total excess amount is determined in Step 1, this total is allocated among HCEs in descending order of their actual dollar amounts of elective deferrals (not their ADRs). The highest dollar deferrals are reduced first, continuing until the entire determined total amount is distributed or the next HCE’s deferral level is reached. This two-step process ensures fairness and is illustrated effectively by examples such as Example 2–4 in study materials for basic scenarios, and Example 8–9 for scenarios involving multiple HCEs and catch-up interactions.

• Deferral amounts and catch-up contributions exclusion in ADP calculation:

  • Initially, catch-up contributions are excluded from the actual deferral ratio (ADR) calculation when determining ADP. This means they do not impact whether an ADP test fails.

  • However, during the correction process, if a plan allows for catch-up contributions, any amounts identified as excess contributions for an HCE may be reclassified as catch-up contributions up to the participant's remaining eligible catch-up limit, rather than being refunded. This is a beneficial recharacterization that helps the HCE retain their pre-tax savings.

• Treatment of excess contributions in ADP (and 402(g)):

  • If an HCE has elective deferrals that exceed the IRC §402(g) limit (the overall individual deferral limit), those excess deferrals are still included in the ADR for ADP calculation purposes, even if they are ultimately refunded under 402(g). This means a distinct correction may be needed for 402(g) and a separate correction for ADP.

  • If a portion of excess contributions is recharacterized as catch-up contributions, this recharacterization effectively absorbs the unused catch-up limits before any remaining excess amounts are distributed to the HCE.

• Exceptions and special rules:

  • If a plan permits catch-up contributions, the final excess distribution amount is first reduced by any available catch-up limit for the HCE. This effectively means that eligible HCEs can keep a portion of their