Offering a 401(k) means complying with IRS and ERISA rules, and one of the cornerstones of compliance is making sure that 401(k) benefits are spread widely among employees, not primarily benefiting the highest paid. In other words, 401(k) rules require that plans do not discriminate in favor of the company’s highest earners.
401(k) Measures of Discrimination
To determine if a plan is discriminatory – that is, favors highly paid employees – ERISA has created a series of tests. Only if a plan passes these tests can it be considered not to discriminate in favor of certain employees. Each of the tests compares plan benefits among two groups of employees: those who are highly paid or business owners and the rest of the employees. ERISA’s term for highly paid workers is “Highly Compensated Employees” (HCEs). The term for everyone else is “Non-Highly Compensated Employees” (NHCEs). So far so good.
An HCE can be defined as an employee who owned more than 5% of the company at any time during the year (or the year before). Or, regardless of ownership, if an employee earned more than $120,000 in 2016, that person would be considered an HCE for the 2017 plan year. Also certain family members of those who are 5% owners are considered HCEs.
However, the plan can choose to define HCEs as the top 20% highest paid employees. Those not in the top 20% are moved to the NHCE group. This type of categorization can help some plans pass the ADP/ACP tests.
ERISA looks at the relationship between HCEs and NHCEs three ways: Coverage, contributions, and accumulated assets.
Coverage is a measure of plan participation by the two groups. Generally, the ratio of the participation rate of eligible NHCEs to the participation rate of the HCEs must be at least 70%.
The comparison of accumulated assets between the groups is called the Top-Heavy test. This test compares the total accumulated assets of key employees to total plan assets. (Key employees are defined differently from HCEs.) A plan is top-heavy if more than 60% of plan assets are those of key employees.
For this blog post, we are most concerned with the tests concerning contributions over the plan year. These are the actual deferral percentage (ADP) and the actual contribution percentage (ACP) tests.
The ADP test compares the average deferral percentage by HCEs to the average deferral percentage of NHCEs. The ACP test is similar, but considers matching employer contributions along with any after-tax employee contributions. The deferral percentage refers to a participants’ 401(k) deferral amount divided by plan compensation.
The ADP and ACP tests sound pretty simple, but there are a few options when it comes to evaluating the test results.
**Pass/Fail: What’s a passing grade on a 401(k) ADP or ACP test? **
Here’s the low down on the relationship between contributions by HCEs and NHCEs.
The ADP and ACP are calculated the same way. Remember, the ADP test examines employee contributions only, while the ACP test compares matching and employee after-tax contributions. For a plan to be nondiscriminatory it must achieve one of the following:
- The average contribution of HCEs can be no more than 125% of the average contribution of the NHCEs. For example, if the NHCE average contribution is 4%, the HCE average contribution can be no more than 5%.
2. The average HCE contribution does not exceed the average NHCE contribution plus 2%, or is no more than twice the NHCE rate, whichever is less. For example, if the NHCE average contribution rate is 4%, to pass the test, the HCE contribution rate can be no more than 6%. That’s because 4% + 2% = 6% and 4% x 2 = 8%. Because 6% is less than 8%, 6% is the maximum HCE contribution rate allowed under this option.
In our example, where the NHCEs contribute 4% on average, the HCEs can achieve the highest contribution rate by opting for the second calculation option.
If you are curious as to when the different options result in higher allowed contribution rates for HCEs, check out the table below:
## **401(k) ADP/ACP TESTING**
Which testing option allows for highest HCE Contribution Rate?
(Highest allowed rate in bold)
|NHCE Contribution Rate||Max HCE Allowed Rate Under Method 1||Max HCE Allowed Rate Under Method 2|
|NHCE + 2%||NHCE x 2|
|*Italics indicates the smaller of the two calculations under Method 2.*|
But there are even more options when it comes to 401(k) ADP/ACP testing. There are different testing methods. The plan can elect to compare the current plan year HCE group against the current year NHCEs, or against the NHCEs from the prior year. For example, if the NHCE deferral rate has improved recently, the current year method may provide an advantage. However, since testing is done prior to year-end, the prior year method adds predictability to the process. Since the NHCE figures are known, the maximum HCE allowed contributions can be known as well.
But – the testing method must be stated in the plan document. Changes may only be made by amendment, and there are certain restrictions regarding switching approaches.
Another option available to plans is that they can choose to “disaggregate” employees if their eligibility requirements are more liberal than those required by law. Participants that are allowed in the plan–even if the plan is not legally required to include them–can be tested separately. But if this approach is taken, it must also be taken with coverage tests.
Implications of failing an ADP/ACP test
If a plan fails the ADP/ACP, the plan must “fix it” within 12 months. A failed test can be fixed in one of two ways: Either make contributions to the NHCEs such that the new relationship results in a passing grade, or, distribute excess contributions back to the HCEs. Ideally any corrections would be completed within 2 ½ months of the end of the plan year. Otherwise, the employer must pay a 10% excise tax on the amount of excess contributions.
If the testing corrections are not made within 12 months the plan can lose its tax-qualified status. Corrections can still be made, but under a far more onerous process.
The Safe Harbor solution
There is one sure fire way to stop worrying about ADP/ACP tests. And that is to implement a Safe Harbor 401(k). The idea is that in exchange for ensuring that 401(k) benefits are spread widely among employees, the plan is exempt from ADP and ACP testing.
There are two ways for plans to comply with Safe Harbor contribution requirements. A Safe Harbor plan can match employee contributions dollar for dollar on the first 3% of each employee’s contribution, plus $0.50 on the dollar on the next 2%. This works out to a maximum 4% match.
The other option is to contribute at least 3% to all employees eligible for the plan, whether or not they make a contribution. This is called a non-elective contribution.
Obviously, the plan’s participation rate, plan eligibility requirements, the savings rates of employees affect the cost of the two options. Note that all safe harbor contributions are considered to be fully vested immediately.
**The alternative to Safe Harbor **
Now that you understand what drives the test results, you can see that for HCEs to make meaningful employee and company contributions, NHCEs must make meaningful contributions as well. Otherwise, the plan is at risk of failing the ADP/ACP tests.
The alternative is often a Safe Harbor plan. But a Safe Harbor approach is not always necessary for sufficient employee engagement to pass non-discrimination tests. A plan that is great at getting employees to join the plan and save at high rates will do the trick. The key is to make the plan user friendly, low hassle, loaded with automation, and accessible by mobile device. Getting employees engaged not only helps you pass the ADP and ACP tests, but also gets your employees on the path to meaningful retirement savings.