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5 min read

Automatic Escalation: Optimize Your 401(k) With This Brilliant Feature

Evan Ross
April 5, 2018
Automatic Escalation: Optimize Your 401(k) With This Brilliant Feature
Table of contents

For sponsors of 401(k) plans, the first part of the year is exam time. That’s when several tests are performed to determine if the plan’s benefits are broadly spread among employees. If the test results indicate the plan favors owners or highly paid employees, corrective action must be taken.

Ensuring that the plan’s benefits are broadly shared is critical for a 401(k) to maintain its tax-deferred status. Each year, the plan must pass the tests, take action to remedy a failed test, or operate as a “Safe Harbor” plan that exempts the 401(k) from undergoing certain tests.

ADP Tests, Coverage Tests, and More – Get Out Your #2 Pencils

The tests required under ERISA are the coverage test, the top-heavy test, the actual contribution percentage test (ACP), and the actual deferral percentage test (ADP).

That’s a lot of testing.

Here’s a summary of the exam line-up:

  • Coverage Test: compares how non-highly compensated employees (NHCEs) choose to participate in the plan compared to the participation rates of highly compensated employees (HCEs). In other words, the test compares the participation rates of the two groups. Here’s how it works: Divide the number of NHCEs who benefit from the plan by the total number of eligible NHCEs. Hold that thought. Now do the same calculation for HCEs – number of participants divided by total eligible. That gives you two ratios, each reflecting the participation rate of each group. Now, divide the ratio you calculated for the NHCEs by the rate for the HCEs. This ratio must be at least 70% for the plan to pass.

If the plan fails the above test, it can perform a similar test that compares the benefits received by the two groups of employees. This calculation can be complicated. The key take away here is that a failed coverage test must be corrected. This can mean making additional company contributions to NHCE employees until the plan gets a passing grade.

  • Top-Heavy Test: compares the accumulated assets of key employees to non-key employees. Here the definition of a key employee differs from that of an HCEs, but the concept is similar. A plan is top-heavy if more than 60% of assets are attributable to key employees.
  • ADP and ACP Tests: compare the deferral rates between HCEs and NHCEs. The ADP test examines employee contributions, while the ACP measures both employer matching and employee contributions.

For this post we’re most interested in the ADP test. And like most of 401(k) testing, things can get complicated.

Who’s Considered a Highly Compensated Employee?

Determining who is and isn’t an HCE is critical for accurate ADP testing. Incorrectly identifying employees can produce incorrect test results.

An HCE meets one of these three criteria:

  1. Owned more than 5% of the company at any during the year (or the preceding year)
  2. Earned more than $120,000 in the preceding year
  3. Certain family members (spouse, child, parent, or grandparent) of a 5% owner

Alternatively, 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 sometimes help plans pass the ADP/ACP tests.

What’s On the ADP Test?

The ADP test compares the average deferral rate of HCEs to NHCEs.

The deferral rate is the amount of the employee contribution as a percentage of compensation.  All employees eligible to make a deferral are included in the calculation regardless of whether they actually contribute in a particular year.

It’s the relationship between the average deferral rates of the two groups that drives tests results.

Two Ways to Pass the ADP Test

1. The 125% Test

In this case, the average HCE deferral cannot exceed 125% of the average NHCE deferral. So if the average HCE deferral is 5% and the average NHCE deferral is 4.2%, the plan passes since 5%/4.2% = 119%, or less than 125%.  If the NHCE deferral rate is 3.9%, the plan would fail this test since 5%/3.9% = 128%.

2. Alternative ADP Pass Conditions

The plan can still pass the ADP test if the HCE deferral rate is less than the smaller result of these two calculations:

1.) The NHCE rate times 2.

2.) The NHCE rate plus 2%.

Ok that’s confusing, so let’s go through this second option. Let’s stick with our HCE rate of 5% and NHCE rate of 3.9% and run those rates through each formula:

Formula 1: 2 x 3.9% = 7.8%
Formula 2: 2% + 3.9% = 5.9%

The lesser of the two figures is 5.9%. So the plan passes as the HCE rate of 5% is less than the allowed rate of 5.9% under this second option.

Plan sponsors have additional flexibility when it comes to the ADP test.

It’s permissible to compare the prior year’s average NHCE deferral rate to the current year’s HCE deferral rate. This can help plan sponsors predict the amount of HCE contributions that would result in a failed test, allowing the HCEs to plan accordingly.

Failed the ADP Test? Here’s How to Fix It

If the plan fails the ADP test, one of two corrective actions must be taken before the last day of the following plan year.

1. Making Distributions to Highly Compensated Employees

Distributions to HCEs can be made until the plan passes the test. And the distributions must be made within 2½ months of the plan’s year end for the employer to avoid a 10% penalty. Even if the plan avoids the 10% penalty, those returned contributions are taxable to the employees.

2. Making Employer Contributions to All NHCEs

This option can be expensive. The employer makes contributions to all NHCEs until the plan passes the ADP test.

Safe Harbor Exemption – Never Worry About ADP Testing Again

As mentioned earlier, it is possible to be exempt from some testing by adopting a plan with certain attributes. These are known as Safe Harbor plans, and they involve making predetermined contributions to employees.

3 Ways to Gain the Safe Harbor Exemption

  1. Make a basic matching contribution: the employer matches employee contributions dollar-for-dollar on the first 3% of deferrals, and 50% on the next 2%. Effectively, the employer is making a 4% match. It’s important to note that this approach doesn’t require contributions to employees who have not joined the plan.
  2. Make a 3% “non-elective” contribution: this is a mandatory contribution of 3% of the eligible employee’s salary regardless of whether or not they have joined the plan.
  3. Adopt a Safe Harbor plan that includes the qualified contribution arrangement (QACA): these plans must feature automatic enrollment and match dollar-for-dollar on the first 1% of an employee’s deferral, plus a 50% match on deferrals up to 6%. That is effectively a 3.5% mandatory match.

The table below illustrates how the cost to the employer can vary under these three approaches:

When evaluating options, keep in mind that automatic enrollment plans, such as the QACA alternative, generally have higher participation rates than non-automatic enrollment plans. Vanguard recently reported that plans on their platform with automatic enrollment averaged 83% participation, which was about 44% higher than non-automatic enrollment plans.

Does Your Plan Need a Tutor for the ADP Test?

A Safe Harbor 401(k) will eliminate the risk of failing the ADP (or ACP) test. The trade-off is committing to significant employer contributions. There is an alternative to a Safe Harbor plan. And that involves generating enough employee engagement to ensure your plan passes non-discrimination tests. The key to sufficient engagement is to make the plan user-friendly, low hassle, loaded with automation, and accessible by mobile devices. Getting employees engaged helps you pass the ADP and ACP tests, and puts your employees on the path to accumulating a meaningful retirement nest egg. Talk to us today to find out how to pass compliance tests without the high cost of a Safe Harbor Plan!

Download the 2024 Safe Harbor Guide
Understand new rules for 2024, benefits of Safe Harbor and strategies to minimize Safe Harbor costs.
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Evan Ross
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1 Schwab 2022 401(k) Participant Study - Gen Z/Millenial Focus, October 2022.
2 As of 12/31/2022. Employees include both current employees and terminated participants with a balance.
3 "Morgan Stanley At Work: The Value of a Financial Advisor" Morgan Stanley, March 2022.
4 Sarah Britton was a client when she provided this testimonial through an independent third party review website. She received no compensation for her remarks. There are no known conflicts of interest in the provision of her comments related to the services provided.