Each year, companies that sponsor 401(k) plans must demonstrate that the amount contributed by eligible employees does not disproportionately favor higher paid employees. If the company provides employer matching contributions, a similar test is performed on the amount of employer match provided to the employees who make salary deferral contributions. The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Tests, commonly referred to as the annual nondiscrimination testing requirements, must be satisfied every plan year and there is a certain amount of disparity permitted between the higher and lower paid employees. If the disparity threshold is exceeded, the result is a failed test that must be corrected.

While the mechanics of the tests are not overly complicated, a failed test can result in certain higher paid employees getting refunds from the plan. Companies typically do not want to have that conversation with the higher paid employees; however, refunds are not the only permitted correction method.

Companies that sponsor 401(k) plans rely on their service providers to complete the required annual nondiscrimination testing for the plan. Often the results are presented to the plan sponsor, perhaps just a pass/fail. If failed, results generally include the amount of the refunds that need to be made to certain highly paid employees. However, there may be other options for employers to explore before issuing refunds.

The purpose of this blog is to provide an understanding of the key terminology, testing options, and correction methods should the plan fail. It is very important for plans sponsors to have a basic understanding of the ADP/ACP testing requirements so that failures can be addressed timely, and options can be explored to prevent failures in the future.

Key Definitions Used in Nondiscrimination Testing

In order to understand the test results that are presented by the service provider, there are several key terms that need to be identified, along with their acronyms.

• Highly Compensated Employee (HCE) – An employee who directly owns more than 5% of the company, indirectly owns more than 5% of the company (family attribution to spouses and lineal ascendants and descendants) or who had gross compensation in excess of the annual dollar limit in the immediately preceding 12 months (generally the prior plan year). The HCE compensation threshold is $155,000 for 2025 testing based on compensation earned in 2024 (indexed annually with the cost-of-living adjustments).

• Non-Highly Compensated Employee (NHCE) – An employee who is not a Highly Compensated Employee.

• Top Paid Group Election (Top 20%) – A plan sponsor may elect in the plan’s legal document to count only HCEs who are in the top 20% when all employees are ranked by highest to lowest compensation. The number of employees in the top 20% is based on the total number of active employees of the employer and includes all related employers.

For a detailed explanation of HCEs and Top 20%, see 401(k)ology – Highly Compensated Employees

• Testing Compensation – Must be a nondiscriminatory definition and does not have to be the same definition used for eligible plan compensation. Therefore, gross compensation may be used in the testing even though the plan document may exclude certain types of compensation (i.e., bonuses and commissions). The compensation used in the testing must be applied consistently across all eligible employees.

• Employee Deferrals – An employee’s deferrals include both pre-tax and Roth deferrals. If an employee has both types of deferrals, they are added together in the ADP Test. Catch-up contributions made by an employee who is age 50+ are excluded from the ADP Test.

• Prior Year or Current Year Testing Method – A plan sponsor must elect in the plan’s legal documents how the average deferral percentage for the NHCEs will be utilized. If the Current Year method is elected, the testing year’s HCE average deferral percentage will be tested against the testing year’s NHCE average deferral percentage (e.g., 2024 ADP of HCEs and 2024 ADP of the NHCEs). If the Prior Year method is elected, the testing year’s HCE average deferral percentage will be tested against the prior plan year’s NHCE average deferral percentage (e.g., 2024 ADP of HCEs and 2023 ADP of the NHCEs).

• Otherwise Excludable Employees – 401(k) plans are not required to benefit employees who are under age 21 or who have not completed a Year of Service (eligibility computation period of 12 months in which the employee works at least 1000 hours of service). If the 401(k) plan permits employees to enter the plan before this statutory eligibility maximum requirement, then the employees in the plan who have not attained age 21 or have never worked 1000 hours in an eligibility computation period (i.e., otherwise excludable employees) may be tested as a separate plan.

• Permissive Disaggregation (Carve Out of Otherwise Excludable Employees) – A plan may be tested as two separate plans, commonly referred to as the “carve out” method. The otherwise excludable employees are tested separately from the employees who have met the age 21 and 1 Year of Service statutory maximum eligibility requirements. Generally, this yields better overall results because there are typically no HCEs in the otherwise excludable group. However, plan sponsors should be aware that children of more than 5% owners are HCEs, and should the plan have relaxed eligibility requirements, those otherwise excludable HCEs could have a negative impact on the permissively disaggregated portion of the tests. One other note of caution is that the ADP/ACP Test may only be tested using permissive disaggregation if the plan also uses the same method to demonstrate that the plan satisfies the annual coverage testing requirements.

• Voluntary After-tax Contributions – Employee voluntary after-tax contributions, if permitted under the specific plan document, are treated as matching contributions for purposes of the Actual Contribution Percentage Test (ACP).

Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Test Basics

Employee Deferral Testing (ADP)

Under IRC §401(k)(3), plans that include 401(k) salary deferrals must satisfy the ADP test each plan year. An actual deferral percentage is calculated for each participant and is the ratio of the participant’s deferrals for the year to testing compensation.

Plans may prove non-discrimination in one of two ways:

1. The average of the ADPs for the HCEs is less than or equal to 1.25 times that for the NHCEs, or

2. The average of the ADPs for the HCEs is less than or equal to both 2 times and 2% plus the ADP of the NHCEs.

Employer match attributable to excess contributions are forfeited (including earnings) before application of the ACP Test described below. If, for example, an HCEs deferrals were matched at 100% and the HCE is due a refund of $1,000 (plus earnings), the match that was provided to the HCE must be reduced by $1,000 (plus earnings) so that the match provided to the HCE does not exceed the formula of 100% of permitted deferrals. This is commonly referred to as “Attributable to Match” (ATM) on the tests prepared by the service providers.

Practice note: 403(b) plans are exempt from the ADP Test because of the Universal Availability of Deferrals applicable to that plan type; however, the ACP Test on matching contributions in 403(b) plans is the same as 401(k) plans.

Employer Match Testing (ACP)

Under IRC §401(m)(3), plans that include 401(m) matching contributions must satisfy the ACP test each plan year. An actual contribution percentage is calculated for each participant (similar to the ADP Test) and is the ratio of the participant’s match (plus after-tax, if applicable) for the year to testing compensation.

Plans may prove non-discrimination in one of two ways:

1. The average of the ACPs for the HCEs is less than or equal to 1.25 times that for the NHCEs, or

2. The average of the ACPs for the HCEs is less than or equal to both 2 times and 2% plus the ACP of the NHCEs.

ADP/ACP Test Examples

Example 1 – Facts:

• Plan Year is the Calendar Year

• Plan uses Current Year Testing Method

• ADP of the HCEs is 7%

• ADP of the NHCEs is 3%

1. Test 1 – 3% times 1.25% = 3.75% (HCE ADP of 7% is greater than 3.75%, so test 1 fails)

2. Test 2 – 3% times 2 = 6%, and 3% plus 2% = 5% (HCE ADP of 7% is greater than 6% and 5%, so test 2 fails)

Example 2 – Facts:

• Plan Year is the 2024 Calendar Year

• Plan uses Prior Year Testing Method

• 2024 ADP of the HCEs is 7%

• 2023 ADP of the NHCEs is 4%

1. Test 1 – 4% times 1.25% = 5% (HCE ADP of 7% is greater than 5%, so test 1 fails)

2. Test 2 – 4% times 2 = 8%, and 4% plus 2% = 6% (HCE ADP of 7% is less than 8% but greater than 6%, so test 2 fails)

Practice Note: In either example, the same mechanics would apply if the tests were for the matching contributions, plus after-tax voluntary contributions (if applicable). While the mechanics of the ACP Test for the match are the same, if a plan has a discretionary match the Current Year Testing Method is generally the testing method elected in the plan provisions.

Standard Correction Methods for Failed Tests

Following are the standard correction methods for failed ADP/ACP Tests:

• Recharacterize Excess Contributions (deferrals) as Catch Up – An HCE, who is catch-up eligible and due a refund, may have excess contributions “recharacterized” as catch-up to prevent or reduce the refund. Recharacterization may only be used if the HCE did not utilize the full catch-up limit for the year. The ADP/ACP test generally includes a summary of the amounts recharacterized as catch-up contributions, showing each HCE who had excess amounts recharacterized.

• Refunds to HCEs – Most commonly, failed ADP/ACP Tests are corrected by refunding excess contributions to HCEs. The refunds must be adjusted for earnings (gains and losses) and are taxable to the affected HCE in the year of the distribution. Losses reduce the refund, just as gains increase the refund. For example, an HCE is due an ADP refund of $1,000 for the 2023 Plan Year but the earnings were a negative $100. The refund of $900 ($1,000 less $100) is made to the HCE in 2024 and is taxable to the HCE in 2024 (not 2023 which was the year of the deferral). If the refund is due to Roth contributions, the impacted HCE will include only the earnings in taxable income because Roth deferrals were made on an after-tax basis (i.e., they are not taxed twice).

• Qualified Non-Elective Contributions (QNECs) – The employer may contribute to the NHCEs in an amount necessary to bring the ADP of the NHCE group up so that the plan passes the test. While this is the costlier approach, it has the significant advantage of avoiding painful refunds to HCEs. In some cases, the amount of the QNEC needed to satisfy the test is small enough that it is worth at least considering making the contribution rather than refunding excess amounts to the HCEs. There are options for allocating QNECs, but that will be dictated by the provisions in the plan’s legal document. Check with the plan’s service provider to see what options are available under the terms of the plan.

Test Correction Deadlines and Excise Tax Reporting

Deadlines

ADP/ACP Tests have two critical deadlines. The first deadline is 2.5 months after the end of the plan year for which the test is being performed. A 2024 calendar year plan’s ADP/ACP Test deadline is March 15, 2025. If refunds of excess contributions and earnings are made by that deadline, the employer will avoid an additional 10% excise tax imposed by the IRS. Unfortunately, the March 15^th deadline (or any other 2.5-month deadline) is not extended when the 15^th falls on a weekend or holiday.

Plans that contain Eligible Automatic Contribution Arrangements (EACA) have additional time to satisfy the ADP/ACP Test without the 10% excise tax penalty. EACAs have 6 months after the plan year end to make refunds to the HCEs if the plan does not pass the ADP or ACP Test. For a calendar year plan, EACAs have until June 30^th of the subsequent year to process refunds.

The second critical deadline is the last day of the plan year following the plan year for which the test is being performed. If a plan fails to correct ADP/ACP test failures by the end of the 12^th month after the plan year end, the plan has a qualification failure that must be corrected under the Employee Plans Compliance Resolution System (EPCRS).

There are two methods under EPCRS for correcting failed ADP/ACP tests after the 12-month deadline and both methods require the employer to make contributions to the NHCEs:

1. The employer makes a QNEC to all eligible NHCEs in the same percentage to each participant in an amount needed to pass the test. This method can be expensive, depending on how badly the test failed. The employer cannot use permissive disaggregation in determining the QNEC.

2. The employer may use the “one-to-one” correction method which requires that the excess contributions plus earnings be refunded to the HCEs and an equivalent QNEC is allocated to all eligible NHCEs. Again, the employer is not permitted to use permissive disaggregation when determining the refunds and the required QNEC.

The impact of not being able to utilize permissive disaggregation is that the test results will likely be much worse.

Excise Taxes

If ADP/ACP Tests are not timely corrected, the IRS imposes an excise tax of 10% on the principal amount of the excess contributions that were not refunded by 2.5 months after the end of the plan year for which the test was applicable (6 months for EACA). The excise tax is not applied to the earnings associated with the corrective refunds made to the HCEs.

The excise tax must be reported on Form 5330 and paid to the IRS by the last day of the 15^th month after the end of the plan year for which the ADP/ACP Test was applicable. For a 2024 calendar year plan, the Form 5330 would be due by March 31, 2026. The reason for the delay is that the employer has until December 31, 2025 to make a QNEC to correct the test rather than issuing refunds to the HCEs.

HCEs with No Account Balance

Occasionally, there will be an HCE with excess contributions that need to be refunded but the HCE terminated employment with the employer and has taken a distribution from the plan. If the HCE elected a direct payment of their account balance in the plan, there are no additional steps required, as the money has already been distributed from the plan and taxable to the HCE.

If the HCE elected a direct rollover of the account before refunds were issued, the rollover includes amounts that are not eligible for rollover and additional steps must be taken by the employer and service provider. First, the service provider will need to amend the Form 1099-R that was issued for the rollover and will send the affected HCE two Forms 1099-R, one for the rollover net of the refund and one for the refund which is taxable to the participant. Second, the employer should send a notification to the HCE explaining why the amount was not eligible for rollover and that the amount should be removed from the IRA or qualified plan that accepted the rollover.

Safe Harbor 401(k) Plans

There are other plan design options available to avoid the nondiscrimination testing of deferrals and match. If a plan is consistently failing the ADP/ACP tests, an employer may want to consider adopting safe harbor plan provisions. Safe harbor plans are exempt from the ADP/ACP tests if certain requirements are met, including required employer contributions and accelerated vesting on those employer contributions. Click HERE to learn more about safe harbor 401(k) plans.

Conclusion

Plan sponsors need to have a basic understanding of the annual nondiscrimination testing required for plans that include employee deferrals and/or employer matching contributions. The most important role of the plan sponsor is to provide the employee census data to the service provider as soon after the plan year end as possible. Most service providers impose deadlines to submit the census data to guarantee that the results will be available in time to meet the 2.5 month (or 6 months for EACAs) initial deadline. Once the results of the test are available, the plan sponsor has decisions to make regarding refunds or alternative test corrections should the test fail.

Newfront Retirement Services understands the complexity of annual nondiscrimination testing and can assist plan sponsors with navigating the corrections needed should you be faced with refunds to the HCEs. As a subject-matter expert – feel free to contact me or just connect to keep up to date on regulatory updates: Joni_LinkedIn

Helpful Links:

• 401(k) plan Fix-it Guide – Failed ADP/ACP Test

• 401(k)ology – Safe Harbor 401(k) Plans

• 401(k)ology – Form 5330 Excise Taxes

• Employee Plans Compliance Resolution System (Rev. Proc. 2021-30)

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