Annual non-discrimination tests for 401(k) plans are mandated by the IRS to ensure that a plan does not unduly benefit owners and highly compensated employees at the expense of other employees. The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests must be passed in order to satisfy the non-discrimination requirements of the IRS if the plan is to continue. If the plan fails either test, the employer must take corrective action to protect its qualified status in the twelve month period following the close of the plan year in which the oversight occurred.
The ADP and ACP tests will uncover an unfair plan by examining the contribution percents of each group. The test first separates the company’s employees into one of the two groups based largely on a set compensation amount. If compensation is greater than a specified dollar amount, the employee is highly compensated. If it is less than the specified dollar amount, the employee is non-highly compensated.
The ADP and ACP tests look at the average contribution percents of each group as a whole. The average contribution percent of the non-highly compensated group directly controls the allowable average of the highly compensated. To determine the allowed percentage of the highly compensated group, the highly compensated group must pass the 1.25 test or the 2% test.
Highly Compensated Employees (HCE):
A Highly Compensated Employee is an employee who for the preceding year had compensation of more than $110,000 (2009, 2010 and 2011) and, if the employer so elects, was in the top 20% of paid employees OR an employee who owns greater than 5% of the business, or is a family member of a 5% owner.
For 2012 plan year testing, a HCE is anyone who was a “5-percent owner” at any time during 2011 or 2012 or anyone who received in excess of $110,000 in compensation during 2011 and, if elected by the employer, is in the top twenty percent of employees based upon compensation. The HCE limit was also $110,000 for 2009, 2010 and 2011 plan year testing. The new HCE limit of $115,000 for 2012 is to be used for 2013 plan year testing.
Since the law includes a look-back provision, employees who earned more than $110,000 in 2010 are generally considered HCEs for 2011 plan year testing, employees who earned more than $110,000 in 2011 are generally considered HCEs for 2012 plan year testing and employees who will earn more than $115,000 in 2012 are generally considered HCEs for 2013 plan year testing.
Actual Deferral Percentage (ADP) Test:
The ADP test measures the deferral rates of two groups: Highly Compensated Employees and Non-Highly-Compensated Employees. For the ADP test, the ratio is salary deferred divided by compensation. The average percent of salary deferred by and to HCEs cannot exceed certain limits based on the average percent of salary deferred by and to the Non-HCEs in the current or preceding year. Essentially, the Non-HCEs of salary deferred as a group on average determine how much the HCEs of salary deferred can be as a group on average.
A plan will pass the test if the average deferrals for the HCEs do not exceed 1.25 times that of the average deferrals for the Non-HCEs OR the average deferrals of HCEs do not exceed the lesser of (a) two percentage points above or (b) two times the average deferrals of Non-HCEs.
Actual Contribution Percentage (ACP) Test:
The ACP test is exactly the same as the ADP only the numerator of the ratio are matching contributions and/or employee after-tax contributions instead of salary deferrals. The same ratio limits between HCE’s and Non-HCE’s are applied to this ratio to determine if the plan has passed the ACP test.
If it is determined that the Plan has failed either the ADP or ACP test, corrective action must be taken within certain time limits in order for the Plan to maintain it’s qualified status. The employer may select from various options depending on the time period when the failure was discovered. These options will be discussed in future articles.
The 1.25 test is satisfied if the highly compensated group does not exceed 1.25 times the average contribution percent of the non-highly compensated group. For example, if the non-highly compensated group’s average was 3%, the highly compensated group’s average would be limited to 3.75%.
The 2% test is satisfied if the average contribution percent of the highly compensated group is not greater than 2% or no more than twice the average of the non-highly compensated group. Put simply, the highly compensated group’s limit is determined by adding 2% to the non-highly group’s average, or doubling that average, whichever result is smallest.