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What is the ADP test? The actual deferral percentage (or “ADP”) test is an annual nondiscrimination testing requirement applicable to 401(k) plans.
The test is conducted shortly after the end of each plan year based on the contributions (“deferrals”) elected by each eligible employee during the year. If the plan fails the ADP test, appropriate corrective action must be taken.
The ADP test compares the average deferral rate (measured as a percentage of compensation) of eligible highly compensated employees (“HCEs”) with the average deferral percentage of eligible non-HCEs. If the deferral percentage of HCEs exceeds the deferral percentage of non-HCEs by more than a specified margin, the ADP test is failed.
In general, the ADP for a plan’s non-HCEs must not be less than two percentage points of the ADP of the HCEs. If the ADP of the non-HCEs is less than 2%, then the ADP of HCEs must not be more than two times the ADP of the non-HCEs.
A failed ADP test is typically corrected in one of two ways:
Due to the expense of the second approach, most employers choose to correct failed ADP tests by distributing excess contributions to the plan’s HCEs – resulting in an unwelcome tax hit to the impacted employees.
The following strategies are available to increase the likelihood that a plan will satisfy the ADP test or otherwise mitigate the impact of a failed ADP test on the plan’s HCEs:
Strategy 1 - Safe Harbor Plan Design
Summary: Special election that allows the plan to automatically pass ADP testing in exchange for a minimum, fully vested employer contribution.
Required Employer Contribution: 3% nonelective contribution for all eligible employees, whether or not they make deferrals under the plan OR Matching contribution of 100% of each employee’s deferrals up to 3% of compensation, plus 50% of each employee’s deferrals between 3% and 5% of compensation (resulting in a total match of 4% of compensation for employees contributing 5% or more).
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Strategy 2 - Automatic Enrollment
Summary: Increase deferral percentage of non-HCEs by automatically enrolling eligible employees at a specified contribution rate unless the employee affirmatively elects to opt out of participation.
Additional Optional Safe Harbor: A plan that uses automatic enrollment can also elect the qualified automatic contribution arrangement (“QACA”) safe harbor, provided that the employer makes a minimum employer contribution that can be slightly lower than the contribution required under a regular safe-harbor plan (total maximum match of 3.5% of compensation under a QACA versus 4% under a non-QACA safe harbor).
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Strategy 3 - Class Exclusions
Summary: Boost the non-HCE deferral percentage by excluding specified classes of employees with traditionally low contribution rates (e.g., seasonal, temporary, interns, etc.). Generally, a plan is permitted to exclude up to 30% of its non-HCEs.
Impact on ADP Test: The ADP test includes the deferral percentage of all eligible employees, including those with a deferral rate of zero. Employees in an excluded class are not included in the ADP test.
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Strategy 4 - Nonqualified Deferred Compensation Plan
Summary: Separate and distinct from the 401(k) plan, a nonqualified deferred compensation (“NQDC”) plan can be established to “capture” any taxable distributions to HCEs resulting from a failed ADP test.
Analysis: The NQDC plan would be set up to automatically transfer corrective distributions from a failed ADP test into an account under the NQDC plan (unless the HCE has elected not to participate). Amounts credited to the NQDC account are not taxed until distributed to the HCE, typically upon termination of employment, death or disability. Earnings can be credited by mirroring the rate of return under the participant’s 401(k) account.
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