In the example above, Jim Smith would be the only HCE, so the ADP would be 10 percent, and the ACP would be three percent ($5,400/$180,000) for the HCE group. The three remaining employees would be classified as NHCEs (assuming no five percent ownership). Their ADP is three percent, and their ACP is one-and-a-half percent.
The ADP test is passed if the ADP for the eligible HCEs does not exceed the greater of:
• 125 percent of the ADP for the group of NHCEs, or the lesser of
• 200 percent of the ADP for the group of NHCEs, or
• The ADP for the NHCEs plus two percent
The test above is also performed for the ACP Test, substituting the ACP for the ADP. In the example above, the ADP test fails 10 percent (HCEs) vs. three percent (NHCEs), while the ACP test just passes three percent HCEs vs. one-and-a-half percent NHCEs. Corrective action would have to be taken for the ADP test failure within the statutory correction period. This is generally accomplished by returning excess contributions to those in the HCE group to bring the ADP test up to passing status. When outside of the statutory correction period, possible corrective action requires the employer to make Qualified Non-Elective Contributions (QNEC) to all eligible NHCEs to bring the NHCE groups’ ADP/ACP within test passing parameters.
Plan sponsors should be aware of multiple factors when it comes to Non-Discrimination Testing failures. They include:
• Plan sponsors can use either the current year or prior year contribution method when calculating ADP and ACP figures. This needs to be specified in the plan document.
• The method chosen (prior or current year) can be changed under limited circumstances. Plans can always change from prior year to current year, but a plan can only change once from current to prior year in a five-year period.
• The benefit of using the prior year method is it defines the acceptable level of HCE contributions, can be communicated to those HCEs in advance.
• Moving from prior to current year method does not guarantee the plan will pass, as averages could still be outside of the allowable range under the current year method.
• All eligible employees need to be included in both ADP and ACP tests, including those that don’t contribute, or were terminated before the end of the year.
One way to avoid non-discrimination testing all together is to establish a Safe Harbor 401(k) plan, which exempts the plan from ADP and ACP test requirements if certain conditions are met. The conditions to note are specified matching formulas, as well as vesting requirements. Another way plan sponsors can combat testing failures is through plan design.
Plan sponsors can look at ways to improve the savings rates of NHCE through enhancements to automatic enrollment, automatic escalation, as well as thoughtful participant communication and education.
Finally, plan sponsors should pay attention to the SECURE Act, that recently passed in the House of Representatives and is now headed for the Senate. It addresses retirement plans and could potentially affect conditions that would qualify a plan for Safe Harbor.
For further information, please contact your Consultant at DiMeo Schneider & Associates, L.L.C.
