Helping Clients Avoid Failed ADP Tests

For the ADP (Actual Deferral Percentage) test, the Internal Revenue Service (IRS) requires 401(k) plans prove that highly compensated employees (HCEs)—those employees who earned more than $115,000 in 2013 or are a 5% (or greater) owner—do not defer significantly more than the non-highly compensated employees (NHCEs).  The test is fairly simple; plan sponsors’ third-party administrators (TPAs) determine the average percentage of compensation the HCEs defer, and compare it to the average the NHCEs defer.  If the spread of these two averages exceeds IRS guidelines, then the test fails.

The best way to avoid this issue is to attack it before it becomes a problem.  In a perfect world, advisers would lead educational seminars that every employee would want to attend with an outcome of 90% or greater participation in the 401(k) plan.  Even the most inspirational financial adviser would find it difficult to achieve this participation goal consistently (especially when there are multiple locations, staff members that live paycheck to paycheck, or employees who are infrequently in the office).

When a plan fails its ADP test there are typically two solutions:  1) provide refunds of deferrals to the HCEs (this is usually the owners and senior staff) adjusted for investment gains/losses or 2) provide additional contributions through the use of a QNEC (Qualified Non Elective Contributions) to the NHCEs.  Plan Sponsors are not usually happy with either alternative.

A more practical solution is for plan sponsors to be more proactive and operate their 401(k) plans to reflect the lower participation (until such time as this statistic changes).

Below are four ideas we have used successfully with our clients.  These are ideas you can suggest plan sponsors implement now to help make their plans more successful, and continue to demonstrate your value in the process.

1)      Interim Testing: Encourage your client to provide mid-year data to its TPA (we typically request data as of June 30 for calendar year plans).  The TPA will perform an interim ADP test that projects the full-year results.  If the results indicate a “failed” test, the plan sponsor will then have ample time to alert the HCEs and offer them the option of cutting back on their deferrals to avoid large refunds.  If the results are better than expected, they will have the opportunity to increase their deferrals.  Either way, there should be limited surprises at the end of the year.  Please Note:  In order for this analysis to be useful, the TPA should explain the test results and provide actual direction for increasing or decreasing contributions for the HCEs.

2)      Prior Year Testing Method: If performing the interim test is just not feasible (i.e., gathering the data is too difficult or time consuming for your client), another alternative is to change the ADP testing method in the plan document to use “prior year” results (instead of “current year”).  By using prior year testing, the NHCE average deferral percentage is known in advance, and dictates what the HCEs can defer this year.  For example, if the NHCEs defer on average 2.5% of their compensation in 2013, the HCEs can defer 4.5% on average in 2014.  Therefore, close to the start of every plan year, the HCEs know just how much they can defer (on average) before the ADP test will fail.  Please Note:  The ability to change to Prior Year from Current Year testing depends on the provisions of the plan document and whether another testing election change has been made recently.  Speak with the TPA to confirm. 

3)      Reflecting the best definition of compensation.  ADP tests simply compare the ratio of deferrals to compensation.  Which definition of compensation is used can have a significant impact on results.  If the plan document permits, the TPA can test the plan using both full W-2 compensation (reflecting compensation prior to the time some short-service employees became participants) as well as compensation from the date the participant actually entered the plan.  Depending on plan demographics, one definition of compensation may produce better results than the other.

4)      Borrowing from Peter to pay Paul.  The Borrowing Method reallocates a participant’s matching dollars (assuming the plan has an employer match) to his salary deferrals, assuming that the plan passes nondiscrimination testing on the match (the actual contribution percentage, or ACP, test).  The goal here is simple: if you can increase an NHCE’s deferral percentage, then the plan’s overall ADP test results will improve.  There are no additional employer contributions made but rather just a “book entry” change.  The worst scenario is that there is no change in the ADP test result.  The best scenario is that the ADP failure will be reduced or eliminated completely.  Please Note: When using this method, any employer match borrowed to improve ADP results must be made 100% vested immediately.

There is no silver bullet to definitely fix ADP test results, but there are numerous ways to mitigate failed results with minimal upset.   I am sure many of you have explored the use of a safe harbor 401(k) design (more about that in a later article), but unfortunately they can be cost-prohibitive and in any event, for existing plans, they cannot be implemented until the start of the 2015 plan year.  Hopefully, these ideas will add value to your client relationships and improve the experience they have with their 401(k) plans.

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.