Don’t Fail the Test – Proactive Steps to Avoid the Dreaded 401(k) Corrective Distribution

October 14th, 2019
by Jonathan Leidy

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Test – the word alone is enough to make even the most studious among us sweat. 

Now place it in the context of your 401(k) plan, i.e. determining whether your plan passes non-discrimination tests, and anxiety levels can easily go through the roof!

This article will take a brief look at ways to correct a failed Average Deferral Percentage (ADP) test, the non-discrimination test mandated by the Internal Revenue Code to determine whether 401(k) elective deferrals unfairly favor highly-compensated employees as well as how to use corrective distributions, a method available to fix a failed test.  It also outlines a few changes that can be made mid-year to improve test results and explains how to avoid the ADP test altogether.

Definition:

Highly-Compensated Employees (HCE): Highly-compensated employees are those employees who own or are deemed to own through family attribution more than 5% of a business at any time during the current or prior plan year OR who had compensation in excess of a specific dollar amount in the prior plan year ($120,000 for 2019 plan year testing).

When your Plan Fails the Test

Typically, the ADP test is done shortly after the end of the plan year, and if your plan fails, corrections are made in accordance with certain procedures and timeframes.

Generally, the plan document specifies the correction procedure; the most common method requires the plan sponsor to first recharacterize excess HCE contributions as “catch-up” contributions, if possible, and then to make corrective distributions of any remaining overcontributions to the HCEs.

Consequently, highly-compensated employees are not only unable to take full advantage of saving for retirement, but the refund of the corrective distributions means they will face additional federal and state income taxes in the year the contributions are refunded.  Usually, that means HCEs will have to refile their taxes, which is time consuming and costly.

Of course, there is another potential remedy. If the plan sponsor chooses, it can make additional contributions to the non-highly compensated employees (NHCEs) to correct a failed ADP test.

Although making corrective distributions to the highly-compensated employees or additional contributions to the non-highly compensated employees will resolve a failed ADP test, there are other options a plan sponsor can adopt on a proactive basis.

Proactive Steps to Not Fail the Test

One option is to have a preliminary ADP test done mid-year to get an early assessment.  If it looks as though the plan won’t pass, here are three ideas to prevent failure:

  1. Restrict the amount of contributions that HCEs can make to the plan to either a uniform dollar amount or percentage of compensation.
  2. Implement matching contributions to encourage NHCEs to participate at higher levels.
  3. Add an automatic enrollment feature with automatic annual increases to increase the NHCEs’ deferral percentages.

Additionally, greater communication can help increase HCE’s awareness of possible corrective distributions, while better matching and enrollment initiatives can boost plan participation.

Skip the Test All Together

Of course, if you are truly as averse to taking tests as the majority of folks are, there is one way to completely eliminate the ADP test: adopt a Safe Harbor plan design for the plan.

A safe harbor plan design requires specific contribution, vesting and participant notification provisions.  The three basic contribution options include:

  • 3% contribution for all eligible employees (non-elective)
  • Match consisting of 100% up to 3% of compensation and a 50% match on the next 2% of compensation (elective)
  • Match consisting of 100% up to 1% of compensation and a 50% match on the next 5% of compensation combined with an automatic enrollment feature (also known as a Qualified Automatic Contribution Arrangement or QACA)

Keep in mind that adopting a Safe Harbor plan will eliminate the ADP test requirement for future plan years only. It cannot be adopted retroactively or mid-year to alleviate a failed ADP test for the current plan year.

A Safe Harbor plan can only be offered for an entire plan year; and since most plans have a 1/1 start date the timing could be perfect for 2020 onward. Keep in mind that participants must be notified 30 to 90 days prior to the start of each plan year, so if Safe Harbor is something you’re interested in, make sure to reach out to us or your current retirement plan provider today.

Non-discrimination testing is an integral part of sponsoring a 401(k) plan, but there is no need to have anxiety about the ADP test.  There are ways to correct a failed test and improve the test results if a failure seems likely as well as a way to guarantee a passing grade every time in the form of a Safe Harbor provision.