Back-to-Basics: Average Deferral Percentage Test
January 20, 2004,
Updated January 31, 2008

Congress has devised several nondiscrimination tests in order to prevent qualified retirement plans from overly favoring highly compensated employees (HCEs). Keep in mind that the first test that must always be done is the coverage test. (Click here for an article on coverage testing.) Once the coverage test is passed or, if not passed, once the necessary steps have been taken to pass coverage, then the average deferral percentage (ADP) test must be performed. Both the coverage test and the ADP test use mathematical techniques to compare the participation and contribution rates of the HCEs to the nonhighly compensated employees (NHCEs) to determine whether the plan is discriminating in favor of the HCEs. 

Who is a Highly Compensated Employee?
Generally, a highly compensated employee is an employee who is either a more than 5% owner of the business (also known as a 5% owner) in the year of testing or the prior year, or someone who makes more than $80,000 in compensation in the prior year, as adjusted annually for cost-of-living increases (COLA). For 2008 testing, we would use the 2007 COLA limit for HCEs which is $100,000.

It is further possible to limit the number of HCEs by compensation to the top 20% paid group, which may be a particularly effective tactic in small plans maintained by professional groups such as law firms and physicians.

Keep in mind that the 5% owner rule also requires careful review of the ownership attribution rules for families and trusts. In effect, certain family members are deemed through their relationship to share in the ownership interests of the 5% owner. The family relationships taken into consideration when determining attribution of ownership include spouse, parent, child and grandchild. An adopted child is also taken into consideration. Not included are siblings, grandparents and in-laws. An example of how this works is if the husband and wife each work for the firm and the husband is 100% owner of the firm; by the family attribution rules, the wife would also own 100% of the business and would thus, be a highly compensated employee owner because she would also be a more than 5% owner. Click here for an article with more details on family attribution.

Performing the ADP Test

For the HCEs, the same process is used to arrive at the HCEs’ ADP. Once both the NHCE and the HCE ADP figures have been determined, they are compared against each other. The HCEs’ ADP may only exceed the NHCEs’ ADP by specific limits. The limits may be summarized as follows:

Using our example in which the NHCEs’ ADP is 2.53%, the HCEs’ ADP is limited to 2.53% plus 2% for a maximum of 4.53%. 

Definition of Compensation
The definition of compensation impacts the calculation of the average deferral ratios (ADRs).  The following issues need to be addressed when determining testing strategies:   

1. Net or gross compensation
   Does the definition of compensation for testing purposes that is selected by the employer include pre-tax contributions?  Effectively, is the employer using “gross” or “net” compensation for testing?

   This choice may dramatically affect the ADR calculation.  For example, in a plan using a testing compensation definition that excludes pre-tax contributions, a participant with compensation of $50,000 who defers $5,000 will have an ADR of 11.11% ($5,000 divided by $45,000). If pre-tax contributions were included in the test, the ADR for this individual would be 10% ($5,000 divided by $50,000).

   Note: If an individual earned over $245,500 in 2008, the net and gross options work the same for that individual. If using the net amount, it is $245,500 less $15,500 for a total of $230,000. If using gross, the $245,500 is limited by the compensation cap to $230,000. 

   If the employer has a significant portion of its highly compensated employees earning over the compensation limit, the test results are usually better if the “net” definition of compensation is used.

2. Compensation while a participant or for entire year

   In the year a participant enters the plan, what is the definition of compensation for the year of entry? Is compensation taken into account for the entire year or is it limited to the time the employee actually participated in the plan?

   This will depend on plan design.  In general, if the compensation calculation period is defined as “plan year while a participant,” compensation included will be limited to that received while the individual was actually eligible to participate. This too will have a dramatic effect on the ADR calculation. For example, in a calendar year plan, if compensation is defined as that received while a participant (instead of an alternate definition such as the entire plan year, the calendar year or the employer’s fiscal year) an employee who earned $60,000 during the entire plan year but only entered the plan on July 1 would be limited to a half year’s compensation in the ADR calculation. If this participant deferred $3,000, the ADR would be 10% ($3,000 divided by $30,000). Had the plan defined compensation as that received during the entire plan year, the ADR would have been 5% ($3,000 divided by $60,000).

   Since very few HCEs enter in the first year, using compensation while a participant will generally improve the testing results.

How does the 20% top-paid group work?
Generally, a highly compensated employee is an individual who is either in the current year or the prior year, a more than 5% owner (either directly or by family attribution) of the business or an employee who received compensation of more than $80,000 as adjusted, in the prior year (i.e., $100,000 in 2007). The law provides an alternative that allows an employer to limit the number of HCEs as determined by compensation to the top 20% paid group.  This may be a particularly effective tactic in small plans maintained by professional groups such as law firms and physicians where more than 20% of employees may be highly compensated.

An example will make it clear.
Assume that a company has 30 eligible employees whose compensation, listed in descending order, is as follows:

Without the top 20% option, all 10 employees making over $100,000 would be considered HCEs.  However, if the top 20% election were made, only the top 20% would be considered HCEs; and therefore, in this example, instead of 10 HCEs, only the top 20%, or the top 6 individuals, would be considered HCEs. This changes 4 of the HCEs into NHCEs, which may greatly alter testing results. As those with higher incomes generally defer more income, this may result in an increase of the average deferral percentage of the NHCE group while lowering the HCE group percentage. 

Current Year Method vs Prior Year Method Testing.
Plan design allows the choice of whether to use either the current year or the prior year testing method for ADP testing. The prior year testing method uses the prior year NHCE’s ADP as the basis for the current year maximum ADP for the HCEs . This makes it easier for some plans to pass the ADP test because the HCEs already know what their maximum ADP level is. For example, in a calendar year plan using the prior year method for the 2008 plan year, if the NHCE’s ADP for 2007 was 3%, then the HCE’s ADP for 2008 could not exceed 5%.

If the current year testing method is used, the HCEs will not know the actual NHCE’s ADP until after the end of the plan year being tested. Although the current year method has less certainty, there are advantages to its use, because the prior year method has a tendency to artificially depress the maximum amount that individual HCEs may defer. This is because the prior method is based on group averages and ignores individual decisions to defer or to not defer.  In addition, the current year method provides more flexible options for the employer in the event the plan was to fail ADP testing.

Note that if the employer wished to pass testing by adding a QNEC to the NHCEs, this must be done by the end of the plan year following the plan year of the NHCEs deferrals. Thus, if in our example, the prior year 2007 NHCE deferrals were being used, any QNEC to be made would have to be done by the end of 2008. However, the test will not be done until early 2009 making it too late to correct by a QNEC.

Note that a plan may shift from the prior year method to the current year method at any time. However, once the change from the prior year method to the current year method occurs, the plan may not return to prior year method testing for five years.

Discretionary amendments during plan year only
Rev. Proc. 2005-66 and 2007-44 stated that discretionary amendment must be made by the end of the plan year for which they are effective. Thus, to change from prior to current year testing or vice versa, the plan amendment must be made during the plan year for which it is to be effective. Unfortunately, most often, the employer does not know that there is a need to change until the test is being done -- after the end of the plan year – when it is too late to make the amendment.

Bill Grossman, QPA

ADP/ACP Testing FAQs From Prior E-mail Alerts
January 31, 2008

In a preliminary ADP test, it was clear that one HCE would have an excess contribution of over $6,000. May the excess contribution be refunded during the current plan year? Or must the participant wait until the actual ADP test is run after the plan year closes?

Treasury regulations state that ADP corrections (1.401(k)-2(b)(2)(v)) and ACP corrections (1.401(m)-2(b)(2)(v)) must be made after the close of the current plan year. There is an exception for an HCE who is receiving his or her entire plan balance during the current plan year.

An employee became eligible to enter a 401(k) plan and make deferrals but was never notified. The employer discovered the mistake and made a corrective contribution. Must the ADP test be rerun?

No.

If the same employee had been properly notified and completed an election form but the election amount she chose was not withheld from her pay nor placed into the plan, must the ADP test be rerun after the correction is made?

There is no clear-cut guidance on this issue. However, since the amount the participant chose and the correction amount were not coordinated with the group average, the conservative answer appears to be “Yes, the ADP test must be rerun.”

If an off-calendar-year plan suffers an ADP test failure, which catch-up limit is used for the recharacterization of the refund?

The catch-up limit is based on the calendar year in which the plan year ends. For example, if the plan year runs from July 1, 2005, to June 30, 2006, the catch-up limit for 2006 ($5,000) would be used for the recharacterization of the refund.

May a plan perform the ADP test using the current year method and the ACP test using the prior year method?

Not on a GUST prototype. According to the List of Required Modifications (LRM) for GUST prototype documents, both tests must be done using the same method.

A plan has a discretionary match formula provision that it has never utilized. May the plan make a matching contribution for this year if it uses the prior year testing method?

Yes.  .  . but! Since this is not a new plan, the plan may not use the 3% assumption available to new plans (in their first year) using prior year testing. A contribution could be made for NHCEs, if the employer so desires. However, the HCEs in this situation would not be able to receive a matching allocation since the prior year NHCE average would be 0%. The plan could change to current year testing — if done before the end of the plan year, but that would require it to use the current year testing method for a minimum of five years.

May a 401(k) plan that utilizes the prior year testing method use a QNEC to correct a failed ADP test?

No. Prior year testing does not permit a QNEC because the 12-month time period during which a QNEC is permitted is past. Here's an example. For a calendar-year plan with prior year testing, the 2005 ADP test is performed in early 2006 using NHCE data from 2004 and HCE data from 2005. If the test fails, a QNEC can only be made within 12 months of the end of the plan year containing the NHCE data. Since the NHCE data in this case is from 2004, the 12-month period has already elapsed. Note that since the only correction for such a failed ADP test is a refund, the test should be completed no later than March 15, 2006. If the refund is not made by that date, the employer is subject to a 10% penalty on the refund amount.

A 401(k) plan with a June 30 year-end date fails the ADP test and refunds excess contributions. To which tax year are the refunded deferrals attributed?

To avoid the 10% penalty on the excess contributions, the ADP test must be completed and excess contributions (elective deferrals) distributed to participants within the two-and-a-half-month period after the plan year ends.

The amount of the excess contributions is determined on a first-in, first-out (FIFO) basis. So, the excess is attributable to the earliest contributions made during the plan year. For example, if excess contributions are returned by September 15, 2008, for the plan year that commenced on July 1, 2007, the returned contributions are attributable to — and are taxable in — the participants’ 2007 tax year. However, this will mean the affected participants will have to file amended 2007 tax returns (Form 1040X) and pay additional income taxes plus interest on the returned contributions. To avoid these consequences, some employers prefer to wait until after the two-and-a-half-month period is over to make the refunds. Although this will result in the employers having to pay a 10% excise tax, delaying the return will mean the excess contributions are taxable to the participants in the year in which they are distributed.

A solution that would avoid both the 10% employer penalty and the refiling burden would be for the employer to make a QNEC contribution.

NOTE: The Pension Protection Act of 2006 has changed this by making the corrective distribution taxable to the participant in the year it is distributed. This starts with the corrections made for plan year 2008.

Which test must be performed first, the ADP/ACP test or the coverage test?

The coverage test is always done first, and the plan must pass the coverage test before the ADP/ACP test may be performed. As a general rule, standardized prototype plans pass coverage testing automatically because only statutory exclusions are permitted. However, nonstandardized prototype plans, volume submitter plans, and individually designed plans are required to perform the coverage test before proceeding to ADP/ACP testing.

MHCO Note: Only those deemed benefiting under the coverage test are subsequently included in the ADP or ACP test as applicable. Thus, if a match has a last day requirement to be eligible and a participant terminates September 30, they will be eligible for and included in the ADP test, but will not be eligible for the ACP test and will not be included.