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Fixing Common Plan Mistakes - Not Correcting ADP/ACP Mistakes Timely

The Issue

Many of you have 401(k) retirement plans that provide for elective contributions. If you do, you may be familiar with the Actual Deferral Percentage test (ADP) and the Actual Contribution Percentage test (ACP). These tests provide a limit on the amount that certain benefits provided under the plan to highly compensated employees (HCEs) may exceed the benefits provided to non-highly compensated employees (NHCEs).

Under the ADP test, the average salary deferrals of the HCEs and NHCEs are calculated and compared on an annual basis based on the plan year. Each employee’s deferral percentage is the percentage of compensation that has been deferred, pre-tax, to the 401(k) plan. The deferral percentages of the HCEs and NHCEs are then averaged to determine the ADP of each group. To pass the test, the ADP of the HCE group may not exceed the ADP for the NHCE group by 1.25 percent or 2 percentage points.

Similar to the ADP test, the ACP test applies to matching contributions and/or employee after-tax contributions. The plan satisfies the nondiscrimination requirements of the law if it passes the ADP and ACP tests.

If the plan fails the ADP and/or ACP tests, corrective action must be taken to protect the qualified status of the arrangement. The law and related regulations provide various methods for correcting mistakes during a “correction period.” This statutory correction period is the 12-month period following the close of the plan year in which the mistake occurs. If corrective distributions are made after the first 2 ½ months of the correction period, the employer (not the HCE) is liable for an excise tax. If correction is not made within the correction period, the plan is considered “disqualified.”

The Problem

One of the most common mistakes submitted for correction under the Voluntary Correction Program (VCP) is the failure to timely test for and correct ADP or ACP mistakes. Common reasons for this mistake are:

  1. Incorrectly classifying employees as HCE or NHCE;
  2. Using an incorrect definition of compensation in the tests; and
  3. Calculating the test incorrectly.

The Fix

Employers may get relief from treatment of the 401(k) plans as nonqualified through the Employee Plans Compliance Resolution System (EPCRS) by correcting the mistakes after the statutory correction period has passed. The Self-Correction Program (SCP) or Voluntary Correction Program (VCP) can be used to correct the mistakes. In order to fix the mistake under SCP, generally the mistake must be fixed within two years after the end of the statutory correction period (i.e., the 12-month period following the close of the plan year). Unless the failure can be classified as insignificant, VCP must be used after this time.

Example: A calendar year plan with a 401(k) arrangement fails the ADP test for the plan year ending 12/31/04. The statutory correction period is the 12-month period from 01/01/05 to 12/31/05. The self-correction period under SCP runs from 01/01/06 to 12/31/07. After this date (unless the violation is considered insignificant), VCP must be used to correct the violation.

Note that there is more than one way to correct ADP and ACP mistakes under EPCRS. Generally, if SCP or VCP is used to correct a violation of the ADP/ACP test after the statutory 12-month correction period, the employer is required to make Qualified Non-Elective contributions (QNECs) for the NHCEs. QNECs are contributions made by the employer that are 100% vested, have the same distribution rules as 401(k) deferrals and do not discriminate in favor of HCEs. Under one corrective approach, the employer contributes enough QNECs to all the NHCEs in order to raise the ADP of the NHCEs to a level necessary that satisfies the ADP test. Another approach under EPCRS permits correction solely by making distributions to the HCEs after the statutory correction period as long as the employer is willing to make a contribution for the NHCEs that equals the total amount being distributed.

Making Sure It Doesn’t Happen Again

Completing the ADP/ACP nondiscrimination tests accurately and timely is vital for employers maintaining 401(k) plans. The plan document, employee data, etc., should be carefully reviewed to ensure that employees are correctly classified, the proper definition of compensation is used and proper testing/correction methods are used. Plans with matching contributions and/or employee after-tax contributions can be structured so that the employer can adjust the contribution rates of the HCEs in order to prevent the plan from failing the ACP test. Similarly, some plans are designed with a discretionary matching contribution formula, where the employer can declare a different rate of matching contribution for the HCEs.

However, keep in mind, that despite all your good efforts, mistakes can happen. In that case, the IRS can help you correct the problem and retain the benefits of your 401(k) retirement plan.

Page Last Reviewed or Updated: 28-Mar-2014