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When ADP/ACP Testing Fails, 401(k) Fiduciaries Should Understand Their Options

Eric Droblyen

December 29, 2022


Today, most 401(k) plans operate on a calendar-based plan year cycle. March 15 was an important date for many of these plans – it was the deadline to make any corrective distributions due to a failed 2015 plan year Average Deferral Percentage (ADP) or Average Contribution Percentage (ACP) test in order to avoid a 10% IRS excise tax.

Failing an ADP/ACP test is not fun. Highly Compensated Employees (HCEs) don’t want their 401(k) contributions refunded (and out-of-pocket taxes increased), while employers don’t want angry HCEs or the stress of correcting a failed ADP/ACP test by March 15.

Although approximately 30% of 401(k) plans subject to ADP/ACP testing fail, it’s an outcome most small businesses want to avoid. Below are steps a 401(k) fiduciary can take to do that.

Become a safe harbor 401(k) plan

So-called safe harbor 401(k) plans automatically pass ADP/ACP testing when certain contribution and participant notice requirements are met. To meet the contribution requirement, an employer must make one of the following three contributions to participants:

  1. Safe harbor match – The employer may select a “basic” or an “enhanced” match. The basic match equals 100% of 401(k) on the first 3% of compensation plus 50% of 401(k) on the next 2% of compensation (4% total). The enhanced match must be at least as generous as the basic match at each % of compensation.
  2. Safe harbor nonelective – The contribution must be 3% (or more) of compensation and be made to all eligible non-HCEs, regardless of whether they made a 401(k) contribution to the plan.
  3. QACA match – if a plan meets certain automatic enrollment requirements, a less costly safe harbor match can be made, equal to 100% of 401(k) on the first 1% of compensation plus 50% match of 401(k) on the next 5% of compensation (3.5% total).

Safe harbor 401(k) plans must also distribute a notice to employees that explains their plan rights and obligations. Participants must receive this notice within 90 days of their plan eligibility date and 30-90 days before the start of each new plan year thereafter.

Increase non-HCE Participation

401(k) plans fail ADP/ACP testing when the average contribution rate of the HCE group exceeds the average of the non-HCE group by more than the legal limit. A way to decrease this margin is by increasing non-HCE participation. This can be done using two methods:

  1. Participant education - Many workers are intimidated by 401(k) participation or don’t fully understand its benefits. Often, non-HCEs are the most confused – which can lead to low participation by this group. Enrollment meetings or other education initiatives can help increase the non-HCE group’s 401(k) knowledge, and in turn, spur their participation. Participant education does not need to be costly. Both the IRS and DOL offer free 401(k) education for workers on their websites.
  2. Automatic enrollment – When a 401(k) plan includes an automatic enrollment feature, employees are automatically enrolled in the plan at a default deferral rate (specified in the plan document) if they fail to make an affirmative deferral election. An automatic enrollment feature can improve non-HCE participation because inaction results in automatic 401(k) participation.
  3. Employer match – When an employer matches 401(k) contributions, workers are more likely to participate in order to receive the match. Unlike a safe harbor match, discretionary matching contributions can be subject to up to a six-year vesting schedule. A vesting schedule allows a plan to recover non-vested match amounts when an employee terminates and then use these forfeitures to offset future contributions.

Evaluate your testing options

401k plans have ADP/ACP testing options. 401(k) fiduciaries should understand these options because changing one or more of them can help their plan pass ADP/ACP testing, or at least, mitigate corrective returns.

  1. Top-paid group (TPG) election – 401(k) plans are permitted to limit the HCE group to employees that rank in the top 20 percent of all employees based on compensation. Making this election moves non-TPG HCEs to the non-HCE group. If the moved HCEs have high contribution rates, this can help a 401(k) plan pass testing.
  2. Current-year testing method – 401(k) plans can choose to ADP/ACP test the current year HCE group against the current year or prior year non-HCE group in their plan document. While many plans choose the prior year testing method because it makes ADP/ACP test results more predictable each year, this method does not help ADP/ACP testing as quickly as the current year method when non-HCE participation is improved.
  3. Permissive disaggregation – When a 401(k) plan has more liberal eligibility requirements than the law requires – 1 year of service, age 21, semi-annual entry dates – it has the option to ADP/ACP test the participants that met the plan’s eligibility requirements, but not the legal limits, separately. This disaggregation often helps ADP/ACP test results because newly-eligible employees (who are almost always non-HCEs) are the least likely to participate. When an ADP/ACP test fails, the plan sponsor should always ask their 401(k) provider if they tried disaggregation to improve test results.

Don’t settle for a failed ADP/ACP test!

If you are a 401(k) fiduciary, you don’t need to settle for annual ADP/ACP test failures – there are steps you can take to avoid or mitigate returns. You just need to know your options. Once you do, you’ll be ready to discuss these options with your 401(k) provider.

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