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February 17, 2009

ADP Test (Actual Deferral Percentage Test)

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Definition

A test that must be performed by plan administrators to determine whether salary deferral contributions to a SARSEP or 401(k) plan discriminate in favor of highly compensated employees (HCE).

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.

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.”

Referring Cite

I.R.C. §§408(k)(6)(A)(iii), 408(k)(6)(D), I.R.C. §401(k)(3)(A), Treas. Reg. §1.401(k)-2(a)(1)(i)

Additional Helpful Information

  • If the plan fails the ACP test, corrective steps can be taken, which include the following:
    1. Refunding amounts to HCEs
    2. Recharacterizing salary deferral contributions as after-tax contributions ( not applicable for SARSEPs)
    3. Contributing additional amounts for non-highly compensated employees
  • An employer may avoid the ADP test for a 401(k) plan by adopting and abiding by the safe harbor provisions as described in IRS Notices 98-52 and 2000-3
  • According to the IRS, 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:
    • Incorrectly classifying employees as HCE or NHCE;
    • Using an incorrect definition of compensation in the tests; and
    • Calculating the test incorrectly.
  • 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.

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Written By

Denise Appleby

Denise is CEO of Appleby Retirement Consulting Inc., a firm that provides IRA resources for financial/ tax/legal professionals. She has over 20 years of experience in the retirement plans field, which includes training and technical consultation.

Denise writes and publishes educational /marketing tools for advisors; available at http://irapublications.com. Denise co-authored several books on IRAs

Denise is a graduate of The John Marshall Law School, where she obtained a Masters of Jurisprudence in Employee Benefits, and has earned 5 professional retirement designations.
She has appeared on numerous media programs, sharing her insights on retirement tax laws.

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