Posted by Maria T. Hurd, CPA
Financial advisors on TV and financial publications in reputable papers and magazines consistently encourage people who participate in an employer-sponsored retirement plan to contribute as much as possible. In many cases, retirement plan platforms offer online tools to assist plan participants in projecting how much they need to save to achieve high income replacement levels when they get to retirement age. Therefore, it is not surprising that highly compensated employees (HCEs) are shocked to hear that they are not permitted to contribute as much as they elected. The refunds they receive when their employer’s plan fails the Actual Deferral Percentage (ADP) and Aggregate Contribution Percentage (ACP) tests leave them puzzled and confused.
The simple explanation for the unexpected refunds is that the IRS wants to ensure that the contributions deposited in the accounts of non-highly compensated employees (NHCEs) are proportional to contributions made for HCEs. Counterintuitive as it may seem to the surprised HCEs, the nondiscrimination rules apply to the elective 401(k) deferrals that they contribute out of their own salary (ADP test) as well as to the match contributions they receive from the employer (ACP test).
As the NHCEs contribute more into the plan, the HCEs are allowed to contribute more into the plan, up to the legislative maximum limits. For example,
|If the Average Deferral Percentage of NHCEs is:||Then the maximum average ADP of HCEs is:|
|Less than 2%||2 times the average for the NHCEs|
|Between 2% and 8%||Average NHCEs plus 2%|
|More than 8%||1.25 times the average NHCEs ADP|
Discrimination Test Refunds
The plan distributes the excess contributions to HCEs, to lower their average percentage contribution until the test is passed. The distributions are made first to HCEs who deferred the highest dollar amounts, not the highest percentage, and they must include earnings. If distributed within 2 ½ months of the end of the plan year, there is no tax penalty to the employer. If returned after 2 ½ months, the employer is subject to a 10% excise tax. HCEs report the distribution as taxable income in the year in which the excess is distributed. The recipients of the excess contributions receive a Form 1099-R to facilitate their tax reporting.
It is important to note that 403(b) plans are not subject to the ADP test, but they are subject to the ACP test, which is the same as the ADP test described above, but computed using the employer match contributions. Excess match contributions are called excess aggregate contributions and they are refunds to the HCEs. They are processed in the same way as excess deferral contributions, except that excess match contributions that are not fully vested are reallocated to other participants or forfeited to an unallocated suspense account to reduce future contributions.
Plans can base the ADP and ACP percentages for NHCEs on either the current or the prior year contributions. The election to use current or prior year data is contained in the plan document. A plan can change from prior year testing to current year testing during any plan year, but once current year testing is elected, the employer cannot change back to prior year testing except under limited circumstances.
Other Highly Compensated Employee Refunds
Refunds of excess contributions are not the only alternative available to employers whose plans have failed the ADP and/or ACP tests. Other options include additional vested contributions to the NHCEs and, prospectively, the plan’s third party administrators and/or ERISA counsel can assist the client in reviewing alternative plan designs that achieve the employer’s objectives in a more cost-effective manner. In many cases, the HCEs receiving the refunds are not in a position to influence the corrective method selected by the employers. In cases when refunds of excess contributions are processed, plan officials have to be prepared to explain why contributing as much as possible is encouraged by the media, but the maximum limits can be lower than expected if the plan does not pass the non-discrimination tests.