The Maximum Contribution May Be Lower Than You Thought: ADP and ACP Test Basics for 401(k) and 403(b) Plans

But It’s My Money!

Business owners and Highly Compensated Employees (HCEs) are often shocked to hear that they cannot contribute the maximum 401(k) or 403(b) deferral ($23,000 and $22,500 for 2024 and 2023, respectively) because their plan did not pass the discrimination tests. Much to their surprise, through the Actual Deferral Percentage (ADP) and the Aggregate Contribution Percentage (ACP) tests, the Internal Revenue Code prevents HCEs from benefiting from tax deferrals significantly more than NHCEs, unless the plan is a safe-harbor plan.

The ADP and ACP Test Formulas

As the NHCEs contribute more to the plan, the HCEs are allowed to contribute more to the plan up to the legislative maximum limits. For example,

Sometimes, ZERO can be a BIG Number

Please note that ALL eligible participants are included in the test, such that both NHCEs and HCEs who are eligible to defer but choose not to contribute will drive down the average contribution percentage for their group. It is a common misconception that employees who are not contributing should not be included in the census data provided to the third-party administrator performing the testing. Unfortunately, not including the zeroes renders the results of the test incorrect.

403(b) deferrals are not subject to the ADP test, but the match is subject to the ACP test.

The ACP test uses the same formula as the ADP test above, and it applies to matching contributions and to after-tax contributions. Often, employers assume the plan will

certainly pass discrimination testing because everyone receives the same match percentage. NOT so! If enough NHCEs are not deferring and all the HCEs are deferring, the average match contribution for the HCEs will exceed the average allowed by the ACP test.

HCE Definition

Internal Revenue Code (IRC) Section 414(q) sets forth two tests for determining if an employee is an HCE – an ownership test and a compensation test. An employee is an HCE if he or she satisfies either of the two tests.

An employee is an HCE under the ownership test if he or she is more than a 5% owner at any time during the current plan year or the immediately preceding determination year (also known as the lookback year), regardless of the amount of compensation received. The interest owned by an individual also includes the interest held by relatives such as spouses, parents, children, and grandparents (but not grandchildren or siblings).

An employee is an HCE under the compensation test (as determined under IRC Section 415(c)(3)) if he or she received compensation from the employer during a lookback year in excess of a limit adjusted annually under IRC Section 415(d).

Alternatively, if elected by the employer, HCEs will include only the top 20% of employees ranked by compensation (also known as the top-paid group election) for the lookback year. The employer may make the election for any year. Once made, the election applies for all subsequent years until it is revoked.

Since nonprofit entities do not have owners, only the compensation test for 401(k) plans applies to 403(b)s. The compensation test is based on a look-back year, and the IRS publishes the limits annually.

See COLA Increases for Dollar Limitations on Benefits and Contributions.

For example, to be considered an HCE for 2023, an employee must have earned more than $135,000 in 2022. Please note that under this rule, non-owner employees have no prior year compensation on their initial year of employment and are, therefore, unable to meet the HCE definition based on a lookback year.

When the Tests Fail, Refund or Contribute

When the ADP and/or the ACP tests fail, the employer can either return the excess contributions to the HCEs or make additional contributions to the NHCEs until the test passes. Additional contributions are immediately vested and are called Qualified Nonelective Contributions (QNECs). For more detail on the QNEC rules, please refer to our blog called “What the Heck is a QNEC?”.

Although the ADP test fails based on a percentage calculation, excess contributions are returned 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 contribution refunds receive a Form 1099-R to facilitate their tax reporting.

Excess match contributions are called excess aggregate contributions. Refunds 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.

Untimely Corrections

Often, 403(b) plan sponsors are not aware that they are subject to the ACP test. When we get the audit work, they find out for the first time that they have not performed a required test. 401(k) plans may be late to correct the ADP and/or the ACP tests. If corrections were needed for previous years, they are late, but there is a solution to regain compliance.

There are two different methods to correct ADP and ACP mistakes beyond the 12-month period following the applicable plan year. Both methods require the employer to make a qualified nonelective contribution (QNEC) to the plan for NHCEs. A qualified nonelective employer contribution (QNEC) is an employer contribution that is always 100% vested and subject to the same distribution restrictions as elective deferrals.

• Method 1:
  • Determine the amount necessary to raise the ADP or ACP of the NHCEs to the percentage needed to pass the tests.
  • Make QNECs for the NHCEs to the extent necessary to pass the tests.
    • You must generally make QNECs for all eligible NHCEs.
    • These contributions must be the same percentage for each participant.
• Method 2 – one-to-one method:
  • Excess contributions (adjusted for earnings) are distributed to the HCEs.
    • The excess contribution is not eligible for favorable tax-free rollover. The refunded excess contribution is taxable to the HCE in the year of distribution, as reported on a current Form 1099-R.
  • That same dollar amount is contributed as a QNEC to the plan and allocated based on compensation to all eligible NHCEs.
    • Matching contributions (and earnings) related to the excess contributions distributed to the HCEs are forfeited.
• If the Plan provides for catch-up contributions, the refund may be recharacterized as a catch-up contribution (up to the catch-up limit) provided:
  • The affected HCE participant is age 50 or older, and
  • The participant has not already used up the catch-up limit for the year.

Don’t Believe the Hype!

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. HCEs can be blind-sided by these tools and publications that do not always take discrimination testing into account when pushing for maximum deferral contributions of $23,000 or $22,500 for 2024 and 2023 respectively.