By Yariel Chiong & Tobi Cogswell
The Internal Revenue Service (IRS) requires qualified retirement plans to undergo different compliance tests depending on the type of plan. For 401(k) plans one of those tests is the ADP/ACP test, which stands for actual deferral percentage/average contribution percentage. The purpose of the test is to determine if there is discrimination against non highly compensated employees (NHCE’s) in favor of highly compensated employess (HCE’s). The HCE’s are normally any greater than 5% owners and anyone who earned more than $110,000 in the prior year (this amount is indexed each year).
ADP/ACP tests are run annually, but you may wish to run an “interim”, or snapshot test that will tell you if you need to reduce the HCE deferrals for the rest of the year. It may also tell you if the HCE’s can increase their deferrals. Why leave a single dollar undeferred and subject to tax by Uncle Sam.
For example: A 401(k) plan that has 12 NHCE’s and 5 HCE’s.
As of 6/30, the actual deferral percentage for the 12 NHCE’s is 2.4% (participation has been poor).
The actual deferral percentage for the 5 HCE’s is 3%. They’ve had test failures in past years so they are deferring very small percentages.
Based on this example, the HCE’s could actually be putting in up to an average of 4.4%, yet they are at 3%.
There are ways to increase percentages closer to the end of the year with change dates, amendments to allow special deferrals during the month of December and so forth. But as we end June, now is the perfect time to do an interim test for calendar year plans.
Most TPA’s and bundled recordkeepers do charge for an interim test. The plan sponsor needs to weigh the cost of the interim test against the planning opportunities of allowing their HCE’s to put more money away in their retirement plan. Contact your consultant or administrator for more information on performing an interim ADP test.
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