Each year, qualified 401(k) plans are required to pass the Actual Deferral Percentage (ADP) test, which is designed to ensure retirement benefits do not disproportionately favor highly paid employees. Should the plan fail, HCEs might be subject to refunding the plan in order to maintain plan compliance.
We’re here to help! Below are our nine recommended ways to proactively design a retirement plan that will help maximize NHCE engagement and participation to ultimately avoid ADP failure:
- Know Your HCEs. Many plan sponsors do not realize that by changing the framework of their HCEs, they can potentially reduce the number of employees who fall within this category. As defined by the IRS, HCEs are individuals who either owned more than 5% of the interest in the business at any time during the current or proceeding year regardless of compensation earned, or who received more than the IRS’ HCE allotted compensation for the proceeding 12-month period ($120,000 for 2016).
Additionally, the top-paid group election can be elected from year to year (the plan document must reflect this change) and permits employees in the top 20% as ranked by compensation to be considered HCEs.
By playing with these options, plan sponsors can improve their NHCE to HCE ratio and therefore better their chances of passing the ADP test.
- Permissive disaggregation. Plans may separately test participants who have not yet met the maximum allowable IRS eligibility rules (age 21, one year and 1,000 hours). For plans that fail the ADP test with all eligible participants included (the standard test), the next step is to run the test using permissive disaggregation (if plan eligibility is more liberal than the statutory requirements of age 21 and one year of service). This does not have to be consistent from year-to-year; plan sponsors can rely on otherwise excludable employee testing results this year and include all employees again next year.
- Current-year testing. For planning purposes, some plan sponsors have relied upon the prior-year testing method. This method compares the current-year deferrals for the HCE group to the prior-year deferrals of the NHCE group. The current-year testing method compares current-year deferrals for both groups. Switching to this method may provide better results as the participants become more aware of the need to save and as their growing income allows them to participate at higher contribution levels. It is important to note that any change in the testing method must remain in effect for five years—the plan can change to the prior year methodology at any time (assuming the plan is amended before year-end), however, the plan cannot change back to current year testing method for at least five years.
- Employer match. If the plan offers a match, stretch it. This provides extra motivation without increasing the plan sponsors’ financial commitment—employees can still receive the full match, while having an additional incentive to contribute a larger portion of their paycheck. Adjusting how the match is applied can be an easy way to increase participant contribution rates.
- Qualified Matching Contributions. Qualified Matching Contributions (QMAC’s) are matching contributions that meet certain distribution and vesting requirements. Even though these are matching contributions, so long as they are fully vested and follow the same distribution restrictions as employee deferrals, they can be “shifted” to help employers pass the ADP test or reduce refunds.
- Employee Education. An increase in participation of the NHCE group can help the ADP test. Promoting the plan to employees through enrollment meetings, payroll stuffers and other efforts will help increase awareness to NHCEs, urging them to enroll and/or increase their contributions.
- Qualified Non-elective Contributions. In certain situations, a failed ADP test can be corrected by having the employer make a “qualified non-elective contribution” (QNEC) on behalf of NHCEs to increase their ADP to the level needed for the HCEs to pass the test. QNECs are required to be immediately 100% vested and subject to withdrawal restrictions. However, this corrective method had proven to be extremely useful at times and may offer a low cost solution.
- Automatic Enrollment. Design features like automatic enrollment certainly addresse poor NHCE participation head on. When an employee becomes eligible, he or she is automatically put into the plan with a default contribution rate and investment strategy, unless the employee opts out or makes an affirmative election to contribute at a different rate. Studies have proven most employees don’t opt out and by re-enrolling existing plan participants, plan sponsors can dramatically improve NHCE participation rates, literally overnight.
Some plans take automatic enrollment a step further by increasing the default contribution rate at set intervals (automatic escalation), for example starting at 3% and increasing it at the start of each subsequent year by 1%, some, up to a maximum of 10%.
- Safe Harbor Plans. Organizations that want to avoid ADP test failures altogether, should consider a safe harbor arrangement. These are special types of 401(k) plans that are not subject to ADP testing. Plan sponsors can make either a safe harbor non-elective contribution or a safe harbor matching contribution to satisfy the IRS’ 401(k) non-discrimination regulations. A safe harbor contribution must apply to at least all eligible NHCEs, and may exclude HCEs from the allocation.
So, how can plan sponsors avoid ADP failure and associated refunds? Retirement plan advisors can help plan/investment committees develop strategies that will minimize the impact of, or even eliminate the need for, refunds. Often times, it’s the committee members who are also the HCEs who feel the pain of having to return all or a portion of their annual deferrals after a failed test. Rather than focusing on the correction, let us proactively help you increase NHCE contributions as a way to avoid the failure in the first place.
