401(k) Plan ADP/ACP Testing

What is the ADP test?
ADP stands for Average Deferral Percentage. 401(k) plans are required to perform this test each year. To maintain their tax-qualified status, the test must be passed.

Very briefly, to perform the test, the employer divides the employees into two groups: Highly Compensated Employees and Non-Highly Compensated Employees. The percentage of salary contributed to the plan is calculated for each eligible employee, and these percentages are then averaged for each group. The average percentage for the Highly Compensated Employees may exceed the average percentage for the Non-Highly Compensated, but only by a limited amount. If the difference is too great, the percentages must be adjusted until the test is passed. The most common way to do this is by refunding contributions made by Highly Compensated Employees. Other methods include increasing plan contributions to Non-Highly Compensated Employees, depending on the specific plans.

Who are Highly Compensated Employees?
Highly Compensated Employees are generally those employees who own more than 5% of the company, or who earned over $110,000 (indexed for 2011) from the company in the preceding year.

How are the refunded contributions determined?
The IRS has specific rules on how the refund amounts are calculated. The refunds begin with the Highly Compensated employee with the highest dollar amount contribution. His or her contribution is lowered first, to the dollar level of the next highest employee. Then both contributions are lowered together until reaching the next highest employee’s dollar level, and so on, until the total dollar amount of refunds returned equals that determined under the IRS procedures for calculating the refund amount. It is important to note that the employer cannot determine who gets a contribution refunded. It is determined only by IRS rules.

What are the tax effects of the contribution refund?
The intended effect of the refund is to restore each participant and the plan to the financial position they would have been in had the contributions been limited to pass the test in the first place.

With the passing of the Pension Protection ACT of 2006, the refunds, regardless of when they are distributed, are taxable to the participant as compensation in the year that the distribution was made .  Please note that this is a change from prior years and will be effective for plan years beginning after 1/1/2008.  The refund contributions will include a small adjustment for any investment earnings during the year to put the plan in the same position it would have been in had the contributions not been made in the first place. If the refund is not distributed within 2½ months of the year-end, they must still be distributed within 12 months of the year-end, however, the excess contributions are subject to a 10% excise tax assessed on the plan sponsor. It is important that the ADP testing be done soon enough to allow time for the plan’s investment provider to pay these refunds within the 2½-month time frame to avoid this excise tax.

A contribution refund is not an IRS penalty; it is merely an adjustment to the affected employees’ plan contributions. The employees still benefit from the tax-deferral on the contributions not refunded. This adjustment preserves the tax-qualified status of the plan, and the tax deferral of contributions and earnings that remain in the plan. The fact that a refund is necessary is not an indication of some failure on the part of the plan sponsor or administrators; it is just an adjustment to limit the contributions of the Highly Compensated employees to the appropriate amount as specified in the Internal Revenue Code

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