At this time of year retirement plan providers are busy completing the annual Actual Deferral Percentage (ADP) tests for qualified retirement plans which contain a salary deferral or Roth 401(k) component. This test in particular can be very impactful to certain plan participants. This is a non-discrimination test for 401(k) plans mandated by the Internal Revenue Service (IRS) to ensure that a plan does not unduly benefit highly compensated employees (HCE) at the expense of other employees. It is one of many tests in the suite of compliance testing that Greenleaf Trust prepares on behalf of our retirement plan clients. Under the ADP testing rules, the average employee contributions (both pre-tax salary deferrals and Roth 401(k) contributions) of the highly compensated employees and non-highly compensated employees (NHCE) are calculated and compared on an annual basis based on the plan year. To pass the test, the ADP of the HCE group may not exceed the ADP for the NHCE group by 1.25 percent or 2 percentage points. If the plan fails the ADP test, corrective action must be taken to protect the qualified status of the plan arrangement. The law and related regulations provide various methods for correcting failures during a “correction period.” This statutory correction period is the 12-month period following the close of the plan year in which the failure occurs. If corrective distributions are made after the first 2 ½ months of the correction period, the employer (not the HCE) is liable for excise tax. If correction is not made within the correction period, the plan is considered disqualified. In essence, however, it is important to note that there is no inherent problem with failing the test as long as corrective action is taken within the proper time frames.

Failing this test can inhibit employee contributions to a 401(k) plan by individuals who meet the criteria and are considered highly compensated. Receiving a distribution of previously deferred compensation dollars including any gains or losses is often not well received by most individuals who may be impacted following an ADP test failure.

One solution to this problem is to incorporate a safe harbor provision to the plan. This option, while adding costs, would alleviate the requirement for completing the annual ADP test, thus allowing all HCE’s to defer the maximum amount allowed by law and no returns of contributions would be required. There are two basic options for a safe harbor contribution provision.

3% Safe Harbor Non-Elective Contribution

Basic or Enhanced Safe Harbor Matching Contribution

The first option is a 3% mandatory employer contribution to all eligible participants based on compensation. Some things to consider regarding this option include:

  • All participants who have met the plan’s definition of eligibility share in this contribution regardless of whether they terminate within the plan year or work less than 1,000 hours.
  • The Safe Harbor Non-Elective Contribution source is immediately vested in the participant’s account (cannot attach a vesting schedule).
  • Generally, the 3% Safe Harbor Non-Elective Contribution may satisfy a top heavy mandatory contribution requirement.
  • This contribution can be easier to budget as it is a straight percentage of compensation.

The second option is a mandatory employer matching contribution which is composed of different tiers based on the basic or enhanced design. A few things to consider with this option are:

  • The Safe Harbor Matching Contribution is only made for those participants who are contributing pre-tax salary deferrals or Roth 401(k) dollars into the plan.
  • Participants who contribute would share in the Safe Harbor Matching Contribution regardless of whether they terminate within the plan year or work fewer than 1,000 hours.
  • The Safe Harbor Matching source is also immediately vested in the participant’s account (cannot attach a vesting schedule).
  • This contribution may not satisfy any top heavy mandatory contribution.
  • This contribution is more difficult to budget as costs could potentially be high if everyone participates in the plan to the fullest extent.
  • The basic safe harbor employer match formula is 100% of salary deferrals up to 3% of compensation deferred plus 50% of salary deferrals up to the next 2% of compensation deferred.
  • The safe harbor employer matching contribution option requires an annual notice which must be provided to all employees no later than 30 days prior to the beginning of the plan year. Ongoing, on an annual basis, a plan sponsor must declare that the plan will be a safe harbor design.

Another solution to the problem of failing this annual test is to add an automatic enrollment feature to the plan. With proper plan documentation and notification to plan participants, this feature allows a plan sponsor to automatically deduct an allowable percentage from a participant’s compensation into the plan. Automatic escalation provisions are also permitted which allows an annual increase of such deferrals of generally one percent. This option is beneficial in multiple ways. It helps with the inertia or inaction of employees to start saving in the qualified retirement plan. Additionally, by automatically enrolling plan participants into the plan, the deferral rate for those not previously participating will increase and, over time, likely lessen the effects of the ADP test failure or remove the failure entirely.

The Retirement Plan Division team would be happy to discuss this test and other non-discrimination tests and options at any time. Please contact us for more information.