The ABCs of ADP testing

Most any employee benefit plan sponsor has seen the term “actual deferral percentage” (ADP). But what exactly does it mean, and how does it affect your plan? It’s a test that all plan sponsors need to be aware of. In fact, the IRS requires qualified retirement plans to comply with ADP requirements — with consequences for failure to do so.

Calculating ADP

The ADP nondiscrimination test compares the average salary deferral percentages for highly compensated employees (HCEs) to the average salary deferral percentages for nonhighly compensated employees (NHCEs) within a plan. For 2011, an HCE is an employee with more than $110,000 in 2010 compensation or an employee who owned more than 5% of the business during 2010 or 2011. The test ensures that the percentage deferred by HCEs in comparison with that deferred by NHCEs is within the IRS limits.

The IRS includes both pretax elective deferrals and designated Roth contributions in the ADP test. But the regulations exclude catch-up contributions. The test also includes anyone eligible to participate in the plan whether or not they defer and regardless of whether they’re active or terminated.

You calculate the ADP for each person by dividing their total annual deferral amount into their annual compensation for the plan year. (An eligible participant who elects not to participate has an ADP of zero.) Then you determine the average for the HCEs as a group and the NHCEs as a group.

Passing the test

To pass ADP testing, the general rule is that the HCE average cannot exceed the NHCE average by more than 2%. But the Internal Revenue Code (IRC) specifically states that the HCEs’ ADP must not exceed the greater of:

  • 1.25 times the ADP for NHCEs, or
  • The lesser of two times the ADP for NHCEs or the ADP for NHCEs plus two percentage points.

Unless the plan document specifically states otherwise, the IRC allows plans to measure the HCEs’ current year deferrals against the prior year’s NHCE deferrals. This approach, called the prior year testing method, helps minimize the potential for a failed test because the HCEs know what their ADP limit is for the current plan year.

If the plan document states that you must use the current year testing method, you can perform a projected ADP test midyear to help estimate the current year ADP limit. This estimate allows HCEs to adjust their deferral percentages in an effort to pass testing.

Correcting mistakes

Plan sponsors must correct a failed ADP test by March 15 of the year following the plan year for calendar year plans or within 2½ months after the close of the plan year for fiscal year plans. If the sponsor chooses to deposit a qualified nonelective contribution (QNEC), they have the statutory correction period to make the deposit (by no later than Dec. 31, 2011, for a failed 2010 test).

To bring the plan into compliance, the IRC provides two correction methods for a failed ADP test:

1. Distribute excess contributions to HCEs. Doing so will bring down their average salary deferral percentages enough to pass. The return of excess contributions to the HCEs is a taxable distribution to the individual in the distribution year. If an HCE is over age 50, some or all of the regular contributions may be reclassified as catch-up contributions, lowering the amount to be refunded.

If you use this method, you must do so by March 15 of the year following the plan year. If not, the plan sponsor must pay a 10% excise tax on the total amount of excess contributions.

2. Contribute a QNEC to some or all NHCEs. This is immediately 100% vested and brings up the NHCE average salary deferral percentage enough to allow the HCEs to keep their deferrals in the plan. You must deposit the QNEC no later than Dec. 31 of the year following the close of the plan year in which the mistake occurred.

The plan administrator will determine the best method of correction depending on individual circumstances for each plan and employer. The method of correction doesn’t have to be the same each plan year of failure.

Knowing your employees

Educating employees about the benefits of retirement saving can help encourage more plan participation and help those already participating to increase their deferral contributions. This, in turn, can help your plan pass future ADP testing.