Don’t let your 401(k) plan fail the compliance tests! One excellent reason is to keep as much money in the plan as possible—especially for the Highly Compensated Employees (HCEs), which is probably you if you’re reading this.

When we talk about the failure of a 401(k), it usually means the plan is not in “compliance,” which means it fails the compliance tests. This post will answer these questions:

  • What is a compliance test?
  • Why do plans sometimes fail the compliance test?
  • If you fail, what does that mean?
  • How can you avoid failing?

What is a compliance test?

Two tests the IRS uses for 401(k) compliance are the ADP (Average Deferral Percentage) and the

ACP (Average Contribution Percentage) nondiscrimination tests. In this guide, “401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests,” the IRS suggests annual tests as follows. “…Plan sponsors must test traditional 401(k) plans each year to ensure that the contributions made by and for rank-and-file employees (Non-Highly Compensated Employees (NHCEs)) are proportional to contributions made for owners and managers (Highly Compensated Employees (HCEs)).” The calculations to assure compliance are on the website.

Why do plans sometimes fail the compliance test?

Sometimes, companies’ plans fail the test because the plan administrators fail to plan. One of the failures comes from an improper classification of highly compensated and non-highly compensated employees. That can happen on the front end—when an employee is enrolled in the 401(k) plan because of a clerical error. Or it can occur throughout the year as people are demoted or elevated to different classifications, and they are not changed in the 401(k) system at the same time.

If we fail, what does that mean?

The ADP and ACP tests are used to make sure your lower rank employees (non-HCEs) contribute to the plan because if they don’t, the owner or highly compensated employee will be penalized by having to return the deferral you’ve contributed no matter how small.

Moreover, the IRS has the following (and more) to say about fixing the mistake (failing the ADP/ACP tests), and what happens if you do not.

“The plan has 2 ½ months after the end of the plan year being tested to correct excess contributions. The plan can distribute excess contributions at any time during the 12-month period. If correction is not made before the end of the 12-month correction period, the plan’s cash or deferred arrangement (CODA) is no longer qualified, and the entire plan may lose its tax-qualified status.”

Losing the tax-qualified status is not the end, either, If the error is not repaired, “the employer is liable for a 10 percent excise tax on excess contributions.”

How can you avoid failing?

One of the ways to avoid failing is to become a safe harbor plan, which automatically passes the ADP/ACP testing. We can suggest several ADP/ACP testing options that are available. Also, employers must make sure non-HCE employees are participating.

Safe-harbor plans include the following available plan features:

  1. Have a safe-harbor match: The employer must at least match 100% of 401(k) on the first 3% of compensation plus 50% of the 401(k) on the next 2% of compensation. That’s a 4% total, and this is a minimum. Employers can be more generous to keep employees happy.
  2. Include a Safe Harbor Nonelective: The contribution must be 3% (or more) of compensation and be made to all eligible non-HCEs, REGARDLESS OF whether they made a 401(k)-plan contribution to the plan.
  3. Set up a QACA (Qualified Automatic Contribution Arrangement) match: If the plan meets certain AUTOMATIC ENROLLMENT REQUIREMENTS, then the employer must at least match 100% of 401(k) on the first 1% of compensation plus 50% match of 401(k) on next 5% of compensation (total of 3.5%).

What ADP/ACP testing options are available?

Sometimes one or another will help pass the testing and mitigate corrective amounts.

  1. Top-Paid Group (TPG) election: 401(k) plans are permitted to limit the HCE group to those in the top 20% of all employee compensation. This means some HCE’s can move down to the non-HCE section and can pass the test!
  2. Current-year testing method: You can choose to test against the current year or prior year non-HCE group.
  3. Permissive disaggregation: If your plan has better eligibility requirements than the law requires. Law requires one year of service and age 21. But if your plan allows immediate eligibility, for example, the plan then has the option to test the participants that met the eligibility requirement, but not the legal limits, separately.

How do you increase the non-HCE participation?

We have a few suggestions for that.

  1. Participant Education: Employers can make lots of free education available for workers. Studies have shown that non-participation is often due to a lack of knowledge about the programs and the value of a retirement plan in the first place.
  2. Automatic Enrollment: Employees are automatically enrolled in the plan at the `default rate – which is the minimum rate of employer contributions required by ERISA.
  3. Employer Match*: Employees are more likely to participate if the employer invests in them by putting money in the form of a match into the employee’s 401(k). It’s like free money.

*Remember, for this one, the employer can set up a vesting schedule, so if the employee leaves before they are vested, they can’t take that matched money with them.

Our Recommendation

Don’t let your plan fail the compliance tests. It could be expensive to fix it if fines are levied. Furthermore, a failure undermines your employees’ trust and can derail your own retirement plans. Don’t let it be shut down for failing to correct errors. Make sure it does not fail by taking some of the steps we’ve mentioned. The goal is to keep as much money in the plan as possible for you (as the HCE) and your non-HC employees.

And as always, please get in touch with your CPA and/or your plan administrator if you have questions.