Ideas to Help You Pass the ADP and/or ACP Testing


By Stephanie Reagan

Tips to Help Pass the ADP and/or ACP Testing

1. Otherwise Excludable Employee Disaggregation

[I.R.C. § 410(a), Reg. § 1.401(k)-1(b)(4)(iv), 1.410(b)-6(b)(3), 1.410(b)-7(c)(3), I.R.C. § 401(k)-3(F), 401(m)(5)(C)]

Otherwise excludable employees are employees who are plan participants whose age or service (or both) are less than the statutory maximum age and service requirements (age of 21 or the date on which he or she completes 1 year of service) and they have not met the statutory entry date. The statutory entry date is the earlier of (1) the first day of the next plan year or (2) six months after the age and service requirements are met.

To encourage early participation in retirement plans, the government allows employers to treat a plan that allows otherwise excludable employees to be essentially excluded for purposes of the ADP test and ACP test by either:

  • Dividing the discrimination test into two testing groups - one group is the otherwise excludable employees; the second group would be all other eligible employees. Then employer may test each group separately for purposes of coverage and nondiscrimination, 1.401(k)-1(b)(4)(iv), 1.410(b)-6(b)(3), or
  • Testing all of the Highly Compensated Employees ("HCEs") (including the otherwise excludable HCEs) with all the eligible employees excluding the otherwise excludable Non-Highly Compensated Employees ("NHCEs").  [I.R.C. §§ 401(k)-3(F), 401(m)(5)(C)]

This method helps the tests to pass because generally employees in their first year of employment are not HCEs unless they are 5% or more owners and they tend to not participate in elective deferrals.

2. Top-paid group election [I.R.C. § 414(g)(3)]

This provision is great for employers with large numbers of HCEs.  In general, the top 20% of employees, with the highest Code Section 415 compensation paid during a given year, are considered members of the top-paid group once the top-paid group election is made.

An employer may make a top-paid group election for a determination year. The effect of the top-paid group election is that an employee (who is not a 5-percent owner) with compensation in excess of $115,000 (adjusted for inflation) for the look-back year is an HCE only if the employee was in the top-paid group for the look-back year. A top-paid group election, once made, applies for all subsequent determination years unless changed by the employer.

Please note that this top-paid election isn't as easy as it sounds.  You have to have really good census data to elect this provision since:

  • The election made by an employer must apply consistently to the determination years of all plans of the employer that begin with or within the same calendar year;
  • Use Code Section 415 to determine compensation for the look-back year; and
  • To determine the top 20%, you look to anyone who performed services for the employer during the look-back year even if they are not eligible to participate in the plan. In determining the top-paid group, one may exclude employees who:

o   Were employed fewer than 6 months at the end of the year

o   Did not attain age 21

o   Normally worked fewer than 17 ½ hours per week

o   Normally worked fewer than seven months during the year

o   Were covered by collective bargaining agreements ( only if such employees made up 90 percent or more of the total employees and they were not covered under the plan)

3. Testing Compensation used in the ADP and ACP discrimination tests

Consider changing the definition of testing compensation to the Form W-2 Box 5 compensation less employee deferral contributions - this compensation change generally increases the Non-Highly Compensated Employees (NHCEs) deferral rates and/or matching rates more than it would be for the Highly Compensated Employees (HCEs) thereby helping the tests pass or flunk by a lower margin.

4. Use of the Prior Year Testing Method

In general, it is not a great idea to use the Prior Year Testing Method.  Employers use the Prior Year Testing Method so that they can curb the current year HCE contributions to a the prior year NHCE ADP and/or ACP percentage.  Given that the ADP and ACP tests are each a two pronged test - determining the amount of HCE refunds based on the HCE percentages and then making refunds from the highest of HCE contributions - HCE refunds would vary depending on the current years' HCE percentages and dollar amounts of deferral contributions each HCE made.  Accordingly, If a HCE were to limit his or her contributions based on prior year testing NHCE percentage results, the HCEs may lose out on deferral contributions actually being allowed to be kept in the plan and more importantly, they may lose their share of matching contributions either allowed to stay in the plan or be refunded to them. 

Let me explain...a plan can state that when there is an ACP test matching contribution refund, the vested match may be refunded to the participant rather than forfeited to the plan.  Thus, this is extra compensation that the participant would not have received otherwise had they not contributed to the plan.  Plus, the refunds of employee deferrals are refunded with earnings and gap period earnings can stay in the plan,

So why use Prior Year Testing if the HCEs should ignore the NHCE percentage results from the prior year anyway?

5. Use of QSLOBs[ Code Section 414(r)]

In a case where a controlled group employer has all of the companies participating one 401(k) plan, if the plan does not pass the ADP or ACP test as a whole, you can consider dividing up the companies into QSOBs under Code Section 414(r).  As a result of a QSLOB Election, each of the QSLOB will be further segregated for purposes of the minimum coverage requirement by qualified separate line of business.  The portion of the 401(k) Plan feature relating to the employees of a particular qualified separate line of business will be treated as a separate “plan” for purposes of applying the minimum coverage requirement.  As a result of this separate testing, the employer will be able to apply the ADP and ACP tests separately for each QSLOB thereby possibly having some or all of the QSOBs of the employer pass the testing after disaggregation. 


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