Congress has devised several types of nondiscrimination tests designed to prevent qualified retirement plans from favoring highly compensated employees (HCEs) disproportionately. One such test is the average deferral percentage (ADP) test. The ADP test is required to be performed annually and entails the use of mathematical formulas to compare the elective deferral rates of HCEs and non-HCEs (NHCEs) and to determine whether the plan is discriminating in favor of the HCEs.
Who is an HCE?
Generally, an HCE is an employee who is either:
- A more-than-5% owner of the business (also known as a 5% owner) in the year of testing or the prior year, or
- Someone who earned more than $80,000 in compensation in the prior year, as adjusted annually for cost-of-living increases. For 2015, the cost-of-living adjusted limit is $120,000.
It is possible to further limit the number of HCEs to those in the top 20% of employees when ranked by pay (which can be a particularly effective tactic for small employers, such as law firms and physicians).
All in the family
The 5%-owner rule requires careful review of the ownership attribution rules for families. Based on their relationship, an individual is deemed to own the stock of a corporation owned by other family members. The family members taken into consideration for purposes of determining attribution of ownership include spouses, parents, children (including adopted children) regardless of age, and grandchildren. An individual can also be deemed to own the stock held by partnerships, corporations, estates, and trusts.
Here’s an example of how the family attribution rules work: If a husband and wife each work for a firm and the husband is actually the sole owner, the wife would also be considered a 100% owner of the business and, thus, an HCE.
Performing the test
To perform the ADP test, first determine all of the employees who were eligible to make elective deferrals during the plan year. It does not matter if an employee actually made an elective deferral but only whether the employee was eligible. Divide the eligible employees into HCEs and NHCEs.
Then, starting with the NHCEs, determine each employee’s actual deferral ratio (ADR) by dividing the employee’s elective deferrals for the plan year by the employee’s compensation. Employees who were eligible but did not defer are included in this calculation at 0%. Once each NHCE’s ADR is determined, the ADRs are averaged to arrive at the ADP for all NHCEs. Here’s an illustration:
NHCE
|
Compensation
|
Deferral
|
ADR
|
1
|
$70,000
|
$4,000
|
5.71%
|
2
|
$28,000
|
$0
|
0%
|
3
|
$30,000
|
$800
|
2.67%
|
4
|
$10,000
|
$0
|
0%
|
5
|
$47,000
|
$2,000
|
4.26%
|
NHCE ADP (5.71% + 0% + 2.67% + 0% + 4.26%) =12.64 ÷ 5 = 2.53%
The same process is used to arrive at the ADP for all HCEs.
For a plan to pass the ADP test, the amount by which the HCE ADP exceeds the NHCE ADP is limited. The limits may be summarized as follows:
NHCE ADP
|
Maximum HCE limit
|
0 to 2%
|
NHCE limit × 2
|
2% to 8%
|
NHCE limit + 2
|
> 8%
|
NHCE limit × 1.25
|
For the plan to pass the ADP test, the HCE ADP is limited to 4.53% (NHCE ADP) plus 2%.
Timing the test
A failed ADP test must be corrected within 12 months after the end of the plan year to avoid disqualification of the plan. To avoid a 10% excise tax on an excess contribution, either the excess contribution (and the applicable earnings) must be refunded within two and a half months (six months for an eligible automatic contribution arrangement) following the end of the plan year, or additional contributions must be made to the plan.
Other factors
This is the big picture of how the ADP test is performed. There is a variety of additional factors to be taken into consideration to optimize the test results.
Copyright © 2016 by NPI and McKay Hochman.
