To demonstrate that their plans do not discriminate in favor of highly compensated employees (HCEs) over non-HCEs (NHCEs), many plan sponsors are required to have Actual Deferral Percentage/Actual Contribution Percentage (ADP/ACP) nondiscrimination tests performed on their retirement plans. In the instances where plans fail those tests, a distribution of corrective refunds to a certain number of the HCEs will be required for those plans to remain in compliance as qualified plans with the IRS.

According to Eric Droblyen from Employee Fiduciary, it is quite common for certain types of plans to fail their ADP/ACP tests. Because saving for retirement can be a high priority for employees and their employers alike, receiving corrective refunds from a retirement plan can cause frustrations to all parties involved. Here are six methods plan sponsors can use to reduce or eliminate nondiscrimination testing refunds:

1. Giving a QNEC or QMAC to all eligible NHCEs

A Qualified Nonelective Contribution (QNEC) is a 100% vested employer contribution that plan sponsors can provide to all eligible NHCEs. A Qualified Matching Contribution (QMAC) is a 100% vested employer contribution that plan sponsors can provide to all eligible NHCEs as well. QMACs are like QNECs in how they are provided to employees, but while QNECs are based on the percentage of an employee’s compensation, QMACs are based on the percentage of an employee’s elective deferrals.

In plans that use the current year testing method, the deadline for giving QNECs and QMACs is the last day of the plan year following the year that was tested (e.g., for a testing failure on December 31, 2022, the QNEC/QMAC deadline would be December 31, 2023). In plans that use the prior year testing method, the deadline will be the last day of the plan year being tested (e.g., for a testing failure on December 31, 2022, the QNEC/QMAC deadline would be December 31, 2022). QNECs and QMACs can be treated as employee deferrals and employer contributions so that plan sponsors can use them to correct both the ADP and ACP tests.

If a plan sponsor’s priority is preventing HCEs from having to receive corrective refunds and additional taxable income, then the use of QNECs and QMACs is a favorable alternative.

2. Using the one-to-one correction method

An alternative (and less expensive) method to giving QNECs and QMACs is to apply the one-to-one correction method. One-to-one corrections become an option after the 12-month period that applies to standard QNECs and QMACs. The first step under this method is for a plan sponsor to distribute ADP/ACP testing refunds to the necessary HCEs, plus any earnings. The second step is to provide QNECs or QMACs to the NHCEs that are of equal value to the testing refunds that were given to the HCEs. The plan sponsor can provide QNECs or QMACs to one of the following groups of NHCEs:

• NHCEs who were eligible during the year of the testing failure.
• NCHEs who were eligible in the year of failure and eligible during the year the correction is completed.
• NHCEs who were eligible in the year of failure and are also employed on the date of the correction.
• NCHEs who were eligible in the year of failure and eligible in the year of the correction and who are still employed on the date that the correction takes place.

Because the one-to-one contribution would be applied more than two and a half months after the year of testing failure, excise taxes will apply. In addition, earnings on the contributions must be calculated from the end of the year of failure through the date of the correction as well.

3. Adopting the prior year testing method

When performing nondiscrimination tests, plans must either use the current year or prior year testing method. Under the current year testing method, current year deferrals and contribution amounts are used to determine the percentages of both HCEs and NHCEs. Under the prior year testing method, the prior year contribution percentages for NHCEs are compared to the current year HCE deferrals and contribution percentages. Utilizing the prior year testing method gives plan sponsors the advance knowledge of the ADP/ACP percentages that HCEs need to equal or average to pass testing in the current year, which reduces the chances of failing the tests at year-end.

4. Encourage NHCEs to enroll in their plans and/or increase their contribution rates

When plans have low NHCE participation rates the likelihood of testing failures dramatically increases. If plan sponsors can raise those rates, the margins between passing and failing test results can potentially decrease, thereby helping reduce or eliminate testing refunds.

Common reasons for low participation rates are that employees may lack understanding of the plan and its benefits, or they might be concerned about whether they can afford to raise their contribution rates. If plan sponsors can better educate their employees about the benefits of the plan and of saving for retirement, there is a greater potential for the NHCEs to either start contributing to their plans or raising their existing contribution rates.

Implementing or improving employer matching and vesting schedules is another way to increase employee plan participation. In addition, a default automatic enrollment contribution rate is another way to encourage retirement plan participation among employees. Increasing those rates in a periodic yet standardized manner will help plan sponsors achieve the goal of reducing or eliminating testing refunds.

5. Amending the plan to implement an HCE contribution limit

If efforts to increase NHCE contribution rates are not producing results, amending the plan to limit HCEs to a specific percentage or dollar rate that they can contribute into the plan is another viable way to improve test results and decrease the need for testing refunds.

Communicating to the HCEs that they could receive refunds that are taxable to them if they continue to contribute at their current rates may incentivize them to reduce their contribution rates willingly. This may be something to consider implementing prior to drafting a plan amendment.

6. Amending the plan to be a safe harbor plan

Safe harbor is a plan design that allows plan sponsors to bypass ADP/ACP nondiscrimination tests by making at least one of the following employer contributions to the plan:

• Basic match: 100% match of employee deferrals up to 3% of compensation followed by a 50% match of the next 2% of compensation.
• Enhanced match: 100% or more match of employee deferrals on no less than 4% and no more than 6% of compensation.
• Qualified automatic contribution arrangement (QACA) safe harbor match: 100% match on the first 1% of compensation followed by a 50% match on the next 5% of compensation.
• Nonelective safe harbor: Plan sponsor makes an employer contribution of at least 3% of compensation without an employee contribution requirement.

Other advantages to adopting a safe harbor plan design are the following:

• All employees can maximize their deferrals, according to permitted limits, without fear of ADP/ACP testing refunds.
• Safe harbor employer contributions are 100% vested.
• Having a safe harbor match can motivate employees to participate in the plan and/or increase their existing contribution rates.

If plan sponsors implement one or a combination of the six methods above, then their goal of reducing or eliminating nondiscrimination testing refunds can likely be achieved.

To review your specific situation, please contact your Milliman relationship manager or a Milliman Compliance consultant.

Additional information from the IRS on 401(k) plan types and the advantages of each can be found here:

https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-contributions

Droblyen, Eric (January 19, 2022). 401(k) Nondiscrimination Study — What % of Plans Fail? Employee Fiduciary. Retrieved November 2, 2022, from https://www.employeefiduciary.com/blog/401k-nondiscrimination-testing-study.