My plan failed the Average Deferral Percentage ("ADP") test; what happens next?
There is no reason for panic or alarm. The IRS requires this test annually to ensure that the plan is considered ‘balanced’ in how employees use it; it is not unusual for higher compensated employees to save more on average than rank-and-file employees -- but regulations require that the balance does not skew too far in their favor. If your plan falls out of balance, it is fairly easy to resolve and avoid any negative long-term consequences and penalties. Read the below article to assist you in understanding your options.
Review the ADP test results on the sponsor portal by logging in & going to My Plan > Annual Testing > Test Results. Review the test results and make sure you agree with:
- The group of employees listed as eligible for the plan year.
- The group of employees was determined to be Highly Compensated Employees (“HCEs”). To see how this is determined, see the What Is Compliance Testing article.
- The group of employees was determined to be non-Highly Compensated Employees (“NHCEs”). To see how this is determined, see the What Is Compliance Testing article.
- The deferral amounts for each employee.
- The compensation amount for each employee.
The accuracy of the compliance tests is dependent on the above items being correct. If Vestwell records were used to complete the testing and determined that the records were not accurate, the test results may change. If you notice any errors or updates, please email us, and we can update the records and revise the test. There will be a charge of $150 per hour for revised testing based on data changes. Therefore, it is in your best interest to ensure all information provided to Vestwell is accurate when submitting the census and year-end questionnaire.
The test results report will show the two correction methods available to you:
- Refund (Distribution) Method.
- Employer Contribution Method.
Refund Method - I want to correct this by refunding (distributing) excess amounts to impacted employees; how does this work?
The test results will show the total amount of corrective distributions per HCE. Once Vestwell receives confirmation to proceed with the refund method, a check will be issued to each affected HCE for their respective corrective distribution amount. Once the corrective distributions have been refunded, they are included as income and no longer qualified retirement money. This means:
- The corrective distributions are not eligible for rollover into a qualified retirement plan.
- The corrective distributions are not subject to the 10% penalty tax for normal pre-retirement distributions.
- The corrective distributions will be subject to ordinary income tax.
- The corrective distributions will be reported via 1099-R for the year of distribution (not the year deferred).
To expand on the last point, the IRS requires the corrective ADP refund distributions to be included as taxable income in the year the check is received. This means that if a plan:
- Failed the ADP test for the 2023 plan year and
- Chose to use the refund method to correct the failure and
- Had corrective distributions in a timely manner by March 15, 2024.
The HCE would receive a check for the corrective distributions in March 2024 with no change to their 2023 W-2. The HCE would receive a 1099-R in January 2024 for use in preparing their 2023 income taxes. The corrective ADP refund distribution is reported as taxable income for the 2024 year, NOT 2023.
What happens if the refunds are distributed after March 15th?
If corrective distributions are refunded after March 15th, the taxation described above does not change; however, the sponsor is responsible for paying a 10% excise tax on the total amount of corrective distributions. Vestwell will prepare the required Form 5330 on behalf of the sponsor and calculate the total excise tax amount. Form 5330 and a check for the excise tax amount must be mailed to the IRS for the failure to be considered correct in full.
Please note: these timeframes describe deadlines associated with plan years ending December 31, 2023. Due dates for ADP test refunds are dependent on the date the plan year ends.
QNEC Method - I want to make an Employer Contribution to avoid refunds to my employees. How does that work?
Vestwell can alternatively calculate an additional employer contribution for non-highly compensated employees, called a QNEC, to bring the test to a passing level. The sponsor will need to weigh the economics of making QNECs as an employer cost versus the cost to highly compensated employees receiving refunds for the year, increasing their taxable income.
Note that QNECs must be 100% vested, regardless of the employee’s length of service. To note, the Plan’s forfeiture balance may be used to pay for some or all of the QNEC. QNECs must be deposited to the plan no later than 12 months following the close of the plan year for which they are allocated - meaning, by December 31, 2024, if made for the plan year ending December 31, 2023. The employer may typically take a deduction as a business cost for the QNEC contribution amount not funded by forfeitures.