BEI- News Releases

How can you correct an ADP Failure

Posted on Wednesday, January 17, 2007

Abstract: Many qualified plans allow participants to borrow from their retirement assets and repay the amount with interest to their own accounts. Trouble is, those who do so often understand neither the rules nor the ramifications of the transaction. This article explains what plan administrators should tell their participants about the fine print of qualified plan loans.

The savings decisions of other participants in a retirement plan can limit how much highly compensated employees (HCEs) can save tax-deferred.

The Employee Retirement Income Security Act (ERISA) requires plans to pass an annual actual deferral percentage (ADP) test that determines a limit for the average of the HCE deferral percentages based on the average of the deferral percentages of nonhighly compensated employees (NHCEs). If your plan fails the ADP test, you must make a correction within 12 months of the plan year end.

To make a timely correction, use one of the following alternatives, subject to your plan's provisions:

Contribution refunds. Return HCE deferrals. To determine the total returnable amount, you reduce the highest HCE percentages until the plan passes, but then the refunds are made to the HCEs with the largest deferral amounts. You must distribute earnings attributable to the excess contributions.

If the plan makes refunds within 2½ months of the plan year end, they're generally taxed in the year the deferrals were made. But refunds made after this date are taxed in the year distributed and the company must pay an excise tax.

QNECs or QMACs. Make a qualified nonelective contribution (QNEC) or shift qualified matching contributions (QMACs) to the ADP test. Doing so increases the NHCE deferral percentages enough to pass.

All QNECs and QMACs must be immediately 100% vested and are subject to the deferral distribution rules. Nonelective contributions must satisfy the nondiscrimination testing with and without the QNECs. Starting in 2006, regulations place restrictions on how you can allocate QNECs and prohibit the shifting of some QMACs.

Recharacterization. If the plan allows after-tax contributions, "recharacterize" excess contributions as such within 2½ months of the plan year end. The participant is then taxed on them and they are included in the actual contribution percentage (ACP) test.

HCEs may be able to maximize deferrals and avoid correction if the plan increases NHCE participation. But if your NHCE participation is low, check whether it meets ADP requirements or make one of the suggested corrections.