When 401(k) Plans Fail ADP/ACP Testing: What It Means and How to Fix It

Authored by Matt Waters

One of the most common compliance headaches for 401(k) plans is failing the ADP/ACP nondiscrimination tests. These tests are designed to ensure that highly compensated employees (HCEs), including owners, executives, and other top earners, aren’t the only ones benefiting from the plan while rank-and-file employees are left behind.

When a plan fails, the fallout can mean frustration for owners, tax headaches for employees, and extra administrative work. Let’s break it down.

How the Tests Work

• ADP (Actual Deferral Percentage) Test: Compares the average salary deferral rates of HCEs to those of non-HCEs.
  
• ACP (Actual Contribution Percentage) Test: Compares the average employer match and after-tax contribution rates of HCEs to those of non-HCEs.
  

Both tests limit how much more HCEs can contribute, relative to the rest of the workforce.

In practice: if lower-paid employees contribute little or nothing, the plan often fails because the averages for HCEs are disproportionately high.

Why Plans Fail

1. Low participation among non-HCEs
   
   • Employees either don’t understand the plan or don’t feel financially able to contribute.
2. High contributions from HCEs
   
   • Owners and executives max out contributions, but staff lags behind.
3. Plan design issues
   
   • No auto-enrollment, no match incentive, or outdated provisions that don’t encourage broad participation.

Correcting a Failed Test

If your plan fails, the IRS requires timely correction. The main options are:

1. Refunds to HCEs
   
   • Excess contributions (plus earnings) are returned to HCEs until the test passes.
     
   • Downside: Owners and executives lose tax-deferred savings, and the refunds are taxable.
2. Qualified Non-Elective Contributions (QNECs)
   
   • The company makes extra contributions to non-HCEs to raise their average and bring the plan into compliance.
     
   • These contributions are 100% vested and costlier for the employer, but they preserve HCEs’ full contributions.
     

Both corrections are time-sensitive. Missed deadlines can lead to penalties or even plan disqualification.

Plan Design Strategies to Prevent Failures

The best strategy isn’t fixing failures, it’s avoiding them altogether. Here are proven approaches:

1. Safe Harbor 401(k) Plans
   
   • The gold standard for avoiding ADP/ACP testing.
     
   • Employer makes a required contribution (either a match or 3% of pay to all employees), and in return, the plan is deemed to automatically pass the tests.
2. Automatic Enrollment & Escalation
   
   • Automatically enroll new hires at a set deferral rate (e.g., 4%) with annual increases.
     
   • Dramatically boosts non-HCE participation and test results.
3. Enhanced Employer Match
   
   • Instead of a flat match (e.g., 50% up to 6%), consider structures that encourage employees to contribute more (e.g., 100% up to 4%).
4. Targeted Education & Communication
   
   • Employees often don’t participate simply because they don’t understand the benefit.
     
   • Providing financial wellness programs, education, and one-on-one guidance can increase deferrals.
5. Regular Compliance Reviews
   
   • Proactive monitoring throughout the year helps spot issues early and allows for mid-year adjustments before testing season.

Bottom Line

ADP/ACP failures are frustrating, but they’re not the end of the world. With timely corrections and smart plan design, employers can avoid annual headaches while ensuring that both executives and employees benefit from the plan.

For many business owners, the best move is adopting a safe harbor plan or integrating auto-enrollment features to keep participation healthy.

When your retirement plan is designed correctly, you not only stay compliant. You create a benefit that attracts and retains talent.

Have questions? Reach our to our team of professionals at Prime Capital Financial Denver to see how we can help. 

This information does not constitute legal or tax advice. Prime Capital Investment Advisors, (“PCIA”) and its associates do not provide legal or tax advice. Individuals should consult with an attorney or professional specializing in the fields of legal, tax, or accounting regarding the applicability of this information for their situations. Advisory products and services offered by Investment Adviser Representatives through Prime Capital Investment Advisors, LLC (“PCIA”), a federally registered investment adviser. PCIA: 6201 College Blvd., Suite#150, Overland Park, KS 66211. PCIA doing business as Prime Capital Financial | Wealth | Retirement | Wellness | Family Office.