--- title: How Are Corrective Refunds Determined for a Failed ADP Test? description: After failing an ADP test, how are corrective refunds for highly compensated employees (HCEs) determined? image: https://www.dwc401k.com/hubfs/Knowledge%20Center/Pillar%20Categories%202024/PNG%20-%20with%20category%20name/hero_401_png_category.png --- [![logo](https://www.dwc401k.com/hubfs/_global/logo.svg "logo")](https://www.dwc401k.com/) [![logo](https://www.dwc401k.com/hubfs/Dwc-2019/SVG/logo.svg "logo")](https://www.dwc401k.com/) [![Contribution Limits](https://no-cache.hubspot.com/cta/default/3113501/af3ae025-72b1-41fa-8855-5e196d6c26e4.png)](https://cta-redirect.hubspot.com/cta/redirect/3113501/af3ae025-72b1-41fa-8855-5e196d6c26e4) [![Log in](https://no-cache.hubspot.com/cta/default/3113501/3466ce37-58ba-4a93-bddb-0d4c8bb8ccbc.png)](https://cta-redirect.hubspot.com/cta/redirect/3113501/3466ce37-58ba-4a93-bddb-0d4c8bb8ccbc) [![services-icon1](https://www.dwc401k.com/hubfs/QOTW/March%202020/services-icon1.png) ## Plan Document A properly drafted document is the foundation of achieving the company's objectives and keeping the plan in operational compliance. ](https://www.dwc401k.com/services/plan-document) [![services-icon2](https://www.dwc401k.com/hubfs/QOTW/March%202020/services-icon2.png) ## Plan Compliance We have a fundamental understanding of how critical plan compliance is to both the IRS and Department of Labor. ](https://www.dwc401k.com/services/plan-compliance) [![services-icon3](https://www.dwc401k.com/hubfs/QOTW/March%202020/services-icon3.svg) ## Defined Benefits Services We work with business owners and investment advisors to determine what makes the most sense by providing a detailed cost benefit analysis. ](https://www.dwc401k.com/services/defined-benefits-services) [![services-icon4](https://www.dwc401k.com/hubfs/QOTW/March%202020/services-icon4.svg) ## Mergers, Aquisitions & Related Company Analysis The DWC team is well-versed enough in the nuances and is ready to help you navigate the situation. ](https://www.dwc401k.com/services/mergers-acquisitions-analysis) [![services-icon5](https://www.dwc401k.com/hubfs/QOTW/March%202020/services-icon5.png) ## Plan Corrections DWC's extensive experience with both the IRS and Department of Labor voluntary correction programs allows us to help you address just about any accident that might happen. ](https://www.dwc401k.com/plan-corrections) [![services-icon6](https://www.dwc401k.com/hubfs/QOTW/March%202020/services-icon6.png) ## Government Audits Being selected for an audit can feel overwhelming, but the process doesn't have to be. ](https://www.dwc401k.com/services/government-audits) ![service-right-icon](https://www.dwc401k.com/hubfs/QOTW/March%202020/service-right-icon.svg) ## Investment Advisor Support DWC has a long history of successfully partnering with investment advisors. 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[ DWC ](https://www.dwc401k.com/blog/author/dwc) | Published: 08/21/2018 | [Highly Compensated Employees](https://www.dwc401k.com/blog/topic/highly-compensated-employees), [Question of the Week (QOTW)](https://www.dwc401k.com/blog/topic/question-of-the-week-qotw), [DWC](https://www.dwc401k.com/blog/topic/dwc), [Plan Correction](https://www.dwc401k.com/blog/topic/plan-correction), [ADP/ACP Tests](https://www.dwc401k.com/blog/topic/adp-acp-tests), [401(k) Q&A](https://www.dwc401k.com/blog/topic/401k-qa) ## Facts Our 401(k) plan failed the ADP test for the first time this year.  We decided to correct the failure by making refunds to the [highly compensated employees](https://www.dwc401k.com/knowledge-center/who-are-highly-compensated-and-key-employees) instead of making additional contributions for the other participants.  However, when we got the actual refund amounts from our TPA, we were surprised to see that those HCEs with the highest deferral percentages are to receive smaller refund amounts. ## Question How are the corrective refunds determined and why don’t all HCEs share in them proportionately? ## Answer The best way to answer your questions is with some examples.  Let’s take a look at Larry and Mary – both HCEs in a 401(k) plan that failed its [ADP test](https://www.dwc401k.com/knowledge-center/nondiscrimination-testing-adp-and-acp-tests). ![QOTW - HCE Corrective Refunds - Participant Compensation](https://www.dwc401k.com/hs-fs/hubfs/QOTW/Tables/QOTW%20-%208.14.2018%20-%20Participant%20Compensation.png?width=600&name=QOTW%20-%208.14.2018%20-%20Participant%20Compensation.png) Under the old rules, the refunds would have first been allocated to Larry since he has the larger deferral percentage.  However, a few years ago Congress changed the rules so that the HCEs with the largest dollar amount are the first to receive refunds.  The current rules include two steps. ### Step #1: Top Down Leveling by Percentage Since the ADP test compares the average percentage deferred by the HCEs to that of the non-HCEs, the first step is to adjust those percentages so that they are within the allowable range of two percentage points.  Let’s assume that the maximum HCE average that passes the test is 7%. ![QOTW - HCE Corrective Refunds - Top Down Leveling by Percentage](https://www.dwc401k.com/hs-fs/hubfs/QOTW/Tables/QOTW%20-%208.14.2018%20-%20Top%20Down%20Levelling%20by%20Percentage.png?width=472&name=QOTW%20-%208.14.2018%20-%20Top%20Down%20Levelling%20by%20Percentage.png) Since Mary’s deferral percent was already below the 7% maximum average, she is not adjusted during this first step. ### Step #2: Calculation of Total Dollars to Refund Next, we multiply the adjusted deferral percentages from step #1 by each participant’s compensation to determine the total dollar amount to be refunded. ![QOTW - HCE Corrective Refunds - Calculation of Dollars to Refund](https://www.dwc401k.com/hs-fs/hubfs/QOTW/Tables/QOTW%20-%208.14.2018%20-%20Calculation%20of%20Dollars%20to%20Refund.png?width=796&name=QOTW%20-%208.14.2018%20-%20Calculation%20of%20Dollars%20to%20Refund.png) Now we know that the total amount to be refunded to correct the failed test is $3,337.50. ### Step #3:  Allocation of Total Refund Amount Since the objective is for the refunds to go to those HCEs who deferred the largest dollar amounts, the total from step #2 is allocated to the HCEs, leveling down from largest deferral amount to smallest, until the total is completely allocated. ![QOTW - HCE Corrective Refunds - Allocation of Total Refund Amount_1](https://www.dwc401k.com/hs-fs/hubfs/QOTW/Tables/QOTW%20-%208.14.2018%20-%20Allocation%20of%20Total%20Refund%20Amount_1.png?width=600&name=QOTW%20-%208.14.2018%20-%20Allocation%20of%20Total%20Refund%20Amount_1.png)   Since Mary’s remaining deferrals still exceed Larry’s even after the entire refund amount is allocated to her, Larry does not receive any refund at all even though his original deferral percentage was larger.  As you can imagine, the more HCEs there are, the more the process gets convoluted with multiple iterations. There are two quick items to note.  First, if Mary is over the age of 50, the entire amount of her refund can be recharacterized as a catch-up contribution rather than paying it out to her.  Second, any amount that will actually be refunded to an HCE must be adjusted to include a proportionate share of investment gains, and the refund amount is taxable to the HCE in the calendar year it is distributed. For more information on the correcting an ADP test, please visit our Knowledge Center [here](https://www.dwc401k.com/blog/deadlines-for-adp-acp-tests) and [here](https://www.dwc401k.com/blog/when-can-we-change-our-adp/acp-testing-method). 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