We have a 401(k) plan that allows for both employee deferrals and a company match. Our annual testing each year is based on the amounts contributed in the previous year. That has allowed us to notify our highly compensated employees of the maximum they can contribute each year to ensure we pass testing.
After several years of not making any matching contributions, we are planning to make one this year. We are concerned, however, that since our testing is based on last year’s contributions (which were 0%) that making a match this year will cause our plan to fail testing.
Are we understanding this situation correctly? If so, is there anything we can do to prevent the testing failure?
Yes and yes! Your understanding of how the test works is correct, and the fact that you are asking before the year ends is the first step in minimizing or preventing the failure.
First, let’s recap how the tests work. The actual deferral percentage, or ADP, test compares the average deferral rates of highly compensated employees to those of non-HCEs. If the spread between the two exceeds the lesser of double the NHCE average or two percentage points, the test fails.
Correcting the test involves either returning money to the HCEs or giving a company contribution to the NHCEs to close the gap to an acceptable level. The actual contribution percentage (ACP) test works the same way but looks at the average matching contributions of the two groups rather than the deferrals.
A plan can use the NCHE average from either the current year or the immediately previous year to run the tests, and the plan document must specify which year will be used. Neither option is inherently better or worse, so the specific details of each plan must be considered to determine which is the better fit.
As noted in the question, using the prior year testing method offers the advantage of predictability. As soon as last year ended, it was possible to determine the NCHE average and calculate the maximum rate for the HCEs for this year. Assuming your HCEs limit their contributions to that level, you can rest assured that the plan will pass the ADP test for this year.
When it comes to inconsistent matching contributions, however, the prior year method creates a bit of a conundrum. Since no match was made last year, the average match of the NHCE group was 0%. That means the HCEs are capped at a 0% match for this year. So, if any matching contribution is made at all this year, the plan will fail the ACP test.
Fortunately, IRS rules allow plans to change their testing method for a year right up until the last day of the year being tested. So, a calendar year plan has until December 31, 2017, to change from prior to current year testing (or vice versa) for the 2017 plan year. What’s more, it is perfectly allowable to use different methods for deferrals than for match. For example, you could continue to use the prior year method for the ADP test and amend to the current year method for the match.
There are two important caveats. One is that switching to the current year method does not guarantee your plan will pass the ACP test, because the averages could still be outside the allowable range; however, the change means you are no longer guaranteed to fail the ACP test as would be the case if you kept the prior year method.
The other is that the rules limit how often you can change testing methods. It is always possible to change from prior to current, but you can only go from current to prior once in any five-year period.