If your plan fails the Actual Deferral Percentage (ADP) compliance test, you have two options to correct it: refund excess deferrals to highly compensated employees (HCEs) or make additional employer contributions to non-highly compensated employees (NHCEs). This article explains how each correction method is calculated, including deadlines and worked examples.
If your plan fails the ADP test, your company can choose one of two corrective actions:
Refund excess deferrals to highly compensated employees (HCEs).
Make additional employer contributions to non-highly compensated employees (NHCEs).
You can choose which option to use each year, as long as you make your choice on time.
The following deadlines apply to plans with a December 31 plan year end:
Mar. 15 — deadline to refund HCEs without owing an excise tax. For eligible automatic contribution arrangement plans and qualified automatic contribution arrangement plans, this deadline extends to Jun. 30.
Dec. 31 of the following year — deadline to refund HCEs with an excise tax owed.
After Dec. 31 of the following year — the failure must be corrected under the Internal Revenue Service (IRS) Employee Plans Compliance Resolution System (EPCRS) correction program.
Once we have all necessary data, a task will appear on your Gusto Retirement administrator dashboard in late Q1. The task outlines the exact dollar amounts for each option by individual.
If you choose to refund excess deferrals to HCEs, checks will be mailed to affected participants in the weeks following completion of your task. Affected employees will get an IRS Form 1099-R in the following year for tax filing purposes.
The first option is to refund enough deferrals from HCEs to reduce their average deferral rate (ADR) to the percentage needed to pass the test. The IRS requires a specific procedure called the leveling method. You do not have discretion in deciding which HCEs get refunds or how much each refund will be.
To apply the leveling method, follow these steps:
Determine the HCE ADR needed to pass the test.
Hypothetically decrease deferral rates for applicable HCEs until the ADR passes.
Determine the total dollar amount of deferrals that need to be refunded based on the hypothetically decreased deferral rates.
Allocate that dollar amount based on the HCEs' deferral amounts in dollars.
Important: The first three steps of the leveling method are hypothetical only. No amounts are actually refunded during those steps — they are used only to determine the total dollar amount that needs to be refunded.
Bad Wolf Inc. has three HCEs: Rose, Mickey, and Jackie. Their deferral rates and compensation are shown below.
Participant
Compensation
Deferral amount
Deferral percentage
Rose
$125,000
$18,000
14.40%
Mickey
$175,000
$9,900
5.66%
Jackie
$205,000
$22,000
10.73%
Average
10.26%
For this plan, testing calculations show that the ADR for HCEs needs to be 7% to pass the ADP test.
Starting with the highest deferral percentage, reduce rates until the ADR reaches 7%.
In this example, reducing Rose's percentage to match Jackie's would only bring the ADR to 9.04%, so both Rose's and Jackie's percentages must be reduced to 7.67% to pass. Because Mickey is already under 7%, his percentage does not need adjusting.
Participant
Actual deferral percentage
Decrease to be level with Jackie
Decrease to reach passing ADR
Rose
14.40%
10.73%
7.67%
Jackie
10.73%
10.73%
7.67%
Mickey
5.66%
5.66%
5.66% (no change)
Average
10.26%
9.04%
7.00%
Using the adjusted deferral percentages, calculate how much in excess contributions needs to be refunded.
Participant
Actual deferral amount
Adjusted deferral percentage
Adjusted deferral amount
Difference
Rose
$18,000
7.67%
$9,587.50
$8,412.50
Mickey
$9,900
5.66%
$9,900.00
$0.00
Jackie
$22,000
7.67%
$15,723.50
$6,276.50
Total
$14,689.00
Now we know $14,689 needs to be refunded. The final step allocates the refund based on the dollar amount deferred, following the same top-down logic from Step 2 — but this time starting with the largest deferral amount instead of the highest deferral percentage.
First, reduce Jackie's deferral amount to either (1) the excess amount that needs to be refunded, or (2) the same dollar amount Rose deferred. That gives us $4,000, but we still need an additional $10,689 in refunds.
Next, decrease Jackie's and Rose's deferral amounts equally to either (1) the remaining excess amount, or (2) the same dollar amount Mickey deferred. At this step, we reach the total refund amount by removing an additional $5,344.50 for both Jackie and Rose.
Participant
Actual deferral amount
Decrease to be level with Rose
Decrease to total refund needed
Total refund amount
Jackie
$22,000
-$4,000
-$5,344.50
$9,344.50
Rose
$18,000
-$0
-$5,344.50
$5,344.50
Mickey
$10,000
-$0
-$0.00
$0.00
Total
$14,689.00
The second option is to provide additional employer contributions to certain NHCEs to bring their ADR up enough to pass the test. Gusto Retirement uses a pro-rata qualified non-elective contribution (QNEC) method that includes the ability to permissively disaggregate testing. This means employees who have not reached age 21 or do not have at least one year of service are tested in their own group.
The system runs the test both ways and provides you with the least expensive option. When permissively disaggregated, each group is tested separately, so only NHCEs in the group that fails will get the QNEC.
Ood Sphere Industries has six employees: one HCE and five NHCEs. By using permissive disaggregation, we create two testing groups — which significantly lowers the cost of the QNEC for the employer.
Participant
Age
Years of service
Compensation
Deferral amount
Deferral percentage
River
38
12
$162,623.00
$19,500.00
11.99%
Donna
42
5
$67,550.00
$2,325.25
3.44%
Wilfred
75
2
$102,211.29
$1,544.62
1.51%
Sylvia
61
7
$100,000.00
$600.00
0.60%
Charlotte
18
2
$31,382.90
$291.61
0.93%
Lee
44
0.25
$6,440.00
$0.00
0.00%
Group 1 — excludable employees
This group includes employees who would be excludable if the plan imposed the maximum age and service requirements: Charlotte (under 21 years old) and Lee (less than one year of eligibility service). Because both Charlotte and Lee are NHCEs, and HCEs are excluded from disaggregation, this portion of the plan passes ADP testing automatically. We can disregard them for the remainder of the test and correction.
Group 2 — remaining employees
This group includes River (HCE), Donna, Wilfred, and Sylvia. The ADR for HCEs is 11.99% while the ADR for NHCEs is 1.85%. This fails the ADP test.
River does not want to give up any of her deferrals, so she chooses to make QNEC contributions for Donna, Wilfred, and Sylvia.
To pass, the ADR for NHCEs must increase to 9.59%. That allows the HCE ADR to remain at 11.99% (9.59% × 125% = 11.99%). Because the ADR was already 1.85%, each NHCE needs to get an additional 7.74% as a QNEC.
Participant
Compensation
QNEC percentage
QNEC amount
Final deferral percentage
River
$162,623.00
0%
$0
11.99%
Donna
$67,550.00
7.74%
$5,228.37
11.18%
Wilfred
$102,211.29
7.74%
$7,911.15
9.25%
Sylvia
$100,000.00
7.74%
$7,740.00
8.34%
Average with QNEC for Donna, Wilfred, and Sylvia
9.59%
To pass the ADP test using QNECs, Ood Sphere will need to make a contribution of $20,879.52.
Important: QNEC contributions are not treated the same as other employer contributions. They must always be 100% vested and follow the same distribution rules as elective deferrals.