ADP/ACP testing teaches us to share
My daughter’s teacher performed an interesting experiment. The teacher handed out bite size candy to all the students and told them to not eat them just yet. Some received more than others, and, in this exercise, it was random who received 10 and who received 2. The teacher then told the students that they had to make a choice; do they share it with those that had less to make it more even or do they keep the stash they had and not share at all. My daughter had 10. The two friends at her table each got 2. She opted to share 2 to each friend giving them each at total of 4 and she now had 6. The kids that shared got a little extra recess as a reward. It was an exercise on wealth distribution in the world of adulthood and the extra recess was a reward for charitable work but it’s a good example of how an ADP test works and why.
Highly Compensated Employees (HCEs) earn higher amounts of compensation than those in the Non Highly Compensated Employee group (NHCE). HCEs get a few more candies each year. The Department of Labor (DOL) wants to ensure that the HCEs are sharing those candies with the NHCEs each year. The way they do this is to limit the deferral percentage an HCE can contribute to the plan as a percentage over those who are a NHCE. Typically, this is either twice as much as the NHCE average deferral rate or 2 percentage points more than the NHCE average deferral rate. The formula used depends on the NHCE rate. The ACP test is a similar test but analyzes the employer matching contributions.
If the HCEs go over the allowed percentage, typically a refund of the excess money they deferred is required. This refund is required 2 ½ months after the plan year end. For those plans who end on 12/31 of each year, the refund is due by March 15th.
But what about your business owner friend who can put in the maximum amount of deferrals each year? Why can’t I do that, you ask? This type of plan requires additional employer contributions or an automatic enrollment provision. Your plan consultant can help you with the proper plan design if you are a business owner that wants to contribute the maximum amount but have been restricted by the ADP limitation.
The DOL doesn’t want those with a higher compensation to have such a big advantage in saving for retirement over those who receive a lower compensation amount. The DOL wants it to be fair, and they do that with limitations and refunds. The ADP/ACP Test is a lesson in sharing.