Nondiscrimination and Nondiscrimination Testing

Under pre-SECURE 2.0 law, two spouses who each have ownership interest in separate businesses often ran into problems trying to pass nondiscrimination testing due to the family attribution rules.  This often limited the flexibility of businesses offering retirement benefits solely due to state community property laws or the existence of minor children—and unintended consequence.  SECURE 2.0 created two important exceptions that can now help closely held business owners offer retirement plans without running afoul of the IRS.<br /> <br /> The government prohibits business owners from establishing retirement plans that primarily benefit highly compensated employees (HCEs) while excluding other less highly compensated individuals.  To prevent businesses from using multiple entities to provide benefits primarily to HCEs and pass the anti-discrimination tests, the law treats certain related entities as a single entity for nondiscrimination testing purposes.<br /> <br /> These “controlled group” rules evaluate the ownership structure of related entities.  If enough common ownership exists, the entities are deemed to be a single business for retirement plan testing purposes.  Similarly, when applying the law, individuals may be deemed to own business interests owned by certain family members—including spouses and minor children.<br /> <br /> Under pre-SECURE 2.0 law, one spouse was always deemed to own the business interests that were owned by their spouse unless a spousal exception applied.<br /> <br /> Under IRC Section 414, the spousal exception applies if all of the following are true: (1) the spouse has no direct interest in their spouse’s business, (2) the spouse does not participate in management of their spouse’s business, and is not a director, officer or employee of that business, (3) no more than 50% of that business’ income is passive (meaning derived from rents, royalties, dividends, interest and annuities), and (4) the spouse’s ownership interests are not subject to restrictions on the spouse’s ability to dispose of them that favor the other spouse or their minor children.<br /> <br /> Ignoring the attribution rules can expose the sponsoring business to steep penalties and potential disqualification.<br /> <br /> Couples who live in community property states were previously unable to qualify for the spousal exception.  In community property states, each spouse is deemed to own 50% of their spouse’s assets acquired during the marriage.  SECURE 2.0 overrides and disregards community property laws for purposes of the Section 414 spousal exception.<br /> <br /> Example: Assume David and Judy are a married couple residing in Texas, a community property state.  During the marriage, each spouse established their own separate business (each owning 100% of the interests in their respective business).  The two businesses are completely unrelated.  However, under pre-SECURE 2.0 law, David was treated as owning 50% of Judy’s business and vice versa under Texas law.  The couple was unable to qualify for the spousal exception because they could not satisfy the “no direct interest” requirement.<br /> <br /> Post-SECURE 2.0, no controlled group is deemed to exist because Texas’ community property laws are disregarded.  Beginning in 2024, David and Judy can each establish individual retirement plans for their business.  Each plan can be structured to pass the nondiscrimination testing rules considering only the individual company’s employees.<br /> <br /> Under pre-SECURE 2.0 law, minor children (under age 21) were treated as though they owned 100% of their parents’ business assets when determining whether a controlled group existed.  Therefore, if two individuals each owned separate businesses, a child in common would be deemed to own 100% of each parent’s business.  That’s true regardless of whether the two parents were ever married.<br /> <br /> Considering the example above, assume David and Judy had a seven-year-old child, Meredith.  Pre-SECURE 2.0, Meredith was deemed to own 100% of David’s business and 100% of Judy’s business.  David and Judy were unable to qualify for the Section 414 spousal exception solely because of Meredith’s existence.<br /> <br /> SECURE 2.0 changed the rules to disaggregate ownership of two businesses where common ownership was based solely on the existence of a minor child.

<div class="Section1"><br /> <br /> A plan&rsquo;s continued tax qualification is conditioned on its meeting the operational requirements of IRC Section 401(c). For a 401(k) plan, that includes passage of annual ADP and ACP testing. When that testing fails, a plan is required either to make certain additional contributions for the nonhighly compensated employees ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3810">3810</a>) or certain distributions to the highly compensated employees ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3809">3809</a>).<a href="#_ftn1" name="_ftnref1">¹</a> Thus, a failure to make these corrections for a failed test is an operational failure that could lead to a loss of the plan&rsquo;s tax qualification.<br /> <br /> When a 401(k) plan fails the ADP testing and elects to distribute certain deferrals to highly compensated employees, those deferrals are referred to as excess contributions.<br /> <br /> When a plan&rsquo;s matching contributions fail the ACP testing and the plan elects to distribute certain matching contributions to highly compensated employees, those matching contributions are referred to as excess aggregate contributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3811">3811</a>). The complexity of the ADP and ACP tests, as well as that of the rules that follow, have led many employers to implement design-based plans that are deemed to satisfy these tests ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3773">3773</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3778">3778</a>).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Rev. Proc. 2013-12 Appendices A (section 3) and B (section 2), as modified by Rev. Proc. 2015-28, 2015-16 IRB 920 and Rev. Proc. 2016-51, 2016-42 IRB 465.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Treas. Reg. &sect;&sect; 1.401(k)-1(g), 1.401(m)-1(d).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> A cash or deferred arrangement will be treated as meeting the nondiscrimination requirement of IRC Section 401(a)(4) if it satisfies the Actual Deferral Percentage (&ldquo;ADP&rdquo;) test ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3803">3803</a>).<a href="#_ftn1" name="_ftnref1">¹</a> A plan can satisfy the ADP test by annually meeting the requirements of the ADP test itself, by satisfying the design-based requirements for a SIMPLE 401(k) plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3778">3778</a>), or by satisfying the design-based requirements for a safe harbor plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3773">3773</a>).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> In plan years beginning after December 31, 2007, a &ldquo;qualified automatic contribution arrangement&rdquo; will satisfy the ADP test requirement ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3762">3762</a>).<a href="#_ftn3" name="_ftnref3">³</a> The final regulations cited here took effect for plan years beginning on or after January 1, 2006.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> A plan will not be treated as violating the ADP test merely on account of the making of (or right to make) catch-up contributions by participants age 50 or over under the provisions of IRC Section 414(v) so long as a universal availability requirement is met ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3761">3761</a>).<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> Salary reductions that give rise to the saver&rsquo;s credit ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3648">3648</a>) may be taken into account for purposes of satisfying the ADP test.<a href="#_ftn6" name="_ftnref6">⁶</a> If the plan provides for employee after-tax contributions or employer matching contributions, those contributions must meet the requirements of IRC Section 401(m) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3804">3804</a>). If the plan includes a profit sharing component (i.e., nonelective contributions that are not QNECs, other than as part of one of the designs explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3778">3778</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3773">3773</a>), that portion of the plan will be subject to nondiscrimination in amount testing ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3848">3848</a>).<br /> <br /> A cash or deferred arrangement in which all of the eligible employees for a plan year are highly compensated employees ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3930">3930</a>) will be deemed to satisfy the ADP test for the plan year.<a href="#_ftn7" name="_ftnref7">⁷</a> A 401(k) plan also is subject to age and service, coverage, and other requirements ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3753">3753</a>).<br /> <br /> Final regulations treat all governmental plans (within the meaning of IRC Section 414(d)) as meeting the coverage and nondiscrimination requirements.<a href="#_ftn8" name="_ftnref8">⁸</a> The IRC states that state and local governmental plans, to the limited extent that they are eligible to offer a cash or deferred arrangement ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3753">3753</a>), meet the requirements of IRC Section 401(k)(3).<a href="#_ftn9" name="_ftnref9">⁹</a> Under earlier guidance, plans established and maintained for its employees by the federal government or by any agency or instrumentality of it, are treated as meeting the requirements of IRC Section 401(k)(3) until the first day of the first plan year beginning on or after the date final regulations were issued (December 29, 2004).<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect; 401(k)(3)(C).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&sect; 401(k)(3)(A)(ii), 401(k)(11)(A), 401(k)(12)(A); Treas. Reg. &sect; 1.401(k)-1(b)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect; 401(k)(13).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-1(g).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; IRC &sect; 414(v)(3)(B).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; Ann. 2001-106, 2001-44 IRB 416, A-10.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-2(a)(1)(ii).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-1(b)(2).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; IRC &sect; 401(k)(3)(G); <em><em>see</em> </em>Notice 2001-46, 2001-2 CB 122, as modified by Notice 2003-6, 2003-3 IRB 298.<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; Notice 2003-6, above; T.D. 9169, 69 FR 78154.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> A defined contribution plan that provides for employee contributions or matching contributions, typically a 401(k) plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3753">3753</a>), must satisfy the Actual Contribution Percentage (&ldquo;ACP&rdquo;) test or one of the alternatives to it ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3805">3805</a>) to meet the nondiscrimination in amount requirement of IRC Section 401(a)(4).<a href="#_ftn1" name="_ftnref1">¹</a> With respect to matching contributions only, two alternative plan designs are available that are deemed to satisfy the ACP test: a SIMPLE 401(k) plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3778">3778</a>), or a safe harbor design ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3773">3773</a>).<a href="#_ftn2" name="_ftnref2">²</a> In plan years beginning after December 31, 2007, a &ldquo;qualified automatic contribution arrangement&rdquo; will satisfy the ACP test requirement with respect to matching contributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3762">3762</a>).<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Matching contributions are subject to a three year cliff or five year graduated vesting schedule ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3869">3869</a>).<br /> <br /> A plan will not be treated as violating the ACP test merely on account of the making of, or the right to make, catch-up contributions by participants age 50 or over under the provisions of IRC Section 414(v) so long as a universal availability requirement is met ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3761">3761</a>).<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> All after-tax employee contributions are subject to ACP testing even if one of the design-based alternatives is used. After-tax employee contributions for this purpose do not include designated Roth contributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3779">3779</a>). The term also does not include rollover amounts, repayment of loans, or any other amounts transferred from another plan.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> The contributions that are required under a safe harbor plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3773">3773</a>) may not be used to satisfy the ACP test for after-tax employee contributions. Any employer matching or nonelective contributions in excess of the amount required to satisfy the safe harbor rules for a qualified cash or deferred arrangement can be taken into account for purposes of satisfying the ACP test.<a href="#_ftn6" name="_ftnref6">⁶</a> Voluntary after-tax employee contributions that give rise to the Saver&rsquo;s Credit ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3648">3648</a>) may be taken into account for purposes of satisfying the ACP test.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> Of course, the plan must satisfy the general nondiscrimination requirements applicable to all qualified plans ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3848">3848</a>). In particular, the availability of matching and employee contributions, as well as any other benefits, rights, and features under the plan, must be nondiscriminatory ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3860">3860</a>).<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect; 401(m)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&sect; 401(m)(10), 401(m)(11).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect; 401(m)(12).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect; 414(v)(3)(B).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-1(a)(3)(ii).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; <em><em>See</em> </em>General Explanation of Tax Legislation Enacted in the 104th Congress (JCT-12-96), p. 153 (the 1996 Blue Book).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; Ann. 2001-106, 2001-44 IRB 416, A-10.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-1(a)(1)(ii).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> A &ldquo;QNEC&rdquo; is any employer contribution (other than elective contributions and matching contributions) with respect to which the employee does not have an election to receive the amount in cash and that satisfies the nonforfeitability and withdrawal restrictions applicable to elective deferrals to qualified cash or deferred (401(k)) arrangements ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3753">3753</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3797">3797</a>).<a href="#_ftn1" name="_ftnref1">¹</a> Elective and qualified nonelective contributions (&ldquo;QNECs&rdquo;) may be taken into account in determining whether a plan satisfies the ACP test, provided certain requirements are met.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Employer matching contributions that are treated as elective contributions for purposes of the actual deferral percentage (&ldquo;ADP&rdquo;) test applicable to cash or deferred arrangements ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3802">3802</a>) are not subject to the ACP test above and may not be used to help employee contributions or other matching contributions to satisfy this test. Similarly, a QNEC that is treated as an elective contribution is subject to the ADP test and is not considered as a matching contribution for purposes of the ACP test.<a href="#_ftn3" name="_ftnref3">³</a> Essentially, a QNEC is a supplemental employer contribution that is tested as if it were an elective deferral for purposes of the ADP test.<br /> <br /> Under limited circumstances set forth in regulations, an employer may elect to include certain elective contributions and QNECs in computing the contribution percentage.<a href="#_ftn4" name="_ftnref4">⁴</a> To be considered in the calculation of the ACP for a year under the prior year testing method, a QNEC must be contributed no later than the end of the 12 month period following the applicable year, even though that year is different than the plan year being tested.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> On July 20, 2018, the IRS published regulations that modify the definitions of QNEC&nbsp;to allow employers to use forfeitures in order to pass nondiscrimination testing that applies to qualified plans. This amendment generally broadens the definition of contributions that qualify as QNECs and permits plan sponsors that allow the use of forfeiture accounts to offset future employer contributions under the plan. Therefore, the final regulations would require that QNECs be fully vested and subject to certain distribution restrictions only when they are allocated to the participant&rsquo;s account, rather than when they are first contributed to the plan. The changes apply to taxable years ending on or after July 20, 2018.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect; 401(m)(4); Treas. Reg. &sect;&sect; 1.401(m)-5, 1.401(k)-1(c)-(d).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-2(a)(6).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-2(a)(6)(vi).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect; 401(m)(3); Treas. Reg. &sect; 1.401(m)-2(a)(6).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-2(a)(6)(i).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; REG-131643-15.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> A plan may provide for an employer to make fully vested contributions for certain nonhighly compensated employees. These contributions then are included as deferrals in the ADP testing and, if sufficiently significant, can cause the plan to satisfy the ADP testing.<br /> <br /> <em>Recharacterization</em>. Excess contributions of highly compensated employees may be recharacterized as after-tax employee contributions only to the extent that the recharacterized amount, together with the amount of any actual after-tax contributions, satisfies the ACP testing.<a href="#_ftn1" name="_ftnref1">¹</a> This amount is treated the same as a match in that testing.<a href="#_ftn2" name="_ftnref2">²</a> Note that these recharacterization rules are different than the recharacterization of Roth IRA conversions eliminated under the 2017 tax reform legislation.<br /> <br /> Recharacterized excess contributions must be included in an employee’s gross income on the earliest date any elective contributions made on behalf of the employee during the plan year would have been received. The payor or plan administrator must report such amounts as employee contributions to the IRS and the employee.<a href="#_ftn3" name="_ftnref3">³</a> These recharacterized contributions continue to be treated as employer contributions that are elective contributions for all other purposes under the IRC (for example, they remain subject to the nonforfeitability and withdrawal requirements applicable to elective contributions).<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> On July 20, 2018, the IRS published final regulations that modify the definitions of QNEC to allow employers to use forfeitures in order to pass nondiscrimination testing that applies to qualified plans. Under the proposal, QNECs need to be nonforfeitable and subject to certain distribution restrictions when they are allocated to participants’ accounts, rather than when they are first contributed to the plan. This amendment generally broadens the definition of contributions that qualify as QNECs and permits plan sponsors that allow the use of forfeiture accounts to offset future employer contributions under the plan. Therefore, the final regulations would require that QNECs be fully vested only when they are allocated to the participant’s account. The changes apply to taxable years ending on or after July 20, 2018.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  Treas. Reg. § 1.401(k)-2(b)(3)(i).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  Treas. Reg. § 1.401(k)-2(b)(3)(ii).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  <em><em>See</em></em> Treas. Reg. § 1.401(k)-2(b)(3)(ii).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  <em><em>See</em> </em>Treas. Reg. § 1.401(k)-2(b)(3)(iii)(C).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.  T.D. 9835.<br /> <br /> </div>

<div class="Section1"><br /> <br /> The actual deferral percentage test requires that the Actual Deferral Percentage (&ldquo;ADP&rdquo;) of eligible highly compensated employees ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3930">3930</a>) be compared to the ADP of all other eligible employees, and that it satisfy one of the following tests:<br /> <br /> <em>Test 1:</em> The actual deferral percentage for eligible highly compensated employees ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3930">3930</a>) for the plan year does not exceed the actual deferral percentage of all other eligible employees for the preceding plan year, multiplied by 1.25.<br /> <br /> <em>Test 2:</em> The actual deferral percentage for eligible highly compensated employees for the plan year does not exceed by more than 2 percent that of all other eligible employees for the preceding plan year and the actual deferral percentage for highly compensated employees for the plan year is not more than the actual deferral percentage of all other eligible employees for the preceding plan year multiplied by two.<br /> <br /> The IRC provides two methods of applying the ADP test: a prior year testing method, and a current year testing method. The method described above is the prior year testing method (as set forth in the IRC), but the current year method is available by election.<a href="#_ftn1" name="_ftnref1">¹</a> Under the current year testing method, the ADP results of nonhighly compensated employees for the current year (instead of the preceding year) are used in each test. The ability of plan sponsors to switch between the current and prior year testing methods is limited.<a href="#_ftn2" name="_ftnref2">²</a> The plan document must reflect which testing method the plan is using for a testing year.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Qualified Matching Contributions (&ldquo;QMACs&rdquo;) and Qualified Nonelective Contributions (&ldquo;QNECs&rdquo;) are employer matching contributions and nonelective contributions, respectively, that are subject to the same nonforfeitability ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3753">3753</a>) and withdrawal restrictions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3797">3797</a>) as elective deferral contributions. Under certain circumstances, elective contributions used to pass the ADP test may include QMACs and QNECs that are made with respect to employees eligible under the cash or deferred arrangement.<a href="#_ftn4" name="_ftnref4">⁴</a> Specific requirements for such use are set forth in regulations.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> QMACs and QNECs may be used only once. In other words, contributions that are treated as elective contributions for purposes of the ADP test may not be taken into account for purposes of the ACP test under IRC Section 401(m) and are not otherwise taken into account in determining whether any other contributions or benefits are nondiscriminatory under IRC Section 401(a)(4). Similarly, QNECs that are treated as matching contributions for purposes of the ACP test may not be used to satisfy the ADP test.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <p style="text-align: center;"><strong>Calculation of Actual Deferral Percentage</strong></p><br /> The actual deferral percentage for a group of eligible employees is the average of the actual deferral ratios of employees in the group for the plan year as calculated separately for each employee and to the nearest 1/100 of 1 percent.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> An employee&rsquo;s actual deferral ratio is determined by dividing the amount of elective contributions (including amounts treated as elective contributions) made to the trust on his or her behalf for the plan year by his or her compensation for the plan year, calculated to the nearest 1/100 of 1 percent.<a href="#_ftn8" name="_ftnref8">⁸</a> Only contributions allocated to the employee&rsquo;s account for the plan year and related to compensation that, but for the election to defer, would have been received during the plan year (or, if attributable to services performed during the plan year, within 2&frac12;&nbsp;months after the close of the plan year) are considered in applying the ADP test. Designated Roth contributions ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3779">3779</a>) are treated as elective deferral contributions for purposes of the<br /> ADP test.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> Compensation, for purposes of calculating actual deferral percentages, generally means compensation for services performed for an employer, which is includable in gross income<br /> ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3867">3867</a>). An employer may limit the period taken into account to that portion of the plan year (or calendar year) in which the employee was an eligible employee, provided that this limit is applied uniformly to all eligible employees.<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <p style="text-align: center;"><strong>Miscellaneous Provisions</strong></p><br /> Although a plan must, by its terms, provide that the ADP test will be met; it may incorporate by reference the 401(k) nondiscrimination provisions of the IRC and regulations.<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect; 401(k)(3)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect; 401(k)(3)(A); Treas. Reg. &sect; 1.401(k)-2(c)(1)(ii).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-1(e)(7).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect; 401(k)(3)(D)(ii).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-2(a)(6).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-2(a)(6)(vi).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-2(a)(2)(i).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-2(a)(3).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-1(f)(4).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-6.<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-1(e)(7).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The IRC provides two methods of applying the ACP test: a prior year testing method, and a current year testing method.<a href="#_ftn1" name="_ftnref1">¹</a> The prior year method is specified in the IRC and the current year method is available by election.<a href="#_ftn2" name="_ftnref2">²</a> A plan generally must specify which of these two methods it is using.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <em>Prior year testing method</em>. Under the prior year testing method, a defined contribution plan that provides for employee or matching contributions meets the ACP test if the contribution percentage for eligible highly compensated employees for the plan year does not exceed the greater of (1) 125 percent of the contribution percentage for all other eligible employees for the preceding plan year, or (2) the lesser of (i) 200 percent of the contribution percentage for all other eligible employees for the preceding plan year or (ii) such contribution percentage for all other employees for the preceding plan year plus two percentage points.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <em>Current year testing method.</em> Under the current year testing method, the ACP results of nonhighly compensated employees for the current year, also known as the &ldquo;testing year,&rdquo; are compared with those of highly compensated employees for the current year. The plan satisfies the ACP test if the contribution percentage for eligible highly compensated employees for the plan year does not exceed the greater of (1) 125 percent of the contribution percentage for all other eligible employees for the plan year or (2) the lesser of (x) 200 percent of the contribution percentage for all other eligible employees for the plan year or (y) such contribution percentage for all other employees for the plan year plus two percentage points.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> A plan is not required to use the same method under the ACP test as it uses under the ADP test ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3802">3802</a>), but special rules must be followed if different methods are used.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Make sure to accurately count highly compensated employees using the family aggregation rules, which treat the spouse, child, grandparent, or parent of a 5 percent owner as a 5 percent owner. Remember that family members may have different last names.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> <hr><br /> <p style="text-align: center;"><strong>Changes in Testing Method</strong></p><br /> <em>Change from current year testing method to prior year testing method</em>. A plan that elects to continue using the current year testing method may be subject to certain restrictions if an employer wants to change to the prior year testing method: one governs the revocability of the election, and a second limits the &ldquo;double counting&rdquo; of certain contributions.<br /> <br /> The election to use the current year testing method ordinarily will not be revocable except with the permission of the IRS.<a href="#_ftn8" name="_ftnref8">⁸</a> Regulations provide for limited circumstances under which a plan will be permitted to change from the current year testing method to the prior year testing method.<a href="#_ftn9" name="_ftnref9">⁹</a> A plan that changes from the current year testing method to the prior year testing method also is subject to limitations designed to prevent double counting of certain contributions.<a href="#_ftn10" name="_ftnref10">¹⁰</a> Plans using the prior year testing method may change back to the currenth year method for any subsequent testing year.<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> Special rules apply in the first plan year; essentially a plan other than a successor plan may designate the ACP of nonhighly compensated employees at 3 percent in the first plan year that the plan uses the prior year testing method. The employer may elect to use the plan&rsquo;s first year ACP results instead.<a href="#_ftn12" name="_ftnref12">¹²</a> The plan document must specify the method that will be<br /> used.<a href="#_ftn13" name="_ftnref13">¹³</a><br /> <p style="text-align: center;"><strong>Miscellaneous Rules</strong></p><br /> Plans that accept rollover contributions generally assume the risk that the contributions qualify for rollover treatment ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3996">3996</a>). The IRS has determined that where a plan accepted a rollover contribution that, in fact, did not qualify for rollover, the amount involved was received by the plan as a voluntary employee contribution, which had to be considered for purposes of the ACP test.<a href="#_ftn14" name="_ftnref14">¹⁴</a><br /> <br /> Matching contributions, other than QMACs ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3802">3802</a>), on behalf of self-employed individuals are not treated as an elective employer contribution for purposes of the limit on elective deferrals under IRC Section 402(g).<a href="#_ftn15" name="_ftnref15">¹⁵</a><br /> <br /> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3806">3806</a> for information on qualified nonelective contributions (QNECs) and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3807">3807</a> for information on calculating the actual contribution percentage.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect; 401(m)(2)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect; 401(m)(2)(A); Treas. Reg. &sect; 1.401(m)-2(a)(2)(ii).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-1(c)(2).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect; 401(m)(2)(A); Treas. Reg. &sect; 1.401(m)-2(a)(2)(ii).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; IRC &sect; 401(m)(2)(A); Treas. Reg. &sect;&sect; 1.401(m)-2(a)(1), 401(m)-2(a)(2)(ii).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-2(c)(3).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; <em><em>See</em> </em>401(k) Plan Fix-It Guide, at http://www.irs.gov/Retirement-Plans/401k-Plan-Fix-It-Guide-The-Plan-Failed-The-401k-ADP-and-ACP-Nondiscrimination-Tests.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; IRC &sect; 401(m)(2)(A).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; Treas. Reg. &sect;&sect; 1.401(m)-2(c)(1), 1.401(k)-2(c)(1)(ii).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-2(a)(6)(vi).<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; IRC &sect; 401(m)(2)(A). <em><em>See</em> </em>Treas. Reg. &sect; 1.401(m)-2(c)(1).<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-2(c)(2)(i).<br /> <br /> <a href="#_ftnref13" name="_ftn13">13</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-1(c)(2).<br /> <br /> <a href="#_ftnref14" name="_ftn14">14</a>.&nbsp; Let. Rul. 8044030.<br /> <br /> <a href="#_ftnref15" name="_ftn15">15</a>.&nbsp; IRC &sect; 402(g)(8).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The ACP for a group of eligible employees is the average of their actual contribution ratios (&ldquo;ACRs&rdquo;) for the year, computed separately for each employee and to the nearest one-hundredth of one percent. An employee&rsquo;s ACR is (1) the sum of matching contributions and employee contributions (including any QNECs taken into account) divided by (2) the employee&rsquo;s compensation ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3891">3891</a>).<a href="#_ftn1" name="_ftnref1">¹</a> Special rules apply for the first year a plan, other than a successor plan, is in existence.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Compensation for this purpose generally is the same as under IRC Section 414(s) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3867">3867</a>), based on the plan year or the calendar year ending within the plan year; the period selected must be applied uniformly for every eligible employee under the plan.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> A matching contribution is (1) any employer contribution, including a discretionary contribution, to a defined contribution plan on account of an employee contribution to a plan maintained by the employer, (2) any employer contribution, including a discretionary contribution, to a defined contribution plan on account of an elective deferral ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3760">3760</a>),<a href="#_ftn4" name="_ftnref4">⁴</a> and (3) any forfeiture allocated on the basis of employee contributions, matching contributions, or elective contributions.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> For purposes of the ACP test, employee contributions generally are contributions that are designated or treated at the time of contribution as after-tax employee contributions, and are allocated to an individual account for each eligible employee.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> Matching contributions are taken into account for a plan year only if such contributions are (1) allocated to the employee&rsquo;s account under the terms of the plan as of a date within the plan year, (2) made on behalf of an employee on account of the employee&rsquo;s contributions (elective or otherwise) for the plan year, and (3) actually paid to the trust no later than the end of the 12 month period immediately following the close of the plan year.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> Matching contributions that do not satisfy these requirements may not be considered in applying the ACP test for any plan year, but instead must meet the general test for the nondiscriminatory amount requirement ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3848">3848</a>) by treating them as if they were nonelective contributions and were the only nonelective employer contributions for the year.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> An eligible employee generally is any employee who is directly or indirectly eligible to make a contribution or to receive a matching contribution (including those derived from forfeitures) for all or a portion of the plan year. Employees who would be eligible to make contributions were it not for a suspension or an election not to participate also are considered eligible.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> Under a special rule for early participation, a plan that separately satisfies the minimum coverage rules ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3842">3842</a>), taking into account only those employees who have not completed one year of service or are under age 21, may ignore, for purposes of the ACP test, eligible nonhighly compensated employees who have not met the age and service requirements in applying the ACP test.<a href="#_ftn10" name="_ftnref10">¹⁰</a> This provision is designed to encourage employers to include younger employees in the plan without the concern that they will &ldquo;pull down&rdquo; the ACP test results.<br /> <br /> Although a plan must, by its terms, provide that the ACP test will be met, it may incorporate by reference the IRC Section 401(m) nondiscrimination provisions.<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-2(a)(3)(i).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&sect; 401(m)(3), 401(k)(3)(E).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-5.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; As defined in Treas. Reg. &sect; 1.402(g)-1(b).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; IRC &sect; 401(m)(4)(A); Treas. Reg. &sect; 1.401(m)-1(a)(2).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-1(a)(3) for details.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-2(a)(4)(iii).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-2(a)(5).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; IRC &sect; 401(m)(5); Treas. Reg. &sect; 1.401(m)-5.<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; IRC &sect; 401(m)(5)(C); Treas. Reg. &sect; 1.401(m)-3(j)(3).<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; Treas. Reg. &sect; 1.401(m)-1(c)(2).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> An otherwise qualified 401(k) plan with a failed ADP test will not be disqualified if, before the end of the following plan year, any excess contributions are distributed along with any allocable income. Additional contributions (&ldquo;QNECs&rdquo;) may be made to the plan by the employer to the accounts of the nonhighly compensated employees sufficient to pass ADP testing.<a href="#_ftn1" name="_ftnref1">¹</a> Another seldom-used option permits recharacterization of these deferrals by treating them as if they had been distributed to the employee and then contributed by the employee to the plan on an after-tax basis. These after-tax employee contributions then are included in the ACP testing. Excess contributions may not remain unallocated in the plan or held in a suspense account for allocation in future years.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Excess contributions are to be distributed (or otherwise corrected) within 2&frac12; months after the end of the plan year to avoid the employer being subject to a 10 percent excise tax on the amount distributed.<a href="#_ftn3" name="_ftnref3">³</a> A plan that contains an automatic enrollment (even if not an &ldquo;eligible automatic contribution arrangement&rdquo;) is subject to an extended time period for distributing refunds of excess contributions of six months rather than 2&frac12; months.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> An excess contribution may consist of elective salary deferrals, Roth employee contributions, QNECs and QMACs, and certain employer contributions, all of which are included in ADP testing.<a href="#_ftn5" name="_ftnref5">⁵</a> A plan will specify whether an ordering of the distributions is required ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3737">3737</a>). Salary deferrals and Roth contributions that exceed $23,500 in 2025 ($23,000 in 2024, $22,500 in 2023, $20,500 in 2022, $19,500 in 2020-2021) are referred to as &ldquo;excess deferrals&rdquo; ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3760">3760</a>) and should not be confused with excess contributions. Special rules apply for coordinating distributions of excess contributions and excess deferrals.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> Excess contributions and income thereon distributed to an employee are treated as earned and received by the employee in the year in which the distributions are made.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> Where the plan specifies, or where the employer elects to make corrective distributions of excess contributions and the distribution is not made within 2&frac12; months after the close of the plan year (or six months if the plan has an automatic enrollment feature), two requirements are triggered. The employer pays a penalty of 10 percent of the excess distribution,<a href="#_ftn8" name="_ftnref8">⁸</a> and a statutory 12 month period applies. If the distribution occurs more than 12 months after the close of the plan year, the plan has an operational failure that must be corrected under EPCRS to avoid the plan&rsquo;s disqualification.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> Corrective distributions of excess contributions may be made without regard to the spousal consent rules ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3882">3882</a>).<a href="#_ftn10" name="_ftnref10">¹⁰</a> Corrective distributions may not be considered for purposes of satisfying the minimum distribution requirements ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3891">3891</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3909">3909</a>).<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Treas. Reg. &sect; 54.4979-1(c)(4); Rev. Proc. 2013-12 Appendices A (section 3), as modified by Rev. Proc. 2015-28, 2015-16 IRB 920 and Rev. Proc. 2016-51, 2016-42 IRB 465.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect; 401(k)(8); Treas. Reg. &sect; 1.401(k)-2(b)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect; 4979; Treas. Reg. &sect;&sect; 1.401(k)-2(b)(5), 54.4979-1.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-2(b)(5)(iii).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; IRC &sect; 401(k)(8)(B). <em><em>See</em></em> Treas. Reg. &sect;&sect; 1.401(k)-6, 1.401(k)-2(b)(2)(iii).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; <em><em>See</em></em> Treas. Reg. &sect; 1.401(k)-2(b)(4)(i).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; IRC &sect; 4979(f)(2).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; Treas. Reg. &sect;&sect; 1.401(k)-2(b)(5), 54.4979-1(a)(4).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-2(b)(5).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-2(b)(2)(vii)(A).<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; Treas. Reg. &sect; 1.401(k)-2(b)(2)(vii)(C).<br /> <br /> </div></div><br />