- February 27, 2025
The tax code governing 401(k) plans was written to prevent qualified retirement plans from overly favoring Highly Compensated Employees (HCEs). A series of non-discrimination tests were devised to measure whether a plan’s design or operation lends to favoring the HCEs over the Non-Highly Compensated Employees (NHCEs). All year end testing begins with the coverage test in accordance with IRS Code section 410(b). Once the coverage test is passed or, if not passed, once steps have been taken to pass coverage, then the average deferral percentage (ADP) test must be performed. The ADP test uses mathematical equations to compare the participation and contribution rates of the HCEs to the NHCEs in order to determine whether the plan is discriminating in favor of the HCEs.
Who is considered a Highly Compensated Employee?
Generally, a highly compensated employee is an employee who is either a more than 5% owner of the business (also known as a 5% owner) in the year of testing or the prior year, or someone who makes more than a specific dollar threshold determined by the IRS and adjusted annually for cost-of-living increases ( for 2022 testing purposes, someone who earns $130,000 or more in 2021). It is possible to further restrict the number of HCEs associated with a particular employer by limiting HCE designation based on a compensation threshold to only the highest paid 20% of employees. This election may be particularly effective for small plans maintained by professional groups such as law firms and physicians. However, this election must be written into the plan document provisions in order to be effective.
The 5% owner rule also requires careful review of the ownership attribution rules for families and trusts. Family attribution rules dictate that the spouse, parent, legal child and grandchild of a more than 5% owner of the company are also considered 5% owners themselves. For example, if John Smith owns 100% of a business that also employs his wife Jane; the family attribution rules dictate that, as hiswife, Jane would also be considered to own 100% of the business. Therefore, both John and Jane would be considered to be HCEs due to either direct or attributed ownership.
How does the ADP Test work mathematically?
To perform the ADP test, first determine every employee who is eligible to make an elective deferral regardless of whether they actually contribute. Then you divide this list into groups: HCEs and NHCEs. Starting with the HCEs, each employee’s Actual Deferral Ratio (ADR) is determined by dividing the employee’s compensation into the amount the employee deferred into the plan. Once each employee’s ADR is determined, the ADRs are averaged to arrive at the HCEs’ ADP.