Shifting to Pass Testing
In certain situations, the “shifting method” is allowed under the nondiscrimination testing regulations to help a 401(k) plan pass a failed ACP test.
Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security, and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in Ohio is representative of a common question on 401(k) testing.
“What options are there for passing the actual contribution percentage (ACP) test other than making qualified nonelective contributions (QNECs) or doing corrective distributions to highly compensated employees (HCEs)?”
Highlights of the discussion
The regulations allow for several correction methods. First, check the plan document for any guidance outlined there regarding how the plan sponsor may correct various plan excesses. It is important to follow the terms of the plan document.
In a testing scenario where a plan is passing the actual deferral percentage (ADP) test and failing the ACP test, one option available in the regulations for passing the failed test is “shifting” the excess percentage by which the plan is passing the ADP test to the ACP test to help with passage. Keep in mind, this shifting method does not involve actually moving assets from one source to another.
The shifting method of passing the ACP test can only be used when the plan is subject to the ADP test. Consequently, it would not be available under a 403(b) plan or a 401(k) safe harbor plan [Treas. Reg. 1.401(m)-2(a)(6)(ii)].
Also, excess deferrals, catch-up contributions, military service contributions under IRC Sec. 414(w), and permissive distributions under an eligible automatic contribution arrangement cannot be used to help pass the ACP test.
Also note that there may be situations where an amount cannot be shifted from the ADP test to the ACP test because no nonHCEs are eligible for a matching allocation either because they terminated before the end of the testing year and there is a last day requirement, or because they did not defer anything, and therefore were not eligible for a match.
Example:
In the example below, the HCE ADP was 5%, although the HCE ADP could have been up to 6%, because that is exactly +2% above the nonHCE ADP of 4%. (1) Therefore, the ADP test passed with 1% to spare. The ACP test, on the other hand, failed by .5%, because the nonHCE ACP would have had to have been at least 1.5% to pass (1.5% + 2.0% = 3.5%).
If the spare 1% by which the ADP test passed is shifted from the nonHCE ADP to the nonHCE ACP test, the ADP test still passes, and the ACP test now passes with +.5% to spare. See the example below:
Before Shift | After Shift | |||
ADP | ACP | ADP | ACP | |
HCE | 5% | 3.5% | 5% | 3.5% |
NHCE | 4% | 1% | 3% | 2% |
Pass/Fail Margin | Pass /+1% | Fail / -.5% | Pass | Pass / +.5% |
Conclusion
Although the shifting method is allowed under the nondiscrimination testing regulations to help a 401(k) plan pass a failed ACP test in situations where a plan has passed the ADP test by a margin, it is important to confirm that the plan document does not specify a different method for passing a failed ACP test.
(1) The HCEs’ ADP may not exceed the lesser of (a) 200% (2 times) that of the nonHCEs’ ADP, or (b) the nonHCEs’ ADP plus 2 percentage points.
