If you are an executive or business owner, you may have received a refund from your 401(k). That can be a frustrating experience. What you thought was tax-deferred savings is now taxable income. So why are you getting refunds and is there anything you can do about it?
Why am I getting refunds?
The most common source of refunds is because your company has failed the ADP test. ADP stands for Actual Deferral Percentage.
What is the ADP test?
The ADP test compares the average savings rate of Highly Compensated Employees (HCEs) to the average savings rate of Non-Highly Compensated Employees (NHCEs). HCE and NHCE are defined by the IRS.
What are HCEs & NHCEs?
For 2021, an employee who earns more than $130,000 is an HCE. Or, if someone owns more than 5% of the business (regardless of their income), they would be considered an HCE. In addition, employees who are related to owners may be included as HCEs because of familial ownership – even if that person does not own the business at all directly. Anyone that is not an HCE falls into the NHCE bucket.
There is an exception to this called the “20% Rule.” The 20% rule limits HCEs for testing to only the top 20% of earners, even if more than that qualify based on income. You see this often in places like New York City and California, especially at organizations like a law firm.
How does the ADP test work?
HCE’s savings rates are limited, on average, to a rate that is more than the average savings rate of the NHCE’s based on the formula below.
A few examples:
- If the HNCE average savings rate is 1.5%, the HCE average is limited to 3% (1.5% X 2)
- If the NHCE average savings rate is 6%, the HCE average is limited to 8% (6% + 2%)
- If the NHCE average savings rate is 9%, the HCE average is limited to 11.25% (9% X 1.25)
What happens if HCEs save more than allowed?
Following the end of the plan year (most plan years end December 31), HCE’s may receive a refund. This is an effort to lower the HCE average based on the formulas above. Instead of being considered money deferred into a retirement plan, refunded money is considered income as if they had never saved it into the 401(k).
What can I do to improve the ADP test?
There are two options to improve the ADP test.
- Use a Safe Harbor Contribution
Employers can contribute to the retirement plan with a Safe Harbor Non-Elective or Safe Harbor Match formula. Using either would allow a company to automatically pass the ADP test. At that point, all employees, including HCE’s, savings would only be limited by IRS guidelines. For 2021 that is $19,500 for people under age 50 and $26,000 for people 50 and older.
- Increase NHCE savings
Longer term, a solution should focus on increasing participation rates and savings rates of NHCEs. Some specific improvements can help increase interest in the 401(K) - decreasing plan costs, improving investment options, and having hands on enrollment sessions with the help of an advisor are all ways to increase your NHCE average savings rate.
If you are having trouble with HCEs receiving refunds in your company, please reach out to us. It is common for small business 401(k) plans to fail this test. We’ve helped manage this situation for several clients. Click here to schedule a meeting with me to see if we can help.
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This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.