You Failed the ADP Test – SO WHAT!

Posted on Jan 17, 2012 by  in 401(k) Retirement Planning, Retirement Plans for Business

As Juhl points out in his recent post entitled Look Out, Plan Refunds Are Coming!, getting a refund of 401(k) contributions made the previous year is rarely a desirable thing.  However, if you do end up getting such a refund, look at the bright side: failing the Average Deferral Percentage test (ADP test) means that you deferred the maximum amount of compensation that you could have for that year.  Also, the excess amount refunded to you was deferred for at least one year (the refund is taxable in the year that it is returned).  Sure, you may not be able to defer the maximum allowed under the law ($17,000 for 2011), but you deferred the maximum that you could given your plan’s terms and the company’s demographics.

Many employers mistakenly spend a lot of time worrying about and taking steps to avoid failing the ADP test.  I think that this is mainly because of the usual stigma associated with failing a “test.”  While I can understand that no one wants to allow their plan to “fail,” the ADP test is one of the few required tests that really has no “penalty” for failure to pass.  Essentially, you will just have to return to the same place you would have been had you not deferred the refunded amount at all. 

I don’t think adjustments to the highly-compensated employees’ contribution rates prior to the close of a plan year in order to avoid failing the ADP test is ever a good idea.  The time and expense that you would incur to calculate the maximum contribution would be far more costly than if you simply wait until the end of the year to determine whether or not a refund was required.  The key to being “ok” with failing is to communicate with the participants who may receive a refund.  It is advisable to explain to those who will receive a refund the one year tax deferral advantage and subsequent return of the excess versus potentially not deferring as much as allowed by making adjustments to avoid failing the ADP test.

As I mentioned above, there is really no penalty for failing to pass the ADP test.  So, I say: “fail away,” take your one-year tax deferral on refunded amounts and then focus on where you can really make a difference – plan design improvements.

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