Your client's 401(k) just failed ADP testing. The administrator says every highly compensated employee must return $8,200 in deferrals, including the CEO. The fix is straightforward if you know the rules.
A qualified plan meets IRC Section 401(a). Employer contributions are deductible when made. Earnings grow tax-deferred. Participants are not taxed until distribution. Losing qualification retroactively strips these benefits for everyone.
After 1960s-era pension failures wiped out long-tenured workers' benefits, Congress passed the Employee Retirement Income Security Act to set minimum floor protections. ERISA governs most private-sector plans with minimum standards for eligibility, vesting, funding, fiduciary conduct, and reporting. Governmental and church plans are generally exempt.
These are eligibility rules, governing when an employee must be allowed into the plan: a qualified plan cannot delay eligibility beyond one year of service (1,000 hours in a 12-month period) or an age above 21. Plans with 100% immediate vesting may stretch the service requirement to two years.
HIGH-FREQUENCY: Employee deferrals are always 100% immediately vested, no exceptions. Employer contributions follow one of two schedules:
Common mistakes
- Confusing ADP testing with top-heavy testing. ADP compares deferral rates between HCEs and NHCEs. Top-heavy checks whether 60%+ of assets belong to key employees. Different people, different tests, different fixes. Trap: "3% minimum contribution for NHCEs" as the ADP correction, that is the top-heavy remedy.
- Applying vesting schedules to employee deferrals. Deferrals are always 100% vested immediately. So are safe harbor contributions. Only employer profit-sharing and non-safe-harbor matching vest on a schedule. Trap: reducing the vested balance by applying graded vesting to deferrals.
- Forgetting the 12-month lookback on plan loans. A prior $30,000 outstanding loan reduces the new maximum to $20,000. Trap: showing $50,000 available when a recent loan cuts it.
Bottom line
- Qualified status delivers deductible contributions, tax-deferred growth, and deferred taxation. Disqualification is retroactive and catastrophic for all participants.
- Eligibility: max 1 year of service (1,000 hours) plus age 21. Employee deferrals are always 100% immediately vested.
- Employer vesting: cliff is 3 years for matching, graded reaches full at 6 years. Deferrals and safe harbor contributions never follow a schedule.
- ADP test: an HCE deferral rate cannot exceed NHCE x 1.25, or alternatively NHCE + 2 (2x cap). A safe harbor 401(k) bypasses testing entirely.
Exam shortcut
ADP test: "1.25x or +2/2x." Vesting rule: "Deferrals: Always. Match: 3 cliff / 6 graded. Safe harbor: Always." HCE = $160K or 5% owner. Key employee = $230K officer or 5%/1% owner. Plan loan: "50/50/10/5", $50,000 max, 50% of vested, $10,000 minimum, 5-year repayment. Safe harbor "BEN": Basic match, Enhanced match, Non-elective 3%.
The full lesson (about 2,566 words, 17 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- F.48
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