401(k) Strategies: How to Reduce Refunds to Executives

By Fred Reish, Bruce Ashton, and Marge Paul, MSPA, MAAA, EA

In order to maximize the value of their 401(k) plans, plan sponsors will want to be aware of the impact of the changes in the calculation of the ADP and ACP tests made by recent legislation. In this article, we discuss a technique that is being used to minimize refunds to key executives. To accomplish this objective, plan sponsors should consider limiting the percentage of pay that certain employees contribute to the plan.

ADP Test
To prove that 401(k) salary deferral contributions do not favor highly compensated employees (HCs), 401(k) plans must pass an annual Average Deferral Percentage (ADP) test. Plans that fail the test are required to refund a portion of the salary deferral contributions made on behalf of HCs or make additional contributions, called QNECs, for nonhighly compensated employees(NHCs). Originally, these refunds were made to HCs contributing the highest percentage of their salary. This usually enabled plan sponsors to avoid making refunds to the highest-paid executives.

For plan years beginning in 1997, the Small Business Job Protection Act (SBJPA) altered the manner in which refunds are allocated. Refunds are now made to HCs with the largest salary deferral amounts (e.g., usually the highest-paid executives).

Limiting Deferral Percentage Reduces Refunds
Plans that cap the percentage of pay that HCs can contribute will minimize 401(k) refunds to key executives. For example, assume two HCs each contributed $10,000 to their 401(k) plan. HC #1 earns $100,000 and HC #2 earns 160,000. Therefore, the ADP for HC #1 is 10%, while the ADP for HC #2 is 6.25%. Assume the ADP for nonhighly compensated employees is 4.25%.

In order to pass the ADP test, the average ADP for HCs must be no greater than 6.25%— e.g., 4.25% (the average ADP for NHCs)+ 2%. Since the average ADP for HCs is 8.25%( 10% + 6.25%) ÷ 2, the plan administrator determines that $3,750 must be refunded to HC #1.

Prior to SBJPA, the entire refund would have been made to HC #1, since that would have been the amount necessary to reduce the participant with the highest ADP to the level of the participant with the next highest ADP, and so on, if there were more HCs. Today, however, SBJPA requires that the $3,750 refund be allocated, first, to the participant with the highest deferral amount. Since each HC has deferred $10,000, the $3,750 refund is allocated equally between them; each HC receives a refund of $1,875. The mathematicians among our readers will note that the plan still does not appear to pass the ADP test. However, IRS Notice 98-1 tells us that the plan now passes, because the correct amount has been refunded.

If the plan had limited HC 401(k) contributions to 6.25% of pay, HC #1 would have made a salary deferral contribution of 6.25% of pay, or $6,250, and refunds would not have been required. Such an amendment can be made to a plan without impacting HC #2 who can continue to contribute $10,000 (6.25% of pay) to the plan.

Limiting salary deferral contribution percentages is one of a number of strategies that can be utilized to improve discrimination testing results. Plan sponsors should not hesitate to contact their advisors for ideas on how testing results can be improved.