The Internal Revenue Service (IRS) carefully scrutinizes the contributions of highly compensated employees (HCEs) to ensure they do not benefit unfairly from tax-deferred retirement savings plans, such as 401(k) plans. But catch-up contributions are not included in actual deferral percentage (ADP) testing because they can skew testing results.
What Is ADP Testing?
For an employer-sponsored retirement plan to retain its tax-qualified status, it must meet certain stringent non-discrimination tests to ensure wealthier employees are not benefiting more from the plan than the average wage earner. The IRS uses ADP testing to verify that plan participation remains relatively equal for employees across all income levels.
Under the requirements of ADP testing, the average salary deferral made by HCEs may only exceed the average contribution of regular employees by a certain percentage. If HCEs are found to have exceeded the contribution limit required by ADP testing, the plan must return excess contributions or risk losing its tax-qualified status.
The IRS imposes strict limitations on the amount that may be contributed to a qualified plan in any given year. For 2020, the maximum employee contribution for those under age 50 is $19,500, with a maximum total contribution limit (including employer participation) of $57,000.
However, to encourage those nearing retirement to ramp up their savings, the IRS allows plan participants over 50 to make annual catch-up contributions that exceed these limits. In 2020, eligible employees may contribute an additional $6,500, increasing the total limit to $26,000 for employee contributions and $63,500 overall.
Why Are Catch-Up Contributions Excluded?
Catch-up contributions are excluded because not all employees are eligible to make them in any given year. Including them in ADP testing risks skewing the results.
If a number of non-highly compensated employees (NHCEs) over the age of 50 maximize their contributions, for example, their aggressive participation increases the average contribution of all NHCEs, even if their peers are not yet eligible to make catch-up contributions.
Though this scenario may be good news for HCEs who would enjoy increased contribution limits, the opposite would be true if it were they who were over age 50. If catch-up contributions made by HCEs were included in testing, the average HCE contribution might exceed the ADP limit more quickly, requiring the plan to return contributions. (For related reading, see "Why Are 401(k) Contributions Limited?")