In the case of tax-deferred retirement financial savings plans, like 401(ok) plans, the Internal Revenue Service (IRS) rigorously scrutinizes the contributions of extremely compensated workers (HCEs) to make sure they don’t profit unfairly. To take action, it makes use of a technique known as precise deferral proportion (ADP) testing. However catch-up contributions by workers of a sure age usually are not included within the measure, as a result of they will skew testing outcomes.
What Is ADP Testing?
For an employer-sponsored retirement plan to retain its tax-qualified standing, it should meet sure stringent non-discrimination exams to make sure wealthier workers usually are not benefiting extra from the plan than the common wage earner. The IRS makes use of Precise Deferral Share (ADP) testing to confirm that plan participation stays comparatively equal for workers throughout all revenue ranges.
Underneath the necessities of ADP testing, the common wage deferral made by HCEs might solely exceed the common contribution of normal workers by a sure proportion. If HCEs are discovered to have exceeded the contribution restrict required by ADP testing, the plan should return extra contributions or threat dropping its tax-qualified standing.
The IRS imposes strict limitations on the quantity that could be contributed to a certified plan in any given yr. For 2022, the utmost worker contribution for these underneath age 50 is $20,500, with a most complete contribution restrict (together with employer participation) of $61,000 (vs. $19,500/$58,000 for 2021).
Nonetheless, to encourage these nearing retirement to ramp up their financial savings, the IRS permits plan individuals over 50 to make annual catch-up contributions that exceed these limits. For 2022, eligible workers might contribute a further $6,500, growing the entire restrict to $27,000 for worker contributions and $67,500 general for 2022.
Why Are Catch-Up Contributions Excluded?
Catch-up contributions are excluded as a result of not all workers are eligible to make them in any given yr. Together with them in ADP testing dangers skewing the outcomes.
If various non-highly compensated employees (NHCEs) over the age of fifty maximize their contributions, for instance, their aggressive participation will increase the common contribution of all NHCEs, even when their friends usually are not but eligible to make catch-up contributions.
Although this situation could also be excellent news for HCEs who would get pleasure from elevated contribution limits, the alternative could be true if it have been they who have been over age 50. If catch-up contributions made by HCEs have been included in testing, the common HCE contribution may exceed the ADP restrict extra rapidly, requiring the plan to return contributions.