12.2 401(k) Plans: Elective Deferrals, Testing & Safe Harbors

401(k) Plans: Elective Deferrals, Testing & Safe Harbors

Quick Answer: A Section 401(k) Cash or Deferred Arrangement (CODA) enables employees to contribute pre-tax or designated Roth funds up to the IRC §402(g) limit of $24,500 (2026), with standard age 50+ catch-up contributions of $8,000 and a SECURE 2.0 "super catch-up" of $11,250 for ages 60–63 (subject to mandatory Roth catch-up for employees earning over $150,000 FICA wages). Traditional plans must pass annual ADP and ACP nondiscrimination tests or eliminate testing altogether by adopting Safe Harbor formulas (Basic Match: 100% on first 3% + 50% on next 2%; 3% Non-Elective; or QACA automatic enrollment designs).

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1. Cash or Deferred Arrangements (CODA) & Elective Deferral Mechanics

Codified under IRC §401(k), a Cash or Deferred Arrangement (CODA) is a specialized provision forming part of a qualified profit-sharing plan, stock bonus plan, or pre-ERISA money purchase plan. Under a CODA, an eligible employee may elect to have the employer either:

1. Pay compensation directly to the employee in cash, or
2. Defer a portion of compensation into the qualified trust on the employee's behalf (Elective Deferrals).

┌────────────────────────────────────────────────────────────────────────┐
│               PRE-TAX ELECTIVE DEFERRALS VS. DESIGNATED ROTH           │
├──────────────────────────┬─────────────────────────────────────────────┤
│ Feature                  │ Pre-Tax Deferral     │ Designated Roth      │
├──────────────────────────┼──────────────────────┼─────────────────────┤
│ Federal Income Tax       │ Excluded from gross  │ Included in gross   │
│ at Contribution          │ income (deductible)  │ income (after-tax)  │
├──────────────────────────┼──────────────────────┼─────────────────────┤
│ FICA Payroll Taxes       │ Subject to Social    │ Subject to Social   │
│ (Social Security/Med)    │ Security & Medicare  │ Security & Medicare │
├──────────────────────────┼──────────────────────┼─────────────────────┤
│ Taxation of Qualified    │ 100% taxed as        │ 100% tax-free       │
│ Distributions            │ ordinary income      │ (earnings + basis)  │
├──────────────────────────┼──────────────────────┼─────────────────────┤
│ Qualified Distribution   │ N/A (always taxable) │ 5-year holding rule │
│ Criteria                 │                      │ + age 59.5/disab/die│
└──────────────────────────┴──────────────────────┴─────────────────────┘

2026 Statutory Deferral Limits & Catch-Up Mechanics

• IRC §402(g) Elective Deferral Limit: For the 2026 calendar tax year, the statutory limit on employee elective deferrals across all 401(k) and 403(b) plans is $24,500.
• Age 50+ General Catch-Up Limit (IRC §414(v)): Participants who attain age 50 or older by the end of the calendar year may make additional catch-up contributions up to $8,000 for 2026 (totaling $32,500).
• SECURE 2.0 Enhanced "Super Catch-Up" (Ages 60, 61, 62, 63): Beginning in 2025 and ongoing in 2026, participants who attain age 60, 61, 62, or 63 during the taxable year are eligible for an elevated catch-up limit equal to the greater of $10,000 or 150% of the regular age 50 catch-up limit. For 2026, this "super catch-up" ceiling is $11,250 (allowing total elective deferrals of $35,750 for participants in this four-year age window).
• Mandatory Roth Catch-Up for High Earners (SECURE 2.0 §603): Under SECURE 2.0, any employee whose wages subject to FICA from the sponsoring employer in the preceding calendar year exceeded $150,000 (indexed) is legally prohibited from making pre-tax catch-up contributions. All catch-up deferrals made by such high earners must be designated as Roth contributions.

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2. Annual Nondiscrimination Testing: ADP and ACP Tests

Because elective deferrals and matching contributions are voluntary, higher-paid executives might contribute at high rates while lower-paid workers contribute little. To maintain tax-qualified status, traditional 401(k) plans must annually satisfy two mathematical nondiscrimination tests comparing the Highly Compensated Employee (HCE) group against the Non-Highly Compensated Employee (NHCE) group:

┌────────────────────────────────────────────────────────────────────────┐
│                     DEFINITION OF A HIGHLY COMPENSATED EMPLOYEE        │
│                             (IRC §414(q) FOR 2026)                     │
├────────────────────────────────────────────────────────────────────────┤
│ An individual is an HCE if they meet EITHER criterion:                 │
│                                                                        │
│ 1. 5% Owner: Owned > 5% of corporate equity or capital/profit interest │
│    at any time during the current or preceding determination year.     │
│                                  OR                                    │
│ 2. Compensation Threshold: Received compensation from the employer in   │
│    the PRECEDING year exceeding $155,000 (2025 look-back / $160,000    │
│    2026 look-back), AND (if elected by employer) was in the top-paid   │
│    20% of employees.                                                   │
└────────────────────────────────────────────────────────────────────────┘

Actual Deferral Percentage (ADP) Test

The ADP Test evaluates employee pre-tax and designated Roth elective deferrals (excluding catch-up contributions). Each eligible employee's Actual Deferral Ratio (ADR = deferrals / compensation) is calculated, including eligible non-participating employees who receive a 0.0% ADR. The ADRs are averaged separately for the NHCE group and the HCE group.

Actual Contribution Percentage (ACP) Test

The ACP Test (under IRC §401(m)) operates identically to the ADP test but evaluates employer matching contributions and employee after-tax voluntary contributions.

The Statutory Mathematical Testing Standards

The ADP and ACP tests are satisfied if the HCE average percentage does not exceed the NHCE average percentage under either of the following two statutory benchmarks:

$\text{Maximum Allowable HCE Rate} = \max \Big( 1.25 \times \text{NHCE Rate}, \; \min(2.0 \times \text{NHCE Rate}, \; \text{NHCE Rate} + 2.0\%) \Big)$

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3. Correction Methods for Failed ADP/ACP Tests

If a plan fails the ADP or ACP test, the plan sponsor must correct the failure within 12 months following the close of the plan year to avoid disqualification under IRC §401(a). Four standard correction methodologies exist:

┌────────────────────────────────────────────────────────────────────────┐
│                     ADP / ACP TEST CORRECTION METHODS                  │
├──────────────────────────┬─────────────────────────────────────────────┤
│ Correction Method        │ Operational Mechanics & Tax Implications    │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 1. Corrective            │ Excess contributions distributed to HCEs    │
│    Distribution          │ (using leveling method based on dollar      │
│                          │ amount). Subject to 10% employer excise tax │
│                          │ if not distributed within 2.5 months        │
│                          │ (6 months for EACAs) after year-end.        │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 2. Recharacterization    │ Excess pre-tax deferrals recharacterized as │
│                          │ after-tax employee contributions; taxable to│
│                          │ HCE immediately, but shifts burden to ACP.  │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 3. QNEC (Qualified       │ Employer funds 100% vested, non-elective    │
│    Nonelective Contrib.) │ contributions allocated to NHCEs to lift the│
│                          │ baseline NHCE ADP average.                  │
├──────────────────────────┼─────────────────────────────────────────────┤
│ 4. QMAC (Qualified       │ Employer funds 100% vested matching dollars │
│    Matching Contrib.)    │ provided to contributing NHCEs to lift the  │
│                          │ NHCE ADP or ACP average.                    │
└──────────────────────────┴─────────────────────────────────────────────┘

• Dollar-Leveling Distribution Method: Under IRC §401(k)(8)(C), excess deferrals are determined on a percentage basis to establish the total excess dollar pool, but are distributed from HCEs in order of the highest dollar amount contributed, not highest percentage. This protects lower-earning HCEs.

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4. Safe Harbor 401(k) Plan Architectures

To eliminate the administrative burden, testing unpredictability, and executive contribution refund risks associated with annual ADP/ACP testing, plan sponsors frequently adopt a Safe Harbor 401(k) Plan under IRC §401(k)(12) and §401(m)(11). A Safe Harbor plan is statutorily deemed to pass ADP and ACP testing and is generally exempt from Top-Heavy minimum contribution rules under IRC §416.

┌────────────────────────────────────────────────────────────────────────┐
│                 SAFE HARBOR 401(k) PLAN DESIGN OPTIONS                 │
├──────────────────┬──────────────────────────────────┬──────────────────┤
│ Safe Harbor Type │ Required Employer Contribution   │ Vesting Schedule │
├──────────────────┼──────────────────────────────────┼──────────────────┤
│ 1. Basic Match   │ 100% on first 3% of comp +       │ 100% Immediate   │
│                  │ 50% on next 2% of comp (4% max)  │ Vesting          │
├──────────────────┼──────────────────────────────────┼──────────────────┤
│ 2. Enhanced Match│ At least equal to Basic Match    │ 100% Immediate   │
│                  │ (e.g., 100% on first 4% of comp) │ Vesting          │
├──────────────────┼──────────────────────────────────┼──────────────────┤
│ 3. Non-Elective  │ 3% of comp to ALL eligible NHCEs │ 100% Immediate   │
│                  │ regardless of whether they defer │ Vesting          │
├──────────────────┼──────────────────────────────────┼──────────────────┤
│ 4. QACA          │ Auto-enroll (3% min to 6% min) + │ Up to 2-Year     │
│    Safe Harbor   │ Match (100% on 1% + 50% on 5%) or│ Cliff Vesting    │
│                  │ 3% Non-Elective                  │ (100% at 2 yrs)  │
└──────────────────┴──────────────────────────────────┴──────────────────┘

1. Traditional Safe Harbor Matching Formulas

• Basic Match Formula: The employer matches 100% of employee elective deferrals up to the first 3% of compensation, plus 50% of elective deferrals on the next 2% of compensation (resulting in a maximum required employer contribution of 4% for an employee deferring 5% or more). Deferrals beyond 5% receive no match under this formula.
• Enhanced Match Formula: The employer provides a match that is at least as generous at every deferral percentage as the basic match, and does not match elective deferrals exceeding 6% of compensation (e.g., a dollar-for-dollar 100% match on the first 4% of compensation).

2. Traditional Safe Harbor Non-Elective Formula

The employer contributes at least 3% of compensation to all eligible NHCEs, regardless of whether the employee chooses to make any elective deferrals. This formula is highly advantageous for employers who wish to avoid tracking employee contribution rates and provide a guaranteed baseline benefit.

3. Qualified Automatic Contribution Arrangement (QACA Safe Harbor)

Enacted under IRC §401(k)(13), a QACA Safe Harbor combines automatic enrollment and automatic escalation with safe harbor testing exemption. Key requirements:

• Mandatory Automatic Enrollment & Escalation: Eligible employees are automatically enrolled at a default deferral rate of at least 3% in Year 1, escalating to at least 4% in Year 2, 5% in Year 3, and 6% in Year 4 and beyond (capped at a maximum of 15%).
• QACA Matching Formula: 100% match on the first 1% of compensation, plus 50% match on deferrals between 1% and 6% (maximum match of 3.5% on 6% deferral).
• Modified Vesting Safe Harbor: Unlike traditional safe harbor contributions which must be 100% immediately vested, QACA safe harbor contributions may be subject to a 2-year cliff vesting schedule (0% in Year 1, 100% after 2 years of service).

Annual Safe Harbor Notice Mandates

Under Treasury regulations, plan sponsors maintaining a safe harbor matching design must provide a comprehensive written notice to all eligible employees within a reasonable window before each plan year begins (between 30 and 90 days prior to the start of the plan year, typically between October 1 and December 1 for a calendar year plan). SECURE Act eliminated the annual notice requirement for plans adopting the 3% Non-Elective safe harbor formula, significantly easing administrative compliance.