# How are Discrimination Test Refunds Calculated?

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# How are Discrimination Test Refunds Calculated?

When a plan corrects a failing ADP or ACP test via refunds, a two-step process sometimes called the “leveling method” is used. The method presented below describes the process for an ADP test failure, but a similar process works for ACP test failures as well.

In the first step, the contributions of the Highly Compensated Employees (HCEs) are reduced until their Average Deferral Percentage (ADP) passes the original test. This is done by reducing the contribution amount of the highest-percentage contributing HCE first, then continuing to the next-highest contributing HCE, and so on until the passing ADP is reached. As a result of this first step, a dollar amount equal to the total contribution reduction is carried over to the second step in the process.

In the second step, the actual refunds are calculated using the total contribution reduction calculated in the first step. Starting with the HCE who contributed the largest dollar amount, her contribution is reduced until the total from the first step is expended or her contribution amount is equal to the next-highest contributing HCE. If the latter event occurs first, then both HCE’s contributions are reduced equally. This procedure continues until the total amount from the first step is used, gradually including as many HCEs as required in descending order of their contributions.

At the end of this process, each HCE has an “excess contribution” amount. If HCEs have not used their catch-up contribution for the year, they may re-characterize their excess contribution amount as catch-up contribution, provided they don’t exceed the annual catch-up limit, thereby reducing or even eliminating their required refund. After catch-ups have been used, the remaining excess contributions are adjusted for earnings and refunded to the HCEs.

The ACP test has a similar process to calculate refunds, with two important differences:

The calculated refund amounts are known as “Excess Aggregate Contributions.”  These may not be re-characterized as catch-up contributions.

An HCE will only receive a refund to the extent she is vested in the matching source. The vested portion is distributed to the HCE, and the unvested portion is forfeited.

(FAQ10RP)