Actual Deferral & Actual Contribution Percentage Test (ADP/ACP)

Introduction

The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are non-discrimination tests applied to employer-sponsored retirement plans, such as 401(k) plans in the United States. These tests are designed to ensure that a fair contribution percentage from both highly compensated employees (HCEs) and non-highly compensated employees (NHCEs) is maintained, thus promoting fairness and avoiding excessive benefits skewing toward higher-paid employees.

Actual Deferral Percentage (ADP) Test

The ADP Test compares the average percentages of salary deferred (contributed) to the 401(k) plans between HCEs and NHCEs.

Determining Highly Compensated Employees (HCEs)

HCEs are defined as employees who:

Received compensation from the employer exceeding a specified dollar limit (e.g., $130,000 in 2021).
Owned more than 5% of the business at any time during the year, regardless of their compensation.

Test Calculation

To perform the ADP Test:

Calculate the deferral percentage for each employee by dividing the annual amount deferred by the employee’s compensation.
Compute the average deferral percentage for HCEs and NHCEs separately.
Apply the IRS rules to ensure the HCE’s average deferral percentage does not exceed a certain threshold compared to NHCEs:

NHCE Average ≤ 2%: HCE Average can be up to NHCE Average x 2
NHCE Average > 2% and ≤ 8%: HCE Average can be NHCE Average + 2%
NHCE Average > 8%: HCE Average can be NHCE Average x 1.25

Example Calculation

Suppose a company has four employees, and the average deferral percentages for NHCEs and HCEs are as follows:

NHCEs Average: 4%
HCEs Average: HCE Threshold would be NHCE Average + 2% = 6%

If the average deferral percentage for HCEs exceeds 6%, the plan fails the ADP Test.

Actual Contribution Percentage (ACP) Test

The ACP Test evaluates the contributions made to employees’ 401(k) plans, which could include employer matching contributions, after-tax contributions, and employee deferrals not assessed in the ADP Test.

Test Calculation

To conduct the ACP Test:

Calculate the contribution percentage for each employee by dividing the total annual contributions by the employee’s compensation.
Compute the average contribution percentage for HCEs and NHCEs separately.
Ensure the HCE’s average contribution does not exceed allowable limits similarly to the ADP Test thresholds.

Example Calculation

Suppose a company has the following average contribution percentages for NHCEs and HCEs:

NHCEs Average: 5%
HCEs Average: HCE Threshold would be NHCE Average + 2% = 7%

If the average contribution percentage for HCEs exceeds 7%, the plan fails the ACP Test.

Corrective Actions for ADP/ACP Test Failures

If the plan fails either the ADP or ACP test, corrective actions must be taken promptly. The most common corrective actions include:

Refunding Excess Contributions: Distributing excess deferrals/contributions made by HCEs to them.
QNECs and QMACs: Providing Qualified Non-Elective Contributions (QNECs) or Qualified Matching Contributions (QMACs) to NHCEs to raise their average percentages.

Administrative Measures and Monitoring

Annual Testing: Conducting annual ADP/ACP tests.
Plan Amendments: Amending plan terms to include safe harbor provisions, thereby exempting the plan from ADP/ACP testing requirements.
Continuous Monitoring: Regularly monitoring contributions and deferrals throughout the year to avoid failures.

Resources and Solutions

Several firms provide ADP/ACP testing assistance, offering automated solutions and tailored consulting to ensure compliance. For instance:

ADP Retirement Services: Automated testing and correction process provided by ADP. ADP Retirement Services
Paychex: Comprehensive 401(k) plan administration including non-discrimination testing and corrections. Paychex
Fidelity: Offers 401(k) plans and services, including non-discrimination testing. Fidelity

Conclusion

ADP and ACP tests are crucial for the compliance of 401(k) plans, ensuring equitable participation among employees regardless of their compensation levels. Plans must perform these tests annually and take necessary corrective actions in case of failures, employing resources and expertise from service providers when required. Abiding by these regulations not only maintains the plan’s qualified status but also fosters a fair retirement savings opportunity across all employees.