What Are the Actual Deferral Percentage (ADP) & Actual Contribution Percentage (ACP) Tests?
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are crucial assessments that companies must conduct to ensure fair 401(k) plans distribution. These tests help ensure high earnings employees do not disproportionately benefit at the expense of others.
Conducting these tests is pivotal for companies to retain the qualified status of their 401(k) plans under IRS rules and the Employee Retirement Income Security Act (ERISA). Failure to pass these tests necessitates corrective actions within the subsequent year to avoid penalties from the IRS, plan disqualification, and potential fiduciary liability for employers.
How ADP and ACP Tests Work
ADP Test
The ADP test compares average salary deferral percentages between highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). An HCE is defined as anyone owning more than a 5% interest in the company at any time during the current or prior year or someone who earned over $130,000 in the 2020 tax year.
This test evaluates both pre-tax and after-tax Roth deferrals, excluding catch-up contributions permitted only for employees aged 50 and up. To comply, the ADP for HCEs must not exceed NHCEs’ ADP by more than two percentage points or be more than twice the NHCE percentage collectively.
ACP Test
The ACP test is similar to the ADP test but focuses on employer matching contributions or employee after-tax contributions.
Correcting an ADP/ACP Test Failure
When a 401(k) plan fails either the ADP or ACP test, employers must act promptly by refunding excess contributions to HCEs to meet compliance criteria. Unfortunately, these refunds are subject to HCEs’ income tax.
Employers can prevent plan failures by establishing buffer zones within their plan documents. One preventive strategy involves capping contributions from HCEs. Employers may also conduct projection tests mid-year to assess if applying any restrictions is necessary.
Alternatively, some companies opt for a Safe Harbor 401(k) plan to avoid the hassle of these tests altogether.
What Is a Safe Harbor Plan?
Safe Harbor 401(k) plans exempt employers from ADP/ACP and other non-discrimination testing requirements if they provide specific matching or nonelective contributions to their employees.
To be eligible, a company must match 100% of the first 3% of compensation deferred, and 50% of deferrals between 3% and 5%, or offer a minimum nonelective contribution of 3% of compensation to all employees, regardless of their participation.
Related Terms: 401(k) plan, highly compensated employees, non-highly compensated employees, Safe Harbor 401(k).
References
Get ready to put your knowledge to the test with this intriguing quiz!
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## What do the ADP and ACP tests primarily ensure in 401(k) plans?
- [ ] That the plan adheres to industry standard fees
- [x] That contributions made to 401(k) plans do not disproportionately favor highly compensated employees (HCEs)
- [ ] That employer contributions exceed certain minimum standards
- [ ] That the plan offers a diverse range of investment options
## Who is affected by the ADP test in a 401(k) plan?
- [ ] Only non-highly compensated employees (NHCEs)
- [x] Highly compensated employees (HCEs)
- [ ] Only plan administrators
- [ ] The plan sponsor
## What does the ACP test compare?
- [ ] Salary deferrals of highly compensated employees vs. stock performance
- [x] Employer matching contributions and after-tax employee contributions
- [ ] Only pretax salary deferrals
- [ ] All employee investment choices
## Which of the following is considered a corrective measure if a company fails the ADP test?
- [ ] Increasing the employer's company match to all employees
- [ ] Disbanding the 401(k) plan altogether
- [x] Returning excess contributions to highly compensated employees
- [ ] Reducing the fees associated with plan management
## How often must the ADP and ACP tests be performed?
- [ ] Monthly
- [ ] Quarterly
- [x] Annually
- [ ] Biennially
## Which of the following can result from a failed ACP test?
- [ ] Increased diversification of investment options
- [ ] Termination of the plan
- [x] Required changes to contributions or refunds to certain employees
- [ ] Lower expense ratios in the plan funds
## What qualifies someone as a highly compensated employee (HCE) for the purposes of the ADP/ACP tests?
- [ ] Employees with over 20 years of service
- [x] Employees owning more than 5% of the business or earning above a certain threshold
- [ ] Employees making less than the plan eligibility requirements
- [ ] All part-time employees regardless of compensation
## Which regulatory body oversees the requirements for ADP and ACP tests?
- [ ] Federal Reserve
- [ ] Financial Industry Regulatory Authority (FINRA)
- [x] Internal Revenue Service (IRS)
- [ ] Environmental Protection Agency (EPA)
## What can companies do to help ensure they would not fail the ADP/ACP tests?
- [ ] Only hire employees who will be NHCEs
- [ ] Eliminate 401(k) plan offerings
- [ ] Focus exclusively on after-tax gifts instead of salary deferrals
- [x] Implement safe harbor contributions or make matching contributions
## When might changes to contributions be returned to employees due to failed ADP/ACP tests?
- [ ] After 10 years of plan participation
- [x] When correction measures need to be implemented to meet compliance
- [ ] If the plan disqualifies the employer from making future contributions
- [ ] If employees do not meet a specified age
