The Actual Deferral Percentage (ADP) Test and the Actual Contribution Percentage (ACP) Test are regulatory requirements designed to ensure fairness in 401(k) retirement plans.
These tests prevent discrimination by ensuring that highly compensated employees (HCEs) do not disproportionately benefit compared to non-highly compensated employees (NHCEs).
What Are the ADP and ACP Tests?
ADP Test: Ensuring Fair Salary Deferrals
The ADP Test measures the average percentage of salary deferrals contributed to a 401(k) by HCEs compared to NHCEs.
It ensures that employee contributions from higher-paid employees are not significantly greater than those of lower-paid employees.
ACP Test: Monitoring Employer Contributions
The ACP Test focuses on employer contributions, such as matching and after-tax contributions.
Like the ADP test, it ensures that HCEs do not disproportionately benefit from these contributions.
Together, these tests promote equitable retirement savings opportunities across all employee groups.
Why Are These Tests Necessary?
Both tests are essential for maintaining the qualified status of a 401(k) plan. Failure to comply can result in:
- Plan disqualification and loss of tax benefits.
- Mandatory corrective actions.
- Potential financial penalties.
By meeting these requirements, employers ensure that their plans remain compliant while fostering equitable retirement benefits.
Identifying HCEs and NHCEs
Highly Compensated Employees (HCEs)
An HCE is defined as an employee who:
- Owns more than 5% of the company at any time during the year or the previous year.
- Earns compensation exceeding the IRS limit, such as $135,000 in 2023.
Non-Highly Compensated Employees (NHCEs)
Employees who do not meet the above criteria are considered NHCEs.
This classification allows for a fair comparison of contributions between groups.
How Are ADP and ACP Tests Calculated?
ADP Test Calculation
Calculate the average deferral percentage for NHCEs.
Example: If three NHCEs defer 5%, 6%, and 7% of their salaries:
Calculate the average deferral percentage for HCEs.
Compare the two averages:
The HCE deferral percentage cannot exceed 1.25 times the NHCE percentage, or
It cannot exceed NHCEs’ deferral percentage by more than two percentage points if the NHCE percentage is less than 8%.
ACP Test Calculation
The ACP test uses the same method but focuses on employer matching and after-tax contributions.
What Happens If a Plan Fails?
If a 401(k) plan fails either test, corrective actions are required:
- Refund Excess Contributions: HCEs may receive refunds of their excess contributions.
- Increase Employer Contributions: Employers can increase NHCE contributions to meet compliance.
- Plan Restructuring: Employers may adopt a safe harbor 401(k) plan to avoid future testing requirements.
These actions must be implemented promptly to maintain the plan’s compliance and tax-advantaged status.
Example
Imagine a company with the following contributions:
- NHCEs:
Employee A: 6%
Employee B: 7%
Employee C: 5%
NHCE Average = (6% + 7% + 5%) / 3 = 6%. - HCEs:
Employee X: 10%
Employee Y: 11%
HCE Average = (10% + 11%) / 2 = 10.5%.
In this case, the HCE average exceeds the allowable limit of 7.5% (6% × 1.25). Corrective action is required to address the excess contributions.
Simplifying Compliance with Safe Harbor Plans
To avoid ADP and ACP testing, many employers adopt safe harbor 401(k) plans.
These plans automatically meet testing requirements by providing:
- A 100% match on the first 3% of employee contributions and 50% on the next 2%, or
- A non-elective contribution of 3% of compensation to all eligible employees.
Although safe harbor plans require additional employer contributions, they simplify compliance and provide certainty.
Final Thoughts
The ADP and ACP tests are essential for ensuring fairness in 401(k) plans and maintaining compliance with IRS regulations.
Employers must carefully monitor contributions, conduct annual testing, and take corrective actions when needed.
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