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Actual contribution percentage test

What Is Actual Contribution Percentage Test?

The Actual Contribution Percentage (ACP) test is a vital nondiscrimination test conducted annually on certain employer-sponsored retirement plans, such as 401(k) plans. This test falls under the broader category of Employee Benefits Compliance and is mandated by the Internal Revenue Service (IRS) to ensure that employer matching contributions and employee after-tax contributions do not disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). Its purpose is to uphold the fairness and equitable distribution of benefits within a qualified plan and maintain its tax-advantaged status49, 50.

History and Origin

The regulatory foundation for the Actual Contribution Percentage (ACP) test, along with other nondiscrimination rules, lies within the Employee Retirement Income Security Act of 1974 (ERISA). ERISA was enacted to protect the retirement assets of American workers by setting minimum standards for most voluntarily established retirement and health plans in private industry47, 48.

While ERISA established the framework for fair treatment, specific nondiscrimination requirements for 401(k) plans, including the ACP test, were introduced and strengthened by Congress in the mid-1980s. The Tax Reform Act of 1984 introduced nondiscrimination requirements, and the Tax Reform Act of 1986 further refined these rules, linking the amount Highly Compensated Employees (HCEs) could contribute to the participation rates of rank-and-file employees46. These legislative actions were crucial in ensuring that tax-advantaged retirement plans served all employees, not just a select few44, 45.

Key Takeaways

  • The Actual Contribution Percentage (ACP) test is an annual IRS-mandated nondiscrimination test for qualified retirement plans.
  • It evaluates if employer matching contributions and employee after-tax contributions disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs).
  • Failing the ACP test requires corrective action, often involving the distribution of excess contributions to HCEs or making additional contributions for NHCEs.
  • The test encourages plan sponsors to promote broad employee participation and contribution to their retirement plans.
  • Safe harbor 401(k) plans can be exempt from the ACP test, provided they meet specific contribution and notice requirements43.

Formula and Calculation

The Actual Contribution Percentage (ACP) test involves calculating a contribution percentage for each eligible employee and then averaging these percentages for two groups: Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs)41, 42.

The individual Actual Contribution Ratio (ACR) for each participant is calculated as follows:

ACR=Matching Contributions+After-Tax ContributionsCompensation\text{ACR} = \frac{\text{Matching Contributions} + \text{After-Tax Contributions}}{\text{Compensation}}

The average ACP for each group (HCEs and NHCEs) is then determined by summing the individual ACRs for all eligible employees within that group and dividing by the number of employees in that group. Note that employees eligible for the plan but not contributing are included in the calculation with a 0% ratio, which lowers the average for that group39, 40.

To pass the Actual Contribution Percentage (ACP) test, the average ACP for the HCE group must not exceed the greater of:

  • 125% of the NHCE average ACP, or
  • The lesser of:
    • 200% of the NHCE average ACP, or
    • The NHCE average ACP plus 2 percentage points38.

Interpreting the Actual Contribution Percentage Test

Interpreting the Actual Contribution Percentage (ACP) test results involves comparing the average contribution rates of the HCE and NHCE groups to determine if the plan adheres to IRS nondiscrimination testing requirements36, 37. A passing test indicates that the plan's design and employee participation patterns do not unduly benefit highly compensated individuals, thus maintaining the plan's tax-qualified status34, 35.

If the ACP test reveals that the HCEs' average contribution percentage exceeds the permissible limits relative to the NHCEs, the plan fails the test33. A failed Actual Contribution Percentage test necessitates corrective actions to avoid potential penalties and maintain the plan's favorable tax treatment32. These corrections typically involve reducing the contributions of HCEs or increasing contributions for NHCEs. The IRS provides guidance on acceptable correction methods in publications like IRS Publication 56030, 31.

Hypothetical Example

Consider a company, "Tech Innovations Inc.," with a 401(k) plan that includes employer matching contributions. For the year, the plan needs to perform its Actual Contribution Percentage (ACP) test.

Non-Highly Compensated Employees (NHCEs):

  • Employee A: Compensation = $50,000, Employer Match = $2,000. ACR = ($2,000 / $50,000) = 4.0%
  • Employee B: Compensation = $45,000, Employer Match = $1,800. ACR = ($1,800 / $45,000) = 4.0%
  • Employee C: Compensation = $60,000, Employer Match = $2,400. ACR = ($2,400 / $60,000) = 4.0%
  • Employee D: Compensation = $40,000, Employer Match = $0 (did not contribute enough to receive match). ACR = ($0 / $40,000) = 0.0%

Average NHCE ACP = (4.0% + 4.0% + 4.0% + 0.0%) / 4 = 3.0%

Highly Compensated Employees (HCEs):

  • Employee X: Compensation = $180,000, Employer Match = $7,200. ACR = ($7,200 / $180,000) = 4.0%
  • Employee Y: Compensation = $200,000, Employer Match = $12,000. ACR = ($12,000 / $200,000) = 6.0%

Average HCE ACP = (4.0% + 6.0%) / 2 = 5.0%

Now, apply the ACP test rules:

  1. Is HCE ACP (5.0%) <= 125% of NHCE ACP (3.0%)? 125% of 3.0% = 3.75%.
    • 5.0% is NOT <= 3.75%. So, the first condition fails.
  2. Is HCE ACP (5.0%) <= (NHCE ACP (3.0%) + 2 percentage points)? 3.0% + 2% = 5.0%.
    • 5.0% IS <= 5.0%. This condition passes.
    • Is HCE ACP (5.0%) <= (200% of NHCE ACP (3.0%))? 200% of 3.0% = 6.0%.
      • 5.0% IS <= 6.0%. This condition passes.

Since the HCE ACP (5.0%) is not greater than the lesser of (200% of NHCE ACP or NHCE ACP + 2%), which is 5.0% (the lesser of 6.0% and 5.0%), the plan passes the Actual Contribution Percentage test. If the HCE average had been, for example, 5.1%, the plan would have failed and corrective action would be required.

Practical Applications

The Actual Contribution Percentage (ACP) test is a critical annual compliance measure for many employer-sponsored retirement plans, particularly 401(k) plans28, 29. Its primary application is to ensure that the plan maintains its tax-qualified status under IRS regulations. Companies that offer employer matching contributions or allow employee after-tax contributions must perform this test to prevent discrimination in favor of Highly Compensated Employees (HCEs)27.

In practice, the ACP test results influence plan administration and participant behavior. If a plan is at risk of failing the test, employers may need to encourage greater participation from Non-Highly Compensated Employees (NHCEs) by enhancing their financial literacy regarding retirement savings, or by adjusting their own contribution strategies26. Employers might also explore options like adopting a safe harbor 401(k) plan design, which can exempt them from the ACP and other nondiscrimination testing if certain contribution requirements are met25. A study analyzing Form 5500 filings found that a significant percentage of retirement plans had "red flag" violations, including issues related to nondiscrimination testing, highlighting the importance of diligent compliance24.

Limitations and Criticisms

While essential for ensuring fairness, the Actual Contribution Percentage (ACP) test, like other nondiscrimination testing, presents certain limitations and can face criticism. One common challenge is the administrative burden it places on plan sponsors. The calculations can be complex, requiring accurate data on employee compensation, matching contributions, and after-tax contributions22, 23. Errors in data or calculation can lead to a failed test, which then requires corrective measures21.

A significant criticism arises from the corrective actions often required when a plan fails the ACP test. If the test fails, highly compensated employees may be required to receive a refund of their excess contributions, or the employer may need to make additional qualified non-elective contributions (QNECs) or qualified matching contributions (QMACs) to the accounts of non-highly compensated employees20. While these corrections prevent plan disqualification, refunds to HCEs can be inconvenient, and additional employer contributions can be costly19. Furthermore, a failure to correct within a specific timeframe can result in an excise tax for the employer18. This reactive nature of corrections, rather than proactive encouragement of NHCE participation, is sometimes seen as a drawback.

Actual Contribution Percentage Test vs. Actual Deferral Percentage Test

The Actual Contribution Percentage (ACP) test and the Actual Deferral Percentage (ADP) test are both critical components of annual nondiscrimination testing for qualified retirement plans. While they share a similar methodology and purpose, they apply to different types of plan contributions.

The Actual Contribution Percentage (ACP) test specifically evaluates employer matching contributions and any employee after-tax contributions17. It ensures that these employer-provided benefits or optional employee contributions do not disproportionately favor Highly Compensated Employees (HCEs).

In contrast, the Actual Deferral Percentage (ADP) test focuses on employee elective deferrals, which are the pre-tax or Roth contributions employees choose to make from their salary15, 16. The ADP test aims to prevent HCEs from deferring a significantly higher percentage of their income into the plan compared to Non-Highly Compensated Employees (NHCEs).

Both tests compare the average contribution percentages of HCEs to those of NHCEs using similar ratio limits, and a failure in either test requires corrective action to maintain the plan's tax-qualified status13, 14.

FAQs

Why is the Actual Contribution Percentage test necessary?

The Actual Contribution Percentage (ACP) test is necessary to ensure that employer-sponsored retirement plans, specifically those with employer matching or after-tax employee contributions, do not unfairly benefit higher-paid employees. It helps maintain the plan's tax-favored status with the IRS and promotes equitable benefit distribution for all eligible employees11, 12.

What happens if a plan fails the Actual Contribution Percentage test?

If a plan fails the Actual Contribution Percentage (ACP) test, the employer must take corrective action. Common methods include distributing "excess contributions" (along with any earnings) back to the Highly Compensated Employees (HCEs) who contributed too much, or making additional qualified non-elective contributions (QNECs) to the accounts of Non-Highly Compensated Employees (NHCEs) to raise their average contribution percentage10. Failure to correct can result in penalties, including an excise tax9.

Can a plan avoid the Actual Contribution Percentage test?

Yes, certain retirement plan designs can help a plan avoid the Actual Contribution Percentage (ACP) test. The most common method is implementing a safe harbor 401(k) plan. These plans are exempt from the ACP and ADP nondiscrimination tests if they meet specific contribution and participant notice requirements, such as providing a guaranteed employer contribution or a specific matching contribution formula8.

What is a "Highly Compensated Employee" for the ACP test?

For the purpose of the Actual Contribution Percentage (ACP) test and other nondiscrimination tests, a Highly Compensated Employee (HCE) is generally defined by the IRS as an employee who meets one of two criteria in the preceding year: they owned more than 5% of the employer (directly or by family attribution), or they received compensation above a certain indexed limit (e.g., $155,000 for 2024, or $150,000 for 2023, for the preceding year)6, 7. A plan can also choose to limit the HCE group to the top 20% of employees ranked by compensation5.

How does the plan document relate to the ACP test?

The plan document is crucial for the Actual Contribution Percentage (ACP) test because it outlines the specific rules and definitions governing the retirement plan, including eligibility, contribution types, and the method elected for nondiscrimination testing (e.g., current year vs. prior year testing for NHCEs)2, 3, 4. Adhering to the provisions of the plan document is essential for accurate testing and overall fiduciary duty compliance1.