Actual deferral & actual contribution percentage test adp acp

What Is Actual Deferral & Actual Contribution Percentage Test (ADP/ACP)?

The Actual Deferral Percentage (ADP) Test and the Actual Contribution Percentage (ACP) Test are annual non-discrimination tests mandated by the Internal Revenue Service (IRS) for certain employer-sponsored retirement savings plans, most notably 401(k) plans. These tests fall under the broader category of Employee Benefits compliance and aim to ensure that qualified retirement plans do not disproportionately favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs) in terms of contributions and benefits. The ADP test specifically examines employee salary deferrals, while the ACP test reviews employer contributions, such as matching contributions and after-tax employee contributions. The purpose of these tests is to uphold the Non-Discrimination Rules that govern qualified plans, ensuring broad participation and equitable access to retirement benefits across all employee demographics.

History and Origin

The regulatory framework for the Actual Deferral & Actual Contribution Percentage Test (ADP/ACP) originates from the Employee Retirement Income Security Act of 1974 (ERISA), a landmark federal law designed to protect the retirement assets of Americans. ERISA established minimum standards for most voluntarily established pension and health plans in private industry. These standards include provisions aimed at preventing discrimination in favor of highly compensated individuals. While ERISA laid the foundation, subsequent tax legislation, particularly the Tax Reform Act of 1986, refined and formalized the specific methodologies for the ADP and ACP tests as they are known today, directly addressing concerns about the equitable distribution of employer contributions and employee deferrals. The growth and popularity of the 401(k) plan, which gained significant traction after 1981, further underscored the necessity for robust non-discrimination oversight to ensure these plans served a broad base of employees, not just those at the top of the income scale.²² The IRS continues to issue guidance on these non-discrimination requirements to ensure compliance.²¹

Key Takeaways

• The Actual Deferral Percentage (ADP) Test evaluates employee salary deferrals, while the Actual Contribution Percentage (ACP) Test examines employer matching and after-tax employee contributions.
• These tests are mandatory for many defined contribution plans, particularly 401(k) plans, to ensure they do not discriminate in favor of Highly Compensated Employees (HCEs).
• Failure to pass the ADP/ACP tests can result in corrective actions, such as refunding excess contributions to HCEs or making additional qualified non-elective contributions (QNECs) to Non-Highly Compensated Employees (NHCEs).
• Safe Harbor Plans are a common strategy employers use to automatically satisfy the ADP and ACP non-discrimination requirements by meeting specific contribution and notice requirements.
• The tests are designed to align the participation and contribution rates of HCEs more closely with those of NHCEs, promoting broader retirement savings opportunities.

Formula and Calculation

The ADP and ACP tests compare the average deferral or contribution percentages of Highly Compensated Employees (HCEs) to those of Non-Highly Compensated Employees (NHCEs).

Actual Deferral Percentage (ADP) Calculation:

The ADP for each group (HCEs and NHCEs) is calculated as follows:

The sum of each individual's actual deferral percentage (salary deferrals, including pre-tax contributions and Roth 401(k) contributions) is divided by the sum of their compensation. This is done for each employee in the group, and then the average of those percentages is taken.

Actual Contribution Percentage (ACP) Calculation:

The ACP for each group (HCEs and NHCEs) is calculated similarly:

Here, "Contributions" refers to matching contributions and after-tax employee contributions.

Testing Limits:

For a plan to pass the ADP or ACP test, the actual deferral percentage (ADP) or actual contribution percentage (ACP) for HCEs cannot exceed the greater of:

1. 125% of the NHCEs' ADP/ACP, or
2. The lesser of:
   • 200% of the NHCEs' ADP/ACP, or
   • The NHCEs' ADP/ACP plus 2 percentage points.

For example, if the NHCE average ADP is 3%, the HCE average ADP cannot exceed 5% (3% + 2%). If the NHCE average ADP is 8%, the HCE average ADP cannot exceed 10% (8% + 2%). If the NHCE average ADP is 2%, the HCE average ADP cannot exceed 4% (2% x 200%). If the NHCE average ADP is 4%, the HCE average ADP cannot exceed 5% (4% x 125%). These limits ensure that the participation and contribution rates of HCEs are reasonably aligned with those of NHCEs.

Interpreting the Actual Deferral & Actual Contribution Percentage Test

Interpreting the Actual Deferral & Actual Contribution Percentage Test (ADP/ACP) results is crucial for plan sponsors to maintain the qualified plan status of their 401(k) or similar retirement plans. Passing these tests means the plan's contribution structure aligns with IRS Non-Discrimination Rules, indicating that Highly Compensated Employees (HCEs) are not disproportionately benefiting compared to Non-Highly Compensated Employees (NHCEs).

If a plan fails an ADP or ACP test, it means the average deferral or contribution rates for HCEs exceed the permissible limits relative to the NHCEs. Such a failure necessitates corrective action to avoid potential penalties and maintain the plan's tax-qualified status. Common corrective measures include:

• Distribution of Excess Contributions: The most common correction is to refund the excess contributions (and related earnings) made by HCEs, thereby lowering their average percentage.
• Qualified Non-Elective Contributions (QNECs): The employer can make additional contributions on behalf of NHCEs to increase their average percentage, bringing the plan into compliance. These contributions are typically 100% vested when made.
• Qualified Matching Contributions (QMACs): Similar to QNECs, but specifically referring to additional employer matching contributions to NHCEs.

The interpretation of the results directly dictates the necessary corrective measures and future plan design adjustments, such as implementing a Safe Harbor Plan to bypass the tests.

Hypothetical Example

Consider "Tech Solutions Inc.," a company with a 401(k) plan that needs to conduct its annual Actual Deferral Percentage (ADP) Test.

Employees and Compensation:

• Highly Compensated Employees (HCEs): John, Lisa, and Mark.
• Non-Highly Compensated Employees (NHCEs): Sarah, David, Emily, and Chris.

Compensation and Deferrals for the Year:

Applying the ADP Test Rules:

The NHCE average ADP is 4.00%. The HCE average ADP cannot exceed the greater of:

1. 125% of the NHCEs' ADP: (4.00% \times 1.25 = 5.00%)
2. The lesser of:
   • 200% of the NHCEs' ADP: (4.00% \times 2.00 = 8.00%)
   • The NHCEs' ADP plus 2 percentage points: (4.00% + 2.00% = 6.00%)
     The lesser of 8.00% and 6.00% is 6.00%.

Comparing 5.00% and 6.00%, the greater limit for HCEs is 6.00%.

In this hypothetical example, Tech Solutions Inc.'s HCE average ADP is 6.83%, which exceeds the permissible limit of 6.00%. Therefore, the plan fails the ADP test. Tech Solutions Inc. would need to take corrective action, such as refunding a portion of the excess pre-tax contributions to John, Lisa, and Mark, or making additional qualified non-elective contributions to the NHCEs to raise their average ADP.

Practical Applications

The Actual Deferral & Actual Contribution Percentage (ADP/ACP) Tests are a cornerstone of compliance for employers offering 401(k) and other defined contribution plans. Their practical application extends across several areas of plan administration and design:

• Regulatory Compliance: Annually, plan administrators must perform these tests to ensure their plans adhere to IRS Non-Discrimination Rules. Failure to pass can jeopardize the plan's tax-qualified status and result in financial penalties for the employer. The IRS provides extensive guidance on these rules and correction methods.²⁰
• Plan Design Strategy: Many employers proactively design their plans to avoid ADP/ACP testing failures. A popular strategy is to implement a Safe Harbor Plan. By making mandatory employer contributions (e.g., a specific matching contribution or a non-elective contribution) that meet IRS requirements, employers can be exempt from the annual ADP and ACP tests.¹⁹ This provides administrative simplicity and certainty.
• Employee Communication and Engagement: Understanding the impact of ADP/ACP tests can inform strategies to encourage broader employee participation, particularly among Non-Highly Compensated Employees (NHCEs). Employers might promote higher NHCE participation through financial literacy education, auto-enrollment features, or enhanced matching contributions to help meet the non-discrimination thresholds and avoid corrective distributions to Highly Compensated Employees (HCEs).
• Contribution Limit Management: For HCEs, the ADP/ACP tests can indirectly affect their ability to contribute the maximum allowable amount to their 401(k). If the NHCE participation rates are low, HCEs may be limited in their pre-tax contributions or matching contributions to ensure the plan passes the tests. This interplay makes compliance a shared responsibility within the organization.

Limitations and Criticisms

While the Actual Deferral & Actual Contribution Percentage Test (ADP/ACP) plays a critical role in enforcing Non-Discrimination Rules within qualified plans, they are not without limitations and criticisms.

One primary criticism is the administrative burden they place on employers. Companies, particularly smaller ones, may find the annual calculations complex and the corrective measures disruptive. The need to track employee compensation, contributions, and Highly Compensated Employee status adds to the operational overhead of managing employee benefits.

Another limitation is that the tests can sometimes inadvertently cap the contributions of Highly Compensated Employees. If Non-Highly Compensated Employee participation or contribution rates are low, HCEs may be required to receive a refund of their contributions to bring the plan into compliance. This can be frustrating for HCEs who are actively trying to maximize their retirement savings within the permitted contribution limits and may discourage their future participation.

Furthermore, while the tests aim to promote broad-based participation, they do not directly mandate minimum participation levels for NHCEs. An employer could technically pass the tests even with relatively low NHCE participation, provided the HCE contribution rates are similarly low or only slightly higher. The existence of Safe Harbor Plans, while^{123456789101112131415161718}