Actual deferral percentage test: Meaning, Criticisms & Real-World Uses

What Is Actual Deferral Percentage Test?

The Actual Deferral Percentage (ADP) test is a crucial annual compliance requirement for employers offering retirement plans, particularly 401(k) plans, falling under the broader category of Retirement Plan Compliance. This test is mandated by the Internal Revenue Service (IRS) to ensure that the amount of elective deferrals made by Highly compensated employees (HCEs) does not disproportionately exceed the deferrals made by Non-highly compensated employees (NHCEs). The purpose of the actual deferral percentage test is to prevent tax-advantaged retirement plans from primarily benefiting a company's highest earners or owners, thereby upholding the principle of nondiscrimination.

History and Origin

The framework for the Actual Deferral Percentage (ADP) test is rooted in the Employee Retirement Income Security Act of 1974 (ERISA), landmark legislation designed to protect the retirement assets of American workers. Before ERISA's enactment, federal law afforded employers and unions significant latitude in designing and operating employee benefit plans, which often put employees at considerable risk of not receiving their promised retirement benefits.⁵ ERISA, signed into law by President Gerald Ford, established minimum standards for most voluntarily established private industry pension and health plans.⁴

As defined contribution plans, such as the 401(k), gained prominence in the decades following ERISA, the need for specific rules to prevent discrimination became apparent. The Internal Revenue Code (IRC) introduced regulations, including the actual deferral percentage test, to ensure that the tax benefits associated with these plans were broadly distributed among employees, not just concentrated among HCEs. This regulatory evolution aimed to align the incentive of offering a qualified plan with equitable access and participation for all employees.

Key Takeaways

The Actual Deferral Percentage (ADP) test is an annual compliance requirement for most 401(k) plans.
It compares the average salary deferral rates of Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs).
The primary goal is to ensure that 401(k) plans do not unfairly favor HCEs, maintaining the plan's tax-qualified status.
Failure to pass the ADP test necessitates corrective action, often involving distributions to HCEs or additional contributions for NHCEs.
Certain plan designs, such as safe harbor 401(k) plans, can automatically satisfy the ADP test.

Formula and Calculation

The Actual Deferral Percentage (ADP) for each group (HCEs and NHCEs) is calculated by averaging the individual actual deferral ratios (ADRs) of all eligible employees within that group. An employee's ADR is their total elective deferrals divided by their eligible compensation for the plan year.

The formula for an individual's Actual Deferral Ratio (ADR) is:

\text{ADR} = \frac{\text{Employee's Elective Deferrals}}{\text{Employee's Eligible Compensation}}

To calculate the ADP for a group (HCEs or NHCEs), sum the individual ADRs for all eligible employees in that group and divide by the number of employees in that group.

\text{ADP}_{\text{Group}} = \frac{\sum \text{ADR}_{\text{Employees in Group}}}{\text{Number of Eligible Employees in Group}}

Once the ADP for both groups is calculated, the actual deferral percentage test is applied using one of two methods:

The 125% Test: The ADP for the HCE group cannot exceed 125% of the ADP for the NHCE group.
The 2-Percentage Point Test: The ADP for the HCE group cannot exceed the ADP for the NHCE group by more than two percentage points. Additionally, the HCE ADP cannot be more than twice the NHCE ADP.

The plan passes the actual deferral percentage test if the HCE ADP satisfies either of these two conditions.

Interpreting the Actual Deferral Percentage Test

Interpreting the actual deferral percentage test involves comparing the calculated ADP for the Highly Compensated Employee (HCE) group against the ADP for the Non-Highly Compensated Employee (NHCE) group, based on specific IRS guidelines. If the HCE group's ADP exceeds the allowable limits relative to the NHCE group, the plan fails the nondiscrimination testing.

A failing actual deferral percentage test indicates that the plan disproportionately favors highly compensated employees. This can jeopardize the qualified plan status and lead to penalties for the employer if not corrected promptly. The permissible difference between the two groups' average deferral percentages is typically quite narrow, aiming to ensure that the benefits of tax-advantaged retirement savings are accessible across the entire workforce.

Hypothetical Example

Consider "Tech Solutions Inc." with a 401(k) plan. In the past year, the company has 100 eligible employees: 10 Highly compensated employees (HCEs) and 90 Non-highly compensated employees (NHCEs).

Let's assume the following:

The average elective deferral percentage for the 90 NHCEs is 4.0%.
The average elective deferral percentage for the 10 HCEs is 7.0%.

Now, let's apply the ADP test rules:

The 125% Test:
- NHCE ADP = 4.0%
- 125% of NHCE ADP = 4.0% * 1.25 = 5.0%
- Since HCE ADP (7.0%) is greater than 5.0%, the plan fails the 125% test.
The 2-Percentage Point Test:
- NHCE ADP = 4.0%
- NHCE ADP + 2 percentage points = 4.0% + 2.0% = 6.0%
- Also, 200% of NHCE ADP = 4.0% * 2 = 8.0%
- The lesser of these two is 6.0%.
- Since HCE ADP (7.0%) is greater than 6.0%, the plan fails the 2-percentage point test.

In this scenario, Tech Solutions Inc. fails both parts of the actual deferral percentage test. To avoid losing the tax-qualified status of its 401(k) plan, the company must take corrective action, such as reducing the elective deferrals of its HCEs or making additional matching contributions or qualified nonelective contributions (QNECs) for its NHCEs.

Practical Applications

The actual deferral percentage test is a critical annual hurdle for employers sponsoring 401(k) plans, serving as a regulatory mechanism to ensure equitable benefit distribution. Its primary application is in compliance and risk management for businesses. By tying the permissible deferral amounts of highly compensated employees to the participation rates of non-highly compensated employees, the test incentivizes companies to promote and encourage broad-based participation in their retirement plan.³

For plan administrators and human resources departments, understanding the nuances of the actual deferral percentage test is vital for maintaining the tax-favored status of their defined contribution plan. This involves careful tracking of employee compensation and contributions throughout the year. If a plan is projected to fail the test, employers might implement strategies such as encouraging greater NHCE participation through financial education or offering enhanced matching contributions. Failure to pass and correct the test can lead to significant penalties, including potential disqualification of the entire plan, which can have adverse tax consequences for both the employer and employees.

Limitations and Criticisms

While designed to promote fairness, the actual deferral percentage test also presents certain limitations and criticisms. One common issue is that plans frequently fail the test, often because Highly compensated employees (HCEs) defer a significantly higher percentage of their salary than Non-highly compensated employees (NHCEs).² When a plan fails, employers are required to take corrective distribution actions. This typically involves refunding excess contributions to HCEs, which can be seen as a disadvantage for those who were trying to save more for retirement. Another correction method involves making qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs) to NHCEs to raise their average deferral percentage, which represents an unexpected cost to the employer.¹

The test can also create administrative burdens for employers, requiring careful data collection and calculation annually. Some critics argue that the test indirectly discourages higher contributions from HCEs, who may feel limited by the participation patterns of other employees. Furthermore, while the test aims to ensure broad participation, it doesn't always guarantee optimal savings rates for all employees, as it primarily focuses on the ratio of contributions rather than absolute amounts. To bypass these complex annual tests, many employers opt for a safe harbor 401(k) plan design, which automatically satisfies the ADP test by meeting certain minimum employer contribution requirements.

Actual deferral percentage test vs. Actual Contribution Percentage Test

The Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test are both critical nondiscrimination tests for qualified plans, particularly 401(k)s, but they focus on different types of contributions.

Feature	Actual Deferral Percentage (ADP) Test	Actual Contribution Percentage (ACP) Test
Focus	Employee elective deferrals (pre-tax and Roth 401(k) contributions)	Employer matching contributions and employee after-tax contributions
Purpose	Ensures that HCEs do not disproportionately defer more of their compensation than NHCEs.	Ensures that employer matches and after-tax employee contributions do not disproportionately favor HCEs.
Calculation Basis	Compares the average deferral percentages of HCEs and NHCEs.	Compares the average contribution percentages (including employer match and after-tax) of HCEs and NHCEs.
Compliance Goal	Prevents discrimination in employee salary deferrals.	Prevents discrimination in employer-provided contributions and additional employee contributions.

While the ADP test examines what employees choose to save from their paychecks, the Actual Contribution Percentage Test looks at contributions made by the employer (e.g., matching funds) and any additional voluntary after-tax contributions employees make. Both tests are designed to prevent the plan from unfairly benefiting Highly compensated employees (HCEs) over Non-highly compensated employees (NHCEs), ensuring the plan remains compliant with Internal Revenue Service (IRS) regulations.

FAQs

1. Why is the Actual Deferral Percentage test required?

The Actual Deferral Percentage test is required by the Internal Revenue Service (IRS) to ensure that 401(k) plans do not unfairly favor Highly compensated employees (HCEs). It's part of broader nondiscrimination testing aimed at ensuring that all eligible employees, including Non-highly compensated employees (NHCEs), have equitable access to the benefits of the retirement plan.

2. What happens if a plan fails the ADP test?

If a plan fails the actual deferral percentage test, the employer must take corrective action. Common solutions include issuing corrective distributions to Highly compensated employees (HCEs) (returning their excess elective deferrals), or making additional contributions (Qualified Nonelective Contributions or Qualified Matching Contributions) for Non-highly compensated employees (NHCEs) to raise their average deferral percentage. Failure to correct a failed test can result in the plan losing its tax-qualified status.

3. Can a 401(k) plan avoid the ADP test?

Yes, certain 401(k) plan designs, primarily safe harbor 401(k) plans, are exempt from the actual deferral percentage test. To qualify as a safe harbor plan, an employer must make specific minimum matching contributions or nonelective contributions to all eligible employees, regardless of whether they defer their own salary.

4. Who is considered a Highly Compensated Employee (HCE) for the ADP test?

For the purpose of the actual deferral percentage test, an Highly compensated employee (HCE) is generally defined by the Internal Revenue Service (IRS) as an individual who: (1) owned more than 5% of the company at any time during the current or prior plan year, or (2) received compensation above a certain indexed dollar amount in the preceding plan year (e.g., $155,000 for 2024, subject to annual adjustments), and, if elected by the employer, was among the top 20% of employees ranked by compensation.