What is an 'Actual Deferral Percentage / Actual Contribution Percentage - ADP/ACP Test'
Annual non-discrimination tests for 401(k) plans mandated by the IRS to ensure that a plan does not unduly benefit owners and highly compensated employees at the expense of other employees. The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests must be passed in order to satisfy the non-discrimination requirements of the IRS if the plan is to continue.
If the plan fails either test, the employer must take corrective action to protect its qualified status in the 12-month period following the close of the plan year in which the oversight occurred.
BREAKING DOWN 'Actual Deferral Percentage / Actual Contribution Percentage - ADP/ACP Test'
The ADP test compares the average salary deferral - as a percentage of pre-tax compensation - of highly compensated employees (HCE) to that of non-highly compensated employees (NHCE). To pass the test, the ADP of the HCE may not exceed the ADP of the NHCE by a factor of 1.25 or 2 percentage points.
The ACP test uses a similar method as the ADP test, except that it uses matching contributions and/or employee after-tax contributions.
Some companies use a Safe Harbor 401(K) plans to avoid the ADP/ACP test entirely.