What Are the Actual Deferral Percentage & Actual Contribution Percentage Tests?
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are two types of annual nondiscrimination tests that 401(k) plans must pass in order to keep their qualified status under IRS rules and the Employee Retirement Income Security Act (ERISA). Both are conducted to make sure 401(k) plans don't unduly benefit highly compensated employees at the expense of other employees. The ADP and 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. Failure to do so can result in IRS imposing pecuniary penalty fees, plan disqualification, and fiduciary liability on the part of the employer.
Understanding Actual Deferral Percentage & Actual Contribution Percentage Tests
The ADP test compares the average salary deferral percentages of highly compensated employees (HCE) to that of non-highly compensated employees (NHCE).
An HCE is any employee who owns more than 5% interest in the company at any time during the current or previous plan year or earned more than $120,000 during the 2018 tax year.
The ADP test takes into account both pre-tax deferrals and after-tax Roth deferrals, but not catch-up contributions. To pass the test, the ADP of the HCE may not exceed the ADP of the NHCE by more than 2 percentage points. In addition, the combined contributions of all HCEs may not be more than two times the percentage of NHCE contributions.
Correcting an ADP/ACP Test Failure
When employers fail the ADP/ACP tests, they can remedy the failure by refunding excess contributions back to HCEs in the amount necessary to pass the test. However, these refunds will be liable for income tax for the HCE individuals.
Some companies set buffer zones within their plan documents to steer plans away from potentially failing the ADP/ACP test in the first place. One option is by designating a percentage of pay cap that HCEs can contribute to the plan. Another option is to place a contribution restriction limit on HCEs at the point where the plan would fail an ADP/ACP test. Setting plan buffer zones may require employers to conduct ADP/ACP test projections, typically in the middle of the plan year, to determine if any restrictions need to be applied.
Still, some companies use a Safe Harbor 401(k) plan to avoid the ADP/ACP test entirely.
What is a Safe Harbor Plan?
Safe Harbor 401(k) plans allow plan sponsors to bypass ADP/ACP and other non-discrimination testing in exchange for providing eligible matching or nonelective contributions on behalf of their employees. To qualify for Safe Harbor, a company must provide a basic match, such as a 100% match on the first 3% of deferred compensation and a 50% match on deferrals of 3% to 5%. They may also provide each employee with a nonelective contribution of at least 3% of compensation, regardless of how much the employee contributes, or if they contribute at all.