The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are regulatory measures designed to ensure that 401(k) retirement plans do not disproportionately favor higher-paid employees.
Understanding the ADP and ACP Tests
Concept and Purpose
The Actual Deferral Percentage (ADP) Test and the Actual Contribution Percentage (ACP) Test are mandated by the Internal Revenue Service (IRS) under the Employee Retirement Income Security Act (ERISA). The primary objective is to maintain equitable contribution practices across employee earnings segments.
ADP Test
The ADP test examines the salary deferrals or elective contributions made by employees. It compares the average deferral rates of Highly Compensated Employees (HCEs) with those of Non-Highly Compensated Employees (NHCEs).
Formula and Example
The ADP for each group is calculated as:
Consider a company where HCEs and NHCEs have the following contributions:
- HCEs: Total Deferrals = $100,000; Total Compensation = $1,000,000
- NHCEs: Total Deferrals = $50,000; Total Compensation = $1,000,000
The ADP for HCEs would be 0.1 (10%) and for NHCEs it would be 0.05 (5%).
The ADP test requires that the ADP of HCEs not exceed the greater of:
- 125% of the ADP for NHCEs, or
- 200% of the ADP for NHCEs, provided the difference is not more than 2%.
ACP Test
The ACP test evaluates matching contributions and employee after-tax contributions. Similar to the ADP test, it compares HCEs to NHCEs but focuses on company matches and other contributions.
Formula and Example
ACP is calculated similarly:
Assume for the same company:
- HCEs: Employer Contributions = $80,000; Post-tax Employee Contributions = $20,000
- NHCEs: Employer Contributions = $40,000; Post-tax Employee Contributions = $10,000
The ACP for HCEs would be 0.1 (10%) and for NHCEs it would be 0.05 (5%).
The test rules mirror those of ADP.
Special Considerations
Non-Compliance Consequences
Failure in either test necessitates corrective measures, such as refunding excess contributions, which can incur additional tax liabilities and administrative burdens.
Safe Harbor Plans
Employers can adopt Safe Harbor 401(k) Plans which are automatically deemed compliant with ADP and ACP tests by making certain mandatory contributions.
Historical Context
These tests were introduced as part of the IRS’s broader initiatives in the 1980s to prevent discrimination in retirement plans. Ensuring balanced benefits between varying employee pay grades remains central to this regulation.
Applicability
Understanding ADP and ACP tests is essential for employers, plan administrators, and financial advisors to monitor and ensure compliance. Non-compliance can lead to financial repercussions and tax penalties.
Comparisons to Related Terms
Highly Compensated Employees (HCEs)
Defined currently as anyone earning more than $135,000 annually (threshold adjusts yearly).
Non-Highly Compensated Employees (NHCEs)
Employees earning below the HCE threshold.
FAQs
What triggers the need for ADP and ACP testing?
How can an employer correct a failed test?
Are all 401(k) plans subject to these tests?
References
- IRS.gov: “401(k) Plan Overview”
- Employee Retirement Income Security Act (ERISA)
- Treasury Regulations and notices on retirement plans.
Summary
The ADP and ACP tests serve as critical mechanisms to ensure fairness in contribution structures of 401(k) plans across different employee income levels. By adhering to these tests, employers can avoid discriminatory practices and maintain compliance with established ERISA guidelines.
