Definition
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are used in U.S retirement planning to ensure that 401(k) plans do not excessively favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). The ADP test compares the average salary deferral percentages of HCEs and NHCEs, while the ACP test looks at the company match and voluntary after-tax contributions made by these groups. If the HCEs’ contributions significantly exceed those of the NHCEs, the plan may fail these compliance tests, leading to refunds for HCEs or additional contributions for NHCEs to balance the disparity.
Phonetic
Here’s how you phonetically pronounce the keyword:Actual Deferral Percentage: Æk-tʃʊ-wəl Diː-fɜː-rəl Pɜːr-sɛn-tɪdʒ Actual Contribution Percentage: Æk-tʃʊ-wəl Kən-trɪ-bjuː-ʃən Pɜːr-sɛn-tɪdʒ Test: tɛstADP: eɪ-diː-piːACP: eɪ-siː-piː
Key Takeaways
- Compliance with non-discrimination rules: ADP/ACP tests are designed to ensure that 401(k) plans do not favor highly compensated employees over non-highly compensated employees. This is done in order to maintain the tax benefits of the plan for all participating employees.
- Annual conduct: ADP/ACP test is usually performed annually, comparing the average salary deferrals and/or after-tax and/or matching contributions of highly compensated employees to those of non-highly compensated employees. It ensures that the contributions made by higher-paid employees and owners are not disproportionately higher than those made by lower-paid employees.
- Consequences of failing the test: If the plan fails the ADP/ACP test, the employer may need to take corrective action, such as making additional contributions to the non-highly compensated employees or refunding the contributions made by the highly compensated employees to bring the plan into compliance.
Importance
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are critical in the business/finance sector for ensuring the compliance of company-sponsored retirement plans with federal non-discrimination laws. These tests are conducted annually and compare the average contributions of highly compensated employees (HCEs) to those of non-highly compensated employees (NHCEs). The importance lies in enforcing the equitable contribution limits for all employees, thereby preventing discrimination in favor of higher-income employees. A failure in ADP or ACP testing could lead to mandatory refunds of contributions or additional contributions for NHCEs, to balance the scales, therefore, maintaining compliance is crucial to avoid financial and regulatory consequences for the company.
Explanation
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are used by employers to ensure that their defined contribution retirement plans, such as 401(k)s and similar plans, do not discriminate in favor of highly compensated employees (HCEs). These tests are mandated by the Internal Revenue Service (IRS) to maintain the tax-advantaged status of the retirement plan. It ensures a more balanced distribution of the perks associated with participating in these types of plans, so that a company doesn’t excessively favor its higher earners at the cost of lower earners. The failure of these tests could lead to corrective actions, including tax obligations.The ADP test compares the average salary deferral percentages of highly compensated employees to that of non-highly compensated employees. Similarly, the ACP test compares the average employer matching contributions and any employee after-tax contributions for the two groups. If the contributions for HCEs exceed those for non-HCEs by more than the amount allowed under the IRS guidelines, the company must take corrective actions, like returning some of the contributions to the HCEs, or increasing the contributions to non-HCEs. These tests ensure a degree of fairness, and sustain the tax-benefits these plans provide.
Examples
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are performed to assure that 401(k) retirement plans do not disproportionately benefit highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). Here are real-world examples illustrating these terms:1. **Company ABC** – This company provides a 401(k) retirement plan option for its employees. They conduct an ADP test at the end of each fiscal year. They discover that their NHCEs have deferred an average of 5% of their pre-tax earnings into the 401(k) plan, but their HCEs deferred an average of 10%. As there is a significant disparity between the two percentages, the company must take action to maintain compliance under the ADP test, either by refunding some of the contributions made by HCEs or by making additional contributions to the accounts of NHCEs.2. **Tech Inc.** – This technology-based corporation offers a matching 401(k) contribution for their employees. They conduct the ACP test yearly to ensure compliance with IRS non-discrimination requirements. Upon review, Tech Inc. finds that NHCEs received an average of 2% in matching contributions, while HCEs received 6%. This disparity prompts Tech Inc to take corrective action by either returning some of the HCEs’ matches or increasing the match for NHCEs.3. **Educational Institution XYZ** – This institution runs a 403(b) plan, a type of retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. While these plans are generally exempt from the ADP/ACP Tests, Institution XYZ also operates a 401(m) plan for employer contributions. They find that their HCEs consistently contribute at a significantly higher amount than their NHCEs in this plan, violating the ACP test. As a result, they have to distribute excess contributions back to their highly compensated employees to align with IRS rules.
Frequently Asked Questions(FAQ)
What is Actual Deferral & Actual Contribution Percentage Test (ADP/ACP)?
The ADP/ACP Test is a benchmark set by the IRS that retirement plans need to meet in order to pass non-discrimination tests. These tests ensure that higher-paid employees are not benefiting too much in comparison to lower-paid employees.
How is the ADP/ACP Test calculated?
The ADP Test is calculated by dividing the total contribution of each eligible employee by the total compensation of all eligible employees. The same method is applied for the ACP Test but it includes employer match contributions and employee after-tax contributions.
Who does the ADP/ACP Test apply to?
The ADP/ACP test applies primarily to companies that offer a 401(k) or similar type of defined contribution retirement plan to their employees.
What happens if our company’s plan fails the ADP or ACP test?
If a plan fails the test, the company may be required to refund some contributions back to the higher-paid employees or make additional contributions to the lower-paid employees.
What strategies can employers use to pass this test?
Companies can consider implementing a Safe Harbor 401(k) plan, using automatic enrollment for all eligible employees, limiting the amount that highly compensated employees can contribute, or making a Qualified Non-Elective Contribution (QNEC) to all eligible employees.
When is the ADP/ACP test performed?
The ADP/ACP test is performed during or after the end of the plan year. It must be parsed by the last day of the following plan year.
What role does employee classification play in the ADP/ACP test?
The test compares the deferral percentage of higher-paid employees, known as Highly Compensated Employees (HCEs), with that of lower-paid employees, known as Non-Highly Compensated Employees (NHCEs).
What are the current thresholds for passing the ADP/ACP tests?
The specific threshold can vary depending on the plan’s specifics. As a general rule, the HCE’s average contributions cannot exceed the NHCE’s average by more than 2%, and HCE’s average contribution can’t be more than 2 times the NHCE’s average contribution.
Can the ADP/ACP tests be avoided?
Yes, by setting up a Safe Harbor or a SIMPLE 401(k) plan, businesses can bypass the ADP/ACP test requirements. These types of plans require employers to make certain mandatory contributions to the employees’ retirement accounts.
Are the ADP/ACP tests the same thing?
No, they are related but not the same thing. ADP test focuses on employee deferrals while ACP test focuses on matching and/or after-tax contributions made to a plan. They are both designed to ensure fairness between different levels of employees.
Related Finance Terms
- Qualified Plans: These are retirement plans that meet specific IRS guidelines. The ADP/ACP tests apply to these kinds of plans to prevent discrimination against lower-earning employees.
- 401(k) Plan: This is a type of retirement savings plan in the United States, often provided by employers. The ADP/ACP tests are often associated with these plans.
- Non-Discrimination Testing: This is a general term for the tests, including the ADP/ACP tests, that qualified retirement plans must pass to ensure that they are not favoring higher-income employees.
- Highly Compensated Employee (HCE): This term refers to an employee who owns more than 5% of the interest in the business at any time during the year or the preceding year, or for the preceding year, had compensation from the business of more than $120,000 (in 2014-2019, indexed for inflation) and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.
- Safe Harbor 401(k): This is a type of 401(k) plan that, if certain requirements are met, is not subject to the ADP/ACP tests.
