Actual Deferral & Actual Contribution Percentage Tests Definition

To learn about retirement plans exempt from ADP and ACP testing, check out the “Retirement Plans Exempt from ADP & ACP Testing” section below for details. The nondiscrimination rules require that the average deferrals and average contributions for the HCE group be within a certain range of the average deferrals and average contributions for the NHCE group. For the ADP test, pre-tax and Roth deferrals, excluding catch-up contributions, are averaged by dividing each eligible plan participant’s deferral amount by his annual compensation .

– 401k plans are permitted to limit the HCE group to employees that rank in the top 20 percent of all employees based on compensation. If the moved HCEs have high contribution rates, this can help a 401k plan pass testing. To alleviate yourself of this testing, one thing that you can do is to utilize a safe harbor 401 plan. Qualifying a 401 for safe harbor requires that you match employee contributions up to 4 percent using one of two different matching schemes.

When conducting the ADP test, administrators are required to include all company employees who are eligible for 401 benefits. While the tests include all compensation in the form of cash or stock, other benefits like health insurance are not included. The ADP test requires employers to compare the average annual deferral rates of HCEs and NHCEs. However, ADP testing specifically excludes any employer matching — it only measures employee deferrals. The ADP test is also based only on employee cash- and stock-based compensation.

All employees eligible to make a deferral are included in the calculation regardless of whether they actually contribute in a particular year. As the NHCEs save more for retirement, the rules allow HCEs to defer more. These nondiscrimination tests for 401 plans are called the Actual Deferral Percentage and Actual Contribution Percentage tests. Communicate with plan administrators to ensure proper employee classification and compliance with the plan terms. The ADP test compares the average salary deferral percentages of highly compensated employees to that of non-highly compensated employees . 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 $130,000 during the 2020 tax year.

The other method is prior year testing where the deferral and contribution percentages for NHCEs in the prior year are compared with HCE deferral and contribution percentages in the current year. The prior year testing method gives employers the ADP and ACP limits for the HCEs in advance, which reduces the chance of a failed test at year-end and the need for taxable refunds or other corrective measures. It is a specific non-discrimination test that applies to employee salary deferral or 401 contributions. Similarly, the ACP test is an acronym for the Average Contribution Percentage test.

The employer can make additional contributions to the 401 to adjust the ADP for the nonhighly compensated employeess so that the plan is in compliance. A portion of the highly compensated employees’ contributions can be re-characterized as employee after-tax contributions.

What Happens When You Fail The Adp Test Or Acp Test

Adjust the contributions for the year if the 401 fails the ADP test. The business that manages the 401 has 12 months to fix the deficiency.

• Plans may use either the current year or prior year average of the NHCEs for this purpose; however, the method selected must be specified in the plan document.
• As the NHCEs save more for retirement, the rules allow HCEs to defer more .
• The ADP test compares the average deferral rates of the HCEs to that of the non-highly compensated employees ; the ACP test does the same for matching contributions.
• Each year, 401 plans must undergo 401 nondiscrimination tests including the ADP and ACP tests.
• The ADP/ACP tests are performed to demonstrate that the plan does not discriminate in favor of highly compensated employees with respect to 401/Roth deferrals and employer matching contributions.

The ADP/ACP tests are performed to demonstrate that the plan does not discriminate in favor of highly compensated employees with respect to 401/Roth deferrals and employer matching contributions. The ADP test compares the average deferral rates of the HCEs to that of the non-highly compensated employees ; the ACP test does the same for matching contributions. Plans may use either the current year or prior year average of the NHCEs for this purpose; however, the method selected must be specified in the plan document. As the NHCEs save more for retirement, the rules allow HCEs to defer more . All employers should understand the tests — known as the actual deferral percentage test and the actual contribution percentage test. Each year, 401 plans must undergo 401 nondiscrimination tests including the ADP and ACP tests. These tests are typically conducted by plan administrators and compare contributions or deferrals of highly compensated employees with those of other plan-eligible employees.

When conducting actual deferral percentage and actual contribution percentage testing for a plan that does not use a safe harbor 401 design, there are several ways to structure a test to enhance the chances of passing. In many plans these excludable employees may be contributing at lower rates than longer tenured employees, and under normal testing procedure could contribute to testing failures. There are two common fixes for a plan that has failed nondiscrimination testing, and neither is terribly desirable. Highly compensated employees may have to remove their previous salary deferrals from the plan or include them as taxable income. On the other hand, your company could also be forced to make extra year-end contributions on behalf of employees to even things out. These retirement plans exempt sponsors from requirements to conduct ADP and ACP testing for employee deferrals and employer matching.

K) Plan Fix

The purpose of 401 nondiscrimination tests is to ensure that all employees are benefiting from the 401 plan — not just company owners and high earners. ADP and ACP testing require that owners and high earners deferrals and contributions don’t greatly exceed those of other employees. A noncompliant plan would have company owners and high earners making more than two-thirds of the total contributions or owning more than 60 percent of plan assets. ADP Test — Under the ADP test, you calculate both HCE and NHCE pre-tax deferral rates. Please review your plan document for the definition of eligible pay as this definition is where we see the most errors.

You are also required to vest all employer contributions immediately with employees, rather than using a 401 vesting schedule. The ACP test requires employers to follow a process similar to the ADP test. First, each employee’s annual contribution rate is determined by adding employee deferrals, after-tax contributions, and employer matching, then dividing the total by each employee’s total annual compensation. Rates are then averaged for HCEs and NHCEs with HCE contributions limited based on the average annual NHCE contribution rate. Safe Harbor 401 plans have become increasingly popular because they allow the HCEs to contribute the maximum amount to the plan each year without concern that the plan will fail the ADP or ACP test. Safe Harbor 401 contributions are always 100% vested and are subject to annual notice requirements.

More In Retirement Plans

Typically, the correction involves issuing a refund for the amount of the excess deferrals or contributions, plus earnings. If corrective distributions are made later than 2 ½ months after the applicable plan year, the employer is liable for an excise tax. Another option for correction of a failed test is for the employer to deposit additional fully vested contributions into the accounts of the NHCEs, in order to increase the average percentage for that group. Yet another alternative testing method is permissive disaggregation. Under this method, one plan may be treated as two plans and each employee group tested separately.

The re-characterized amount would be added to the individual employees’ taxable income for the year. Excess contributions could also be distributed to the highly compensated employees. Assess whether the 401 passes the ADP Test by comparing the average salary deferrals of highly compensated employees and nonhighly compensated employees. As with the ADP test, ACP testing includes all cash- and stock-based employee compensation throughout the year. However, unlike the ADP test, the ACP test measures not only employee salary deferrals but also matching employer contributions. This means that, if you fail the ADP test, you are almost guaranteed to fail ACP testing as well. The ADP test is typically conducted by a plan administrator and requires that the average deferral rate for HCEs stay within certain limits relative to the average deferral rate of NHCEs.

The testing may be performed using prior year or current year contributions. With the current year testing method, the current year deferrals and compensation amounts are used to determine the averages for both the HCE and NHCE groups. The prior year testing method allows the plan to compare the prior year deferral and compensation amounts for NHCEs to the current year HCE deferral and compensation amounts. The prior year testing method provides employers with the information necessary to limit the HCE contributions in advance. In theory, this means the plan is less likely to fail the ADP or ACP test. The deferral rate is the amount of the employee contribution as a percentage of compensation.

These individual deferral ratios are then aggregated and averaged to find the overall Actual Deferral Percentage. Employees who are eligible but do not contribute must be also included, and they are figured into the average with a 0%. The ACP test is performed in the same manner, but tests employer matching and employee after-tax contributions.

Ways To Gain The Safe Harbor Exemption

You must include eligible employees who do not participate in the plan with a deferral percentage of zero. Eligible nonparticipating employees tend to be NHCEs, pulling that group’s deferral percentage down. To pass the test, the HCEs’ average ADP cannot be higher than the greater of 1) 125% of the NHCEs’ average ADP, or 2) the lesser of two percentage points above or two times the NHCEs’ average ADP. One popular way to encourage employees to participate is by offering matching contributions.

The more tenured employees—who are more likely to be actively deferring—are tested in one group. The less tenured employees—those who could have been excluded by plan design—are tested as a separate group.

However, nondiscrimination testing is still required for profit-sharing contributions for plans including safe harbor 401 plans. The actual deferral percentage test and actual contribution percentage test are both required to be administered every year to ensure traditional 401 plans are in compliance. While ADP considers only employee deferrals, ACP also includes employer contributions. However, plan sponsors must conduct both tests regardless of whether or not they match. If the plan fails the ADP or ACP test, corrective action must be taken to protect the tax qualified status of the plan. The statutory correction period is the 12-month period following the close of the plan year in which the failure occurs.