Understanding ADP and ACP Tests
Let me explain what ADP and ACP tests are. The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are essential checks that companies with 401(k) plans must perform to make sure these plans don't give unfair advantages to highly paid employees over everyone else.
If you're running a company with a 401(k), you need to run these tests to keep the plan qualified under IRS rules and ERISA. If your plan fails either test, you have a 12-month window after the plan year ends to fix it. Otherwise, you could face penalties, plan disqualification, and even fiduciary liability as the employer.
Key Points on ADP and ACP
You should know that these tests prove your 401(k) doesn't discriminate against non-highly compensated employees. The ADP test looks at pre-tax deferrals and Roth deferrals. The ACP test examines employer matching contributions and employee after-tax contributions.
How These Tests Operate
The ADP test compares the average salary deferral percentages of highly compensated employees (HCEs) to those of non-highly compensated employees (NHCEs). An HCE is someone who owns more than 5% of the company anytime in the current or previous year, or earned over $155,000 in 2024.
This test includes pre-tax and after-tax Roth deferrals but skips catch-up contributions for those 50 and older. To pass, the HCE ADP can't exceed the NHCE ADP by more than two percentage points, and HCE contributions overall can't be more than twice the NHCE percentage.
The ACP test works similarly but focuses on matching contributions and employee after-tax contributions.
Fixing Test Failures
If you fail the ADP or ACP test, you can correct it by refunding excess contributions to HCEs enough to pass. Keep in mind, those refunds are taxable income for the HCEs.
Some companies build buffer zones into their plans to avoid failures, like capping HCE contributions or setting limits where the plan might fail. This might mean running mid-year projections to apply restrictions if needed.
Alternatively, you could opt for a safe harbor 401(k) to skip these tests altogether.
What a Safe Harbor Plan Entails
Safe harbor 401(k) plans let you avoid ADP, ACP, and other non-discrimination tests by offering eligible matching or nonelective contributions to employees.
To qualify, provide something like a 100% match on the first 3% of deferred compensation and 50% on the next 3% to 6%, or give each employee at least 3% nonelective contribution regardless of their own contributions.
Defining Actual Deferral Percentage
The Actual Deferral Percentage (ADP) measures how much pay employees set aside for their 401(k), looking at pretax and Roth deferrals. It compares high-earners to others to ensure fairness.
Defining Actual Contribution Percentage
Similar to ADP, the Actual Contribution Percentage (ACP) test ensures equitable treatment in 401(k) plans by examining employer matching and after-tax contributions, regardless of employee earnings.
Wrapping It Up
In summary, ADP and ACP tests make sure 401(k) plans don't favor higher-paid employees. Your plan must pass them to stay IRS-qualified. Failing means penalties and liability, so consider a safe harbor option to sidestep the hassle.
