What are Actual Deferral & Actual Contribution Percentage Tests?
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are important compliance tests that must be performed by employers who offer a 401(k) or other similar retirement plans. These tests are designed to ensure that highly compensated employees (HCEs) do not disproportionately benefit from the plan compared to non-highly compensated employees (NHCEs).
ADP Test
The ADP test measures the amount of salary deferrals made by HCEs compared to NHCEs. It calculates the average deferral percentage for both groups and compares them to determine if the HCEs are contributing a disproportionate amount to the plan. If the ADP of the HCEs exceeds certain limits set by the IRS, corrective actions must be taken to avoid penalties and maintain the plan’s qualified status.
ACP Test
The ACP test is similar to the ADP test but focuses on employer matching contributions and after-tax employee contributions. It compares the average contribution percentage of HCEs to NHCEs to ensure that the matching contributions made by the employer are not disproportionately benefiting the HCEs. If the ACP of the HCEs exceeds certain limits set by the IRS, corrective actions must be taken to avoid penalties.
Both tests are important because they help ensure that retirement plans are fair and equitable for all employees. By preventing highly compensated employees from disproportionately benefiting from the plan, these tests promote retirement savings for all employees and help prevent discrimination in employee benefit plans.
Employers must perform these tests annually to maintain the qualified status of their retirement plans. If the tests fail, employers have several options to correct the failures, such as returning excess contributions to HCEs or making additional contributions to NHCEs. It is important for employers to work closely with their plan administrators or benefits consultants to ensure compliance with these tests and take appropriate corrective actions if needed.
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