How Actual Deferral Percentage/Actual Contribution Percentage - ADP/ACP Tests Work

The abbreviation ADP stands for actual deferral percentage. It is a distinguishing test between the total percentage of HCE, highly compensated employees, and NHCE, non-highly compensated employees. Essentially, you take the whole amount deferred for every employee, divide it by that employee's compensation, evaluate all the HCE's outcomes, and compare them with the NHCE average.

ACP stands for actual contribution percentage. While the actual deferral percentage (ADP) test focuses on the total average wage of HCE to NHCE, the ACP test uses the quantity deferred to you by the employer matching contributions of the HCE against the NHCE. These two tests are executed annually and are crucial to ensure every company's plan is following the law.

If your plan fails either of these tests, you need to make corrections. Those changes would consist of either refunding deferrals made by highly compensated employees or by providing additional employer contributions in an amount to satisfy the requirements above. If you choose to form your plan on a Safe Harbor plan, it automatically passes these tests.

Example of Actual Deferral Percentage/Actual Contribution Percentage - ADP/ACP Test

An HCE is any employee who owns 5% interest within the company at any time during the present or previous plan year or gained $130,000 during the 2020 tax year. Once the test is performed, the ADP of the HCE might not quite go beyond the ADP of the NHCE by two percentage points. Additionally, the combined contributions of all HCEs might not be twice the share of NHCE contributions. The actual contrition percentage test uses the same method used in the ADP test, but it evalutates matching contributions or employee after-tax contributions.

For example, if an employer has 100 workers in Greg company, 50 workers earn over $125,000, and the other 50 workers are owners. There would be 50 highly compensated employees or workers in Greg company without the top-paid group selection plan and vice versa. The plan will have only 10 HCEs, assuming the two owners are within this top 30%. Both owners are not in that top 30% group, so the plan would have 15 HCEs.

Significance of Actual Deferral Percentage/Actual Contribution Percentage - ADP/ACP Test

There is notable significance of the actual deferral percentage/actual contribution percentage- ADP/ACP Test. The ADP and ACP tests to ensure that companies aren't favoring owners and highly paid individuals. They use the ADP test to determine if the plan allows HCEs to contribute through salary deduction in a great amount compared to NHCEs, while the ACP test looks at whether employer matching contributions favor HCEs in comparison to NHCEs.

Actual Deferral Percentage/Actual Contribution Percentage - ADP/ACP Test vs. Safe Harbor Plan

The ADP and ACP tests are performed in various tests annually to ensure that 401(k) plans are not favoring business owners or other highly paid employees. An independent party usually executes these tests because of the convoluted nature of the testing and to make sure the quality is neutral. They can also perform the testing using previous or current year contributions. The designed document will state which process to use.

Therefore, with the present year testing method, the present year deferrals and compensation amounts should determine the averages for both the HCE and NHCE groups. Safe Harbor 401(k) plans permit employers to pass ADP/ACP and another non-discrimination testing to provide suitable matching or non-selected contributions on behalf of their employees. To use a safe harbor, a corporation must provide a basic match, like a 100% match on the main 3% of deferred compensation and a 50% match on deferrals of three to five. They also give each worker a non-selected contribution at a minimum of 3% of compensation, no matter what proportion the worker adds or adds at all.

Safe Harbor 401(k) plans became increasingly popular because they permit the HCEs to contribute the utmost amount to the plan annually without fear that the plan will fail the ADP or ACP test. Hence, companies require the employer to plan some minimum level of contribution for every participant annually, either as a percentage of compensation or a selected level of matching. Also, its contributions are always 100% vested and are subject to annual notice requirements. If you have a Safe Harbor plan design, you won't have to perform these tests regularly.