Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Tests
Overview
The ADP and ACP tests are nondiscrimination checks that employers must run on 401(k) plans to ensure the plans do not disproportionately favor highly compensated employees (HCEs) over non‑highly compensated employees (NHCEs). Passing these tests is required to maintain a plan’s qualified tax status under IRS and ERISA rules. Failure to correct violations can lead to penalties, plan disqualification, and fiduciary liability.
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What ADP and ACP Measure
- ADP (Actual Deferral Percentage): Measures employee salary deferrals to the plan — both pretax and Roth deferrals. Catch‑up contributions (for employees age 50+) are excluded.
- ACP (Actual Contribution Percentage): Measures employer matching contributions and employee after‑tax contributions.
Who Is an HCE
An employee is an HCE if either:
– They owned more than 5% of the company at any time during the current or prior plan year, or
– Their compensation exceeded the statutory threshold ($155,000 for tax year 2024).
How the Tests Work
- ADP compares average deferral percentages of HCEs with those of NHCEs. Limits generally prevent the HCE ADP from exceeding the NHCE ADP by more than a set margin (commonly no more than two percentage points), and the combined HCE average generally may not exceed a multiple of the NHCE average (commonly up to two times).
- ACP uses a similar comparison method but applies to matching and after‑tax contributions.
- Employers typically perform these tests annually for each plan year.
Correcting Test Failures
If a plan fails ADP or ACP testing, employers must take corrective action within the 12 months following the end of the plan year in which the failure occurred. Common corrective approaches include:
– Refunding excess contributions to HCEs (refunds are taxable to recipients).
– Taking plan‑document steps or mid‑year adjustments to reduce the likelihood of failure (for example, contribution caps or buffer zones based on projections).
Note: Employers often run mid‑year projections to determine whether restrictions or corrective measures will be needed.
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Safe Harbor 401(k) Option
A safe harbor 401(k) lets plan sponsors avoid ADP and ACP testing by committing to specified employer contributions:
– A common safe harbor match is 100% of the first 3% deferred and 50% of deferrals from 3% to 6%.
– Alternatively, the employer can make a nonelective contribution of at least 3% of compensation to all eligible employees, regardless of employee deferral.
Electing safe harbor status requires following the safe harbor rules and notice requirements but eliminates routine ADP/ACP testing.
Key Takeaways
- ADP and ACP tests protect NHCEs by ensuring higher‑paid employees don’t receive disproportionate plan benefits.
- ADP covers pretax and Roth deferrals; ACP covers employer matches and after‑tax contributions.
- Employers must correct failures promptly (within 12 months after the plan year) or face tax and fiduciary consequences.
- Safe harbor plans are a common way to bypass these tests by providing required employer contributions.
Bottom Line
ADP and ACP testing are essential compliance components for 401(k) plans. Employers should monitor contributions, run projections as needed, and consider plan design choices (including safe harbor provisions) to reduce the risk of test failures and the administrative and tax consequences that follow.