The actual deferral percentage (ADP) and actual contribution percentage (ACP) tests are essential evaluations for 401(k) plans to ensure fairness and compliance with IRS regulations. This article explores the intricacies of ADP and ACP tests, their significance, and corrective measures in case of failure.
Understanding the actual deferral & actual contribution percentage tests (ADP/ACP)
401(k) plans are a valuable employee benefit, but to maintain their qualified status under IRS rules and the Employee Retirement Income Security Act (ERISA), companies offering these plans must adhere to specific testing requirements. The actual deferral percentage (ADP) and actual contribution percentage (ACP) tests are critical components in this regulatory landscape.
Why are ADP and ACP tests necessary?
ADP and ACP tests are designed to prevent 401(k) plans from unfairly benefiting highly-compensated employees (HCEs) at the expense of non-highly compensated employees (NHCEs). If these tests are not conducted or if the plan fails to meet the specified criteria, it can lead to severe consequences for the employer.
How ADP and ACP tests work
The ADP test compares the average salary deferral percentages of HCEs to that of NHCEs. HCEs are individuals who own more than a 5% interest in the company or earned over $130,000 during the tax year. This test considers pre-tax and after-tax Roth deferrals but excludes catch-up contributions available to employees aged 50 and over.
To pass the ADP test, the deferral percentage of HCEs must not exceed that of NHCEs by more than two percentage points. Additionally, the combined contributions of all HCEs must not be more than two times the percentage of NHCE contributions.
The ACP test is similar to the ADP test but focuses on matching contributions or employee after-tax contributions.
Correcting an ADP/ACP test failure
When a plan fails the ADP/ACP tests, corrective actions must be taken. This typically involves refunding excess contributions to HCEs to bring the plan into compliance. However, these refunds are subject to income tax for the recipients.
Some companies take preventive measures by incorporating buffer zones within their plan documents. These measures can include setting contribution caps for HCEs or imposing contribution limits to avoid potential ADP/ACP test failures. Employers may conduct ADP/ACP test projections during the plan year to determine if any restrictions are necessary.
Safe Harbor 401(k) plans
Some companies opt for Safe Harbor 401(k) plans to bypass the ADP/ACP tests altogether. Safe Harbor plans require employers to provide eligible matching or nonelective contributions for their employees in exchange for avoiding certain non-discrimination testing.
To qualify for Safe Harbor status, a company must offer a basic match, such as a 100% match on the first 3% of deferred compensation and a 50% match on deferrals of 3% to 5%. Alternatively, they can provide each employee with a nonelective contribution of at least 3% of compensation, regardless of employee contributions.
Benefits and drawbacks of ADP and ACP tests
Here is a list of the benefits and drawbacks of ADP and ACP tests:
- Ensure fairness in 401(k) plan contributions.
- Compliance with IRS regulations and ERISA.
- Prevent highly-compensated employees from disproportionately benefiting.
- Complexity in conducting and understanding the tests.
- Possible corrective actions and tax implications for failures.
Comprehensive examples of ADP and ACP testing
Let’s delve into practical examples to better understand how ADP and ACP testing works:
Example 1: ADP testing
Imagine Company A offers a 401(k) plan to its employees, including highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). In the ADP test, it’s found that the HCEs’ average salary deferral percentage is 7%, while the NHCEs’ average is 4%. Company A has failed the ADP test because the gap between the two percentages exceeds the allowable two percentage points. Corrective action is required.
Example 2: ACP testing
Now, consider Company B, which also has HCEs and NHCEs. In the ACP test, it’s discovered that the company’s matching contributions for HCEs exceed the allowable limits compared to NHCEs. This failure necessitates corrective measures, including adjusting the matching contributions to meet the criteria.
Understanding the actual deferral percentage (ADP) and actual contribution percentage (ACP) tests is crucial for companies that offer 401(k) plans. These tests ensure that employee contributions are distributed fairly and in compliance with IRS regulations and ERISA. Failing to pass these tests can result in penalties and other consequences. Companies have the option to explore Safe Harbor plans as an alternative to simplify compliance. By comprehending the intricacies of these tests and the available solutions, employers can maintain a healthy and compliant 401(k) plan for the benefit of all their employees.
Frequently asked questions
What are the specific consequences of failing the ADP or ACP tests?
If a 401(k) plan fails the Actual Deferral Percentage (ADP) or Actual Contribution Percentage (ACP) tests, it can have several consequences. Employers may face pecuniary penalties, the disqualification of the plan, and even fiduciary liability. Corrective actions, such as refunding excess contributions, must be taken within a specified timeframe to avoid these penalties.
Are there any exemptions or exceptions for smaller companies regarding ADP and ACP tests?
Smaller companies may be eligible for certain exemptions or exceptions to ADP and ACP testing requirements. Companies with a limited number of employees or those that don’t have highly compensated employees (HCEs) may qualify for these exemptions. It’s essential to consult with a benefits specialist or legal counsel to determine eligibility.
How often do companies need to conduct ADP and ACP tests?
ADP and ACP tests are typically conducted annually. Employers must perform these tests after the close of the plan year. The results help companies ensure the compliance and fairness of their 401(k) plans for the benefit of all employees.
What is the purpose of Safe Harbor 401(k) plans, and are they suitable for all companies?
Safe Harbor 401(k) plans are designed to simplify compliance with ADP and ACP testing. These plans require employers to make eligible matching or nonelective contributions on behalf of their employees. While Safe Harbor plans offer benefits in terms of testing exemptions, they come with specific contribution requirements and may not be suitable for all companies. Employers should carefully assess their needs and consult with benefits experts to determine if Safe Harbor plans are the right choice.
Can companies set buffer zones to prevent ADP and ACP test failures?
Yes, some companies opt to set buffer zones within their 401(k) plan documents to reduce the risk of ADP and ACP test failures. These buffer zones may include contribution caps for highly compensated employees (HCEs) or contribution limits to ensure compliance. Employers may periodically conduct test projections to gauge whether any restrictions are necessary to maintain compliance.
Do ADP and ACP tests consider catch-up contributions made by employees aged 50 and over?
No, ADP and ACP tests do not consider catch-up contributions. These tests focus on the average salary deferral percentages of highly compensated employees (HCEs) compared to non-highly compensated employees (NHCEs). Catch-up contributions, which are available to employees aged 50 and over, are excluded from these calculations.
- ADP and ACP tests are vital for maintaining fairness and compliance in 401(k) plans.
- If a plan fails these tests, corrective actions must be taken to avoid penalties.
- Safe Harbor plans offer an alternative to avoid the complexity of ADP/ACP testing.
View article sources
- The plan failed the 401(k) ADP and ACP nondiscrimination … – IRS
- What is Actual Deferred Percentage (ADP)? – BambooHR
- 401(k) Plans For Small Businesses Supplement – US Department of Labour