Understanding the IRS's ADP and ACP tests is critical when starting or managing a plan.
This guide will cover everything you need to know to pass the year-end ADP and ACP tests. We'll explore what they are, why they're important, and what to do if you fail.
What are ADP and ACP Tests?
These tests ensure fairness and balance in retirement plans, but they often go unnoticed in the 401(k) world.
The Actual Deferral Percentage (ADP) test focuses on how much employees contribute to their 401(k) plans. It compares the average deferral percentage of highly compensated employees (HCEs) to non-highly compensated employees (NHCEs). It checks if higher-paid employees contribute more to the 401(k) plan than lower-paid employees.
The Actual Contribution Percentage (ACP) test checks employer contributions, like matching or after-tax employee contributions. Like the ADP test, the ACP test compares the average contribution percentage of HCEs to that of NHCEs.
The ADP and ACP tests aim to prevent 401(k) plans from unfairly benefiting highly-paid employees.
What are HCEs and NHCEs?
Now that we've covered what ADP and ACP tests are let's get to know the key players in these tests:
2023 HCE Definition
An HCE is any individual who meets the following criteria:
- Holds more than 5% of the employer's interest, directly or through family attribution, at any point during 2023 or 2022, or
- Received eligible compensation that surpassed $135,000 in 2022 or $150,000 in 2023
Employers may also choose an alternative HCE definition in their plan document. Under the top-paid group election, the HCE limit includes the top 20% of wage earners.
2023 NHCE Definition
On the flip side, a NHCE is, quite simply, everyone else.
What is the ADP Test?
The Actual Deferral Percentage (ADP) test compares the average 401(k) savings rates of highly compensated employees (HCEs) to non-highly compensated employees (NHCEs). To pass these tests HCEs and NHCEs must join and save at similar rates.
- Step 1: Calculate the deferral percentage (ADP%) for each employee. Simply divide the employee's 401(k) contributions by their total plan eligible compensation.
- Step 2: Calculate the average ADP% for HCEs and NHCEs.
- Step 3: Compare the average ADP for the HCE group vs. the NHCE group.
To pass these tests, the ADP% for both groups must be relatively close.
What is the ACP Test?
The Actual Contribution Percentage test (ACP) ensures that HCEs and NHCEs receive similar company contributions. It is like the ADP test, but instead of looking at employee deferrals, it focuses on employer contributions. This includes any matching contributions made by the employer or after-tax contributions made by the employee. To pass the ACP, the average contribution percentage for both groups needs to be relatively close.
2023 ADP/ACP Testing Limits
The same limits apply to both the ADP and ACP tests. The maximum deferral and contribution percentages for HCE’s are based on the ADP%/ACP% of the NHCEs as follows:
What Happens if a Plan Fails ADP or ACP Testing?
Failing the ADP/ACP is serious because it could potentially jeopardize the tax-advantaged status of the plan. But don't worry; two easy options exist for fixing a failed ADP/ACP test.
Option 1: Refund HCE Contributions
The first remedy is to refund enough HCE contributions to pass the tests.
For plans that do not have an EACA arrangement, you must give refunds 2.5 months after the plan year ends or face a 10% tax on extra contributions. If you don't process refunds within 12 months, the plan may lose its tax qualification status.
Option2: Make Contributions to NHCEs:
The employer can make additional contributions to the 401(k) accounts of NHCEs, known as Qualified Non-Elective Contributions (QNECs). QNECs effectively increase the deferral percentage or matching rate of NHCEs to bring the plan within ADP/ACP limits.
The Impact on Employees
Now let's look at the people involved in ADP and ACP tests: the employees.
While refunding HCE contributions doesn't cost money, it can likely frustrate HCEs. Taxpayers must report HCE refunds as ordinary income in the year they receive them. This means that your HCEs are going to have an unexpected tax bill.
On the other hand, you can make additional contributions to NHCEs. However, this can become expensive, especially if you fail these tests year after year.
How to Avoid Failing ADP or ACP Tests
So, how can employers avoid failing these tests?
#1 Adopt Safe Harbor
One of the most effective ways to avoid failing ADP or ACP tests is to adopt a Safe Harbor plan provision. A Safe Harbor 401(k) plan may allow employers to pass the ADP and ACP tests automatically. Employers must make a Safe Harbor match or a Safe Harbor non-elective follow a few simple rules.
#2 Boost Participation
While adopting a Safe Harbor plan can be an effective strategy, it's not the only one. Employers can also encourage broader participation in the 401(k) plan among NHCEs or explore adopting certain plan designs that help you pass the ADP test.
#3 Customize eligibility
Plans with high employee turnover may be able to improve ADP/ACP tests results by increasing 401(k) Eligibility. If an employee does not plan on working at your company for very long, they may be less likely to save into the plan. By requiring employees to work for a longer period of time, you may end up with a pool of NHCEs that are more likely to save.
#4 Cap HCE contributions
Another strategy is to limit the contributions of HCEs. Of course, this might not be too popular with HCEs.
Frequently Asked Questions
Are Catch-up Contributions Included in ADP Test?
No. The ADP test ignores 50+ Catchup Contributions when calculating the deferral percentage for HCEs and NHCEs.
Are After-Tax Contributions Included in the ADP or ACP Test?
The ADP test ignores after-tax contributions when calculating the deferral percentage. However, the ACP test does consider after-tax contributions. Allowing after-tax contributions can be a great strategy for plan sponsors who fail the ADP test.
What happens if you fail the ACP Test?
If a 401(k) plan fails the ACP test, they have 12 months from the end of the plan year to either return HCE contributions or make additional contributions to NHCEs. Companies that do not correct the failure by the deadline, risk significant IRS penalties including plan disqualifications.
What happens if you fail the ADP Test?
If a 401(k) plan fails the ADP test, they have 12 months from the end of the plan year to either return HCE contributions or make additional contributions to NHCEs. Companies that do not correct the failure by the deadline, risk significant IRS penalties including plan disqualifications.
What does a failed ADP Test Mean?
A failed ADP test indicates that HCEs are participating and saving into the plan at significantly higher rates than NHCEs. To correct a failed ADP test, the company needs to either return HCE contributions or make additional contributions to NHCEs until they pass the ADP limits. Failing to make corrections within 12 month of the end of the plan year could result in significant IRS penalties, including plan disqualification.
What does a failed ACP Test Mean?
A failed ADP test indicates that HCEs received significantly more company contributions than NHCEs or HCEs made significantly more after-tax contributions. To correct a failed ACP test, the company needs to either: (1) return company contributions or after tax contributions to HCEs; or (2) make additional contributions to NHCEs. Companies that fail to correct the failure within 12 month of the end of the plan year may face significant IRS penalties, including plan disqualification.
Remember, these tests ensure that 401(k) plans don't favor higher earners over lower earners. By understanding these tests, employers and employees can better navigate the 401(k) landscape and work towards a secure retirement.