What ADP and ACP tests are (plain definition)
– ADP (Actual Deferral Percentage) test: a compliance check that compares the average percentage of pay that highly compensated employees (HCEs) set aside into a 401(k) via pre‑tax deferrals and Roth deferrals to the average percentage deferred by non‑highly compensated employees (NHCEs). Its purpose is to prevent 401(k) plans from disproportionately favoring higher‑paid staff.
– ACP (Actual Contribution Percentage) test: a parallel check that compares employer matching contributions and employee after‑tax contributions made for HCEs versus NHCEs.
Key terms (defined)
– Highly Compensated Employee (HCE): an employee who either owned more than 5% of the company at any time during the current or prior plan year, or whose compensation exceeded the IRS threshold (for 2024 this was $155,000).
– Non‑Highly Compensated Employee (NHCE): an employee who is not an HCE.
– Catch‑up contributions: additional elective deferrals that employees aged 50 or older may make; these are excluded from the ADP and ACP calculations.
Why these tests matter
Plans must pass the ADP and ACP tests to keep their tax‑qualified status under IRS rules and ERISA. A failed test can trigger corrective actions, taxes for affected employees, potential penalties, and fiduciary exposure for the employer.
How the tests are calculated (conceptual)
– ADP compares the average deferral rate of HCEs to the average deferral rate of NHCEs, using only pretax and Roth deferrals and excluding catch‑ups.
– ACP compares the average employer match plus after‑tax employee contributions for HCEs to that for NHCEs.
– The tests limit how much higher the HCE average can be relative to the NHCE average. (Plan documents and the IRS set the exact tolerances and alternative methods; many employers use a maximum differential and multiplier approach.)
Common compliance outcomes and remedies
– If a plan fails ADP and/or ACP for a plan year, the employer generally has up to 12 months after the plan year to correct the failure.
– Typical corrective action is refunding the excess contributions (or “excess deferrals”) to HCEs in the amount necessary to bring the averages into compliance. Those refunds are taxable to the recipients.
– Employers may alternatively recharacterize or reallocate contributions where allowed by plan terms and IRS rules.
Practical ways employers reduce failure risk
– Mid‑year projections and testing to spot trouble early.
– Buffer zones or contribution caps on HCE deferrals written into the plan document.
– Sponsoring a safe harbor 401(k) design that makes the plan exempt from ADP/ACP and certain other nondiscrimination tests in exchange for meeting specific employer contribution requirements.
What a safe harbor 401(k) is
A safe harbor plan avoids ADP and ACP testing if the employer makes a required contribution for eligible employees. Typical safe harbor options include:
– A basic match such as 100% on the first 3% of deferrals and 50% on deferrals from 3% to 6%.
– Or a nonelective contribution of at least 3% of compensation to all eligible employees, regardless of whether they defer.
Checklist for plan sponsors (brief)
– Identify HCEs and NHCEs each plan year.
– Track pretax and Roth deferrals, employer matches, and after‑tax employee contributions separately.
– Run or arrange ADP and ACP testing promptly after year‑end; consider mid‑year projections.
– If a failure looks likely, plan corrective action: refund excesses or take permitted reallocation steps before the correction deadline.
– Consider adopting a safe harbor design if consistent tests failures are a concern.
– Update plan documents and participant communications to reflect any caps or safe harbor elections.
Worked numeric example
Assumptions
– Two HCEs:
– HCE A: salary $200,000, defers 5% → $10,000.
– HCE B: salary $150,000, defers 4% → $6,000.
– Group HCE average deferral = (10,000 + 6,000) / (200,000 + 150,000) = 16,000 / 350,000 = 4.57% (rounded).
– Suppose the NHCE group average deferral is 2.0%.
Test criterion (example rule)
– Employer’s plan requires that the HCE average not exceed the NHCE average by more than 2.0 percentage points. So the allowable HCE average ≤ 2.0% + 2.0% = 4.0%.
Determine failure and corrective amount
– Current HCE average ≈ 4.57%; allowable average = 4.0% → excess average = 0.57% of total HCE compensation.
– Total HCE compensation = $350,000. Required target total HCE deferrals = 4.0% × 350,000 = $14,000.
– Actual total HCE deferrals = $16,000 → required refund = $16,000 − $14,000 = $2,000.
– A simple pro‑rata refund: HCE A’s share = (10,000 / 16,000) × 2,000 = $1,250; HCE B’s share = (6,000 / 16,000) × 2,000 = $750.
– Note: the plan’s correction method must follow plan documents and IRS guidance; refunded amounts are generally taxable to recipients.
Practical notes and assumptions
– The numeric example uses a simplified allocation method for illustration; actual plans may use other IRS‑permitted correction methods.
– Contribution limits, compensation thresholds, and exact test formulas can change annually; always use current IRS figures for year‑specific calculations.
Selected reputable sources
– Investopedia — ADP and ACP Tests: https://www.investopedia.com/terms/a/actual-deferral-percentage-actual-contribution-percentage.asp
– Internal Revenue Service — 401(k) Resource Guide for Plan Sponsors (overview of rules and testing): https://www.irs.gov/retirement-plans/plan-sponsor/401k-resource-guide-plan-sponsors
– Internal Revenue Service — COLA Increases for Dollar Limitations on Benefits and Contributions: https://www.irs.gov/newsroom/cola-increases-for-dollar-limitations-on-benefits-and-contributions
– U.S. Department of Labor — 401(k) Plans and Guidance (ERISA perspective): https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/publications/401k-plan-fix-it-guide
Educational disclaimer
This explainer is educational only and does not constitute individualized tax, legal, or investment advice. For plan‑specific calculations, corrections, or decisions, consult your ERISA attorney, third‑party administrator, or tax advisor.